FRM Part II · FRM Exam Part II · Portfolio Construction
A risk manager reviews an equal-weighted smart beta equity portfolio of 500 stocks that is rebalanced quarterly. Compared with the market-cap-weighted index, which characteristic is the most likely implicit exposure that should be monitored?
An equal-weighted portfolio implicitly tilts toward small-cap stocks and has higher turnover. Each stock gets the same weight regardless of size, so small caps are overweighted relative to the index, and periodic rebalancing back to equal weights trades frequently, raising costs and tracking error.
- AA tilt toward small-cap stocks and higher turnoverCorrect
- BA tilt toward large-cap stocks and lower turnover
- CZero exposure to the size factor
- DLower tracking error because weights are more diversified
Explanation
Equal weighting gives small companies far more weight than their market cap, creating an implicit size tilt, and rebalancing back to equal weights generates turnover and liquidity costs. Option B is the reverse. Option C is wrong given the size tilt. Option D is wrong because equal weighting typically increases tracking error versus cap-weighted.
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