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FRM Part II · FRM Exam Part II · Factors

A risk manager reviews a long-short factor portfolio built by sorting stocks into quintiles on a value signal. The manager wants to tighten implementation to reduce turnover and trading costs while preserving most factor exposure. Which change is the most consistent with that goal, and what is its main drawback?

Using buffer zones is the best choice: holdings are kept until they move well past the quintile cutoff, which cuts turnover and trading costs. The drawback is that retained stocks somewhat dilute pure factor exposure, so there is a trade-off between implementation cost and signal strength.

  1. ARebalance daily to the exact quintile cutoffs; the drawback is lower exposure to the signal
  2. BUse buffer zones so existing holdings are retained until they move well beyond the cutoff; the drawback is some dilution of pure factor exposureCorrect
  3. CEqual-weight the extreme decile only; the drawback is higher diversification
  4. DUse market-cap weights within quintiles; the drawback is lower capacity

Explanation

Buffering lets holdings stay in the portfolio until they drift well past the cutoff, lowering turnover and cost, but stale positions slightly dilute the purity of factor exposure. Daily exact rebalancing raises turnover. Concentrating on the extreme decile raises concentration, not diversification, and cap weighting would typically reduce, not raise, capacity concerns in the stated way.

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