FRM Part II · FRM Exam Part II · Portfolio Construction
A pension fund replaces a capitalization-weighted equity index allocation with a single-factor smart beta product that weights stocks by their book value. Compared with the cap-weighted index, which outcome is the most likely consequence of this change?
Weighting by book value rather than market capitalization overweights cheap stocks (low price-to-book) and underweights expensive ones, creating a systematic value tilt. The portfolio stays long-only equity, so it retains market exposure and has non-zero tracking error versus the cap-weighted index.
- AThe portfolio gains a systematic tilt toward value stocks and away from large-cap growth stocksCorrect
- BThe portfolio becomes market neutral because weights no longer depend on price
- CThe portfolio's tracking error to the cap-weighted index falls to zero
- DThe portfolio eliminates exposure to the market factor
Explanation
Weighting by book value rather than market value overweights stocks with low price-to-book ratios and underweights those with high ratios, creating a value tilt. The portfolio remains long-only equities, so it keeps market beta and has positive tracking error to the cap-weighted index.
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