FRM Part II · FRM Exam Part II · Factor Theory
A risk manager reviews a smart beta ETF whose backtest shows strong factor returns but whose assets under management have grown tenfold. Which risk is most directly heightened by this growth?
Capacity and crowding risk rises. As assets grow, more capital chases the same factor exposures, which can compress the premium, and larger trades in less liquid stocks raise market impact costs. Backtested returns usually ignore these effects, so realized performance can fall short.
- AReduced factor premium due to crowding and higher trading costs from capacity limitsCorrect
- BLower exposure to the targeted factor from diversification
- CElimination of rebalancing turnover
- DLower tracking error relative to the factor index
Explanation
As assets in a factor strategy grow, crowding can compress the premium, and trading larger sizes in less liquid names raises market impact costs. Backtests ignore these capacity effects.
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