FRM Part II · FRM Exam Part II · Factors
A pension fund replaces its market-capitalization-weighted equity index with a smart beta product that weights stocks by fundamental measures such as book value, sales and dividends. Relative to the cap-weighted index, which exposure is this approach most likely to introduce as a by-product?
The fundamental-weighted portfolio tends to carry a value tilt. Because weights depend on book value, sales or dividends rather than price, expensive stocks are underweighted and cheap stocks overweighted relative to a cap-weighted index. It does not introduce momentum or remove factor exposures.
- AA tilt toward value stocks, because weights no longer rise with priceCorrect
- BA tilt toward momentum stocks, because weights follow recent returns
- CA tilt toward large-cap growth stocks, because sales are weighted heavily
- DA reduction in all factor exposures, because weights become independent of prices
Explanation
Fundamental weighting sets weights independently of market price. Stocks whose prices are high relative to fundamentals are underweighted versus cap weighting, and cheap stocks are overweighted, which creates an implicit value tilt. Momentum is not targeted, and the approach does not remove factor exposure.
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