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FRM Part II · FRM Exam Part II · Factors

A risk manager adds the Fama-French HML factor to a CAPM regression for a deep-value equity fund and finds that the fund's CAPM alpha of 2% per year falls to nearly zero, with a significantly positive HML loading. What is the best conclusion?

The CAPM alpha mostly reflected exposure to the value factor rather than skill. Once HML is included, the positive loading explains the excess return, so the alpha disappears. Alpha is only meaningful relative to the factor model used, and omitted factors can masquerade as manager skill.

  1. AThe CAPM alpha largely reflected compensation for systematic value exposure rather than manager skillCorrect
  2. BThe fund manager has demonstrated greater skill after controlling for HML
  3. CThe HML factor is invalid because it reduced the alpha
  4. DThe fund's market beta must have been mis-estimated and equals zero

Explanation

Alpha measured against an incomplete model can capture return from omitted factors. Once HML is included, the value premium explains the return, so the apparent alpha was factor exposure. It does not show greater skill, invalidate HML, or imply a zero beta.

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