FRM Part II · FRM Exam Part II · Factors
An analyst adds the momentum factor (UMD) to the Fama-French three-factor model to evaluate a fund. The fund's alpha falls from 2.4% to 0.3% annually and becomes statistically insignificant, while it has a significant positive loading on UMD. What is the best conclusion?
Most of the original alpha was return from momentum exposure rather than skill. Once UMD is included, alpha drops from 2.4% to an insignificant 0.3% and the fund loads positively on momentum, so the three-factor alpha was overstated by an omitted factor.
- AMost of the original alpha was compensation for exposure to momentum rather than manager skillCorrect
- BThe fund has no exposure to the market factor
- CThe momentum factor is a measure of firm size and so duplicates SMB
- DThe original alpha was understated by the three-factor model
Explanation
When an added factor absorbs most of the alpha and the fund loads positively on it, the earlier alpha was largely factor return from momentum exposure. It indicates the three-factor alpha was overstated, not understated. Momentum is based on past returns, not size, and the result says nothing about market beta.
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