FRM Part II · FRM Exam Part II · Portfolio Construction
A pension fund wants to replace a market-cap-weighted equity allocation with a rules-based smart beta strategy that tilts toward stocks with low price-to-book ratios. Which statement best describes the main source of expected excess return the fund is seeking?
The fund is seeking a systematic value factor premium. Smart beta captures compensation for factor exposure, such as low price-to-book stocks, through transparent rules rather than discretionary stock picking, and it intentionally accepts tracking error against the cap-weighted benchmark.
- ACompensation for bearing exposure to a systematic value factor premiumCorrect
- BSuperior security selection from discretionary manager forecasts
- CReduction of all systematic risk through diversification across many stocks
- DElimination of tracking error relative to the cap-weighted benchmark
Explanation
Smart beta strategies seek returns from systematic factor exposures such as value, which are rewarded risk premia or behavioral premia, delivered through transparent rules. Option B describes active alpha. Option C is incorrect because diversification cannot remove systematic risk. Option D is wrong because a factor tilt deliberately creates tracking error versus the cap-weighted index.
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