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FRM Part II · FRM Exam Part II · Factor Theory

A pension fund's investment committee is comparing two approaches to building a portfolio. Approach A divides capital among equities, bonds, and commodities by asset class. Approach B divides capital among value, momentum, carry, and low-volatility style factors. Which statement best captures the main rationale offered by factor-based allocation for Approach B?

Factor-based allocation is justified because different asset classes often load on the same underlying risk factors. Looking only at asset class labels can hide concentrated exposures, while allocating across factors shows the true sources of risk and return. It neither removes systematic risk nor guarantees positive factor returns.

  1. AAsset class labels are the most reliable way to identify distinct sources of risk and return
  2. BAssets in different classes can share exposure to the same underlying risk factors, so allocating by factors shows the true sources of riskCorrect
  3. CFactor allocation removes all systematic risk from the portfolio
  4. DFactor allocation guarantees positive returns for each factor over any holding period

Explanation

Factor theory holds that asset classes are bundles of underlying factor exposures, and different asset classes can load on the same factors (for example, equity and credit both carry economic growth risk). Allocating by factors reveals and controls these exposures. It does not eliminate systematic risk or guarantee factor returns, which can be negative for long periods.

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