Skip to content

FRM Part II · FRM Exam Part II · Factor Theory

A pension fund compares two ways of diversifying its portfolio: spreading capital across asset classes (equities, credit, real estate, commodities) versus spreading risk across underlying factors (equity risk, rates, inflation, liquidity). In a market crisis, most of the asset classes fall together. Which statement best explains why the asset-class approach delivered less diversification than expected?

Asset classes that look different often share the same underlying factor exposures, especially equity market risk. When that common factor falls in a crisis, they decline together, so asset-class diversification is weaker than it appears. Allocating across factors addresses the real drivers of risk.

  1. AAsset classes carry no factor exposure, so correlations are driven only by manager skill
  2. BMany asset classes load heavily on the same underlying factor, such as equity market risk, so they fall together in stressCorrect
  3. CFactor diversification always increases expected returns, whereas asset-class diversification does not
  4. DAsset-class correlations are constant over time, so stress adds no new information

Explanation

Different asset classes often share exposure to common factors, notably equity market risk and illiquidity. When that factor suffers, they decline together, so labels overstate diversification. Factor-based allocation looks through labels to the true risk drivers. The other options misstate the facts: correlations rise in stress, and diversification does not guarantee higher returns.

Did you get it right without looking?

One question tells you little. A timed set on Factor Theory shows your real accuracy, how long you take and where you lose marks.

Practise Factor TheoryFree diagnostic mock

More Factor Theory questions