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FRM Part II · FRM Exam Part II · Factor Theory

An asset owner replaces a market-cap-weighted equity mandate with a smart beta product that weights stocks by fundamentals such as book value, sales, and dividends. Relative to the cap-weighted index, which effect is the product most likely to produce?

Fundamental weighting produces an implicit value tilt. Weights depend on measures like book value and sales rather than price, so stocks that look cheap relative to fundamentals receive more weight than in a cap-weighted index. Market beta remains and outperformance is not guaranteed.

  1. AImplicit tilt toward value stocks because weights no longer rise with priceCorrect
  2. BImplicit tilt toward growth stocks because weights follow earnings momentum
  3. CElimination of all exposure to the market factor
  4. DGuaranteed positive alpha after fees

Explanation

Cap weighting increases weight as price rises. Fundamental weighting ties weights to economic size rather than price, so cheaper stocks (high fundamentals relative to price) get larger weights, creating a value tilt. Market exposure remains, and alpha is not guaranteed.

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