FRM Part II · FRM Exam Part II · Factor Theory
A risk manager reviews a multi-factor smart beta portfolio that combines value, momentum, and low volatility sleeves. The manager observes that in a market crash, the momentum sleeve and the value sleeve experienced sharp simultaneous losses even though their average correlation is low. Which is the most appropriate conclusion?
Factor correlations are not stable and can rise during market stress, so the diversification gained from combining factors may weaken in crashes. Low average correlation does not rule out simultaneous losses, and such losses do not show that the premia are absent.
- AFactor correlations are stable, so diversification benefits persist in all regimes
- BFactor correlations can rise in stress periods, so diversification benefits from combining factors may weaken when most neededCorrect
- CLow average correlation implies the sleeves cannot lose simultaneously
- DThe losses prove that the factors carry no risk premium
Explanation
Correlations between factor returns are time-varying and tend to increase in stress, so unconditional low correlation overstates crisis diversification. Simultaneous losses do not disprove a premium; premia compensate for bearing such bad-times risk.
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