FRM Part II · FRM Exam Part II · Portfolio Construction
A portfolio manager builds a long-only smart beta equity portfolio by selecting stocks with the lowest trailing volatility and weighting them equally. Which statement best describes the main risk of this approach relative to a cap-weighted benchmark?
The main risk is unintended concentration: low-volatility screening overweights defensive sectors and creates interest-rate sensitivity, which generates tracking error against a cap-weighted benchmark. It does not remove market exposure or guarantee outperformance in rising markets, where low-volatility portfolios usually lag.
- AIt has no tracking error because it holds the same stocks as the benchmark
- BIt introduces concentrated, unintended sector and interest-rate sensitivity exposures that can drive tracking errorCorrect
- CIt eliminates all exposure to the market factor
- DIt guarantees higher returns than the benchmark in rising markets
Explanation
Low-volatility screens tend to overweight defensive sectors such as utilities and staples and carry bond-like rate sensitivity. These unintended tilts produce tracking error versus a cap-weighted benchmark. Market beta is reduced, not eliminated, and outperformance in rising markets is not guaranteed; low-vol portfolios typically lag then.
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