FRM Part II · FRM Exam Part II · Factor Theory
A portfolio manager wants to diversify across factors using the approach in which the investor allocates to factor premiums whose returns are driven by different economic states. Which combination best illustrates this principle?
The best illustration is combining equity risk with a defensive low-volatility factor and an inflation-linked exposure, because they respond to different macroeconomic states. Equity and high-yield credit share growth risk, and doubling up on one factor concentrates risk instead of diversifying it.
- ACombining value and a deep-value equity sector tilt that both gain in the same recoveries
- BCombining equity market risk and a high-yield credit spread exposure
- CCombining equity risk with a defensive, low-volatility factor and an inflation-linked exposure that perform well in different macro statesCorrect
- DDoubling the allocation to the single factor with the highest historical Sharpe ratio
Explanation
Diversification across factors works best when the factors respond to different macro states such as growth, inflation, and risk aversion. Equity and high-yield credit share growth risk, and two value-type tilts duplicate exposure. Concentrating in the highest past Sharpe ratio factor raises concentration and estimation risk.
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