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FRM Part II · FRM Exam Part II · Factors

An asset owner builds a multi-factor equity portfolio and compares two approaches: (A) combining separate single-factor portfolios (value, momentum, quality) with equal allocations, and (B) selecting stocks that score well on a composite of all three factors. Which statement best describes the typical difference?

The integrated composite approach tends to hold stocks with moderate exposure to every factor, which can capture interaction benefits when factors are negatively correlated. Combining separate single-factor portfolios still diversifies across factor returns but holds stocks strong on one factor and possibly weak on others.

  1. AApproach A always gives higher factor exposure per stock because each stock is chosen for one factor only
  2. BApproach B tends to hold stocks with moderate exposure to all factors, which can capture interaction benefits when factors are negatively correlatedCorrect
  3. CApproach B cannot be implemented without leverage
  4. DApproach A cannot benefit from diversification across factor returns

Explanation

An integrated composite score favors stocks that rank reasonably well on every factor, which can capture cross-factor interactions, especially when factors are negatively correlated. Approach A diversifies across factor returns but holds stocks with strong exposure to one factor and possibly weak exposure to others. Neither requires leverage.

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