FRM Part II · FRM Exam Part II · Factor Theory
An asset owner wants to decide how to allocate to several rewarded factors. Which consideration is most consistent with factor theory when judging whether a factor deserves a strategic allocation?
A factor merits strategic allocation when it offers a persistent premium with a credible rational, behavioral or structural explanation and diversifies other holdings. Short-term performance, index weight or popularity do not establish a durable reward for bearing the factor's risk.
- AWhether the factor has a persistent risk premium supported by a rational, behavioral or structural explanation and low correlation to other factorsCorrect
- BWhether the factor performed best over the past quarter
- CWhether the factor has a market-capitalization weight in the index
- DWhether the factor name is widely used by marketers
Explanation
Strategic factor allocation should rely on factors with persistent premiums grounded in economic, behavioral or structural reasoning, and ideally diversifying behavior. Recent performance is a poor basis, and index weight or popularity says nothing about expected premium.
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