Passive Equity Investing Core Practice Question

CFA Level III
#1

When comparing factor-based strategies relative to the market-cap weighting of an index, Stapleton’s comments are most likely:

My View - Both are transparent, rule based and investable. Then why transparency is a relative characteristic. So he is incorrect about transparency

  2. A.correct.

  3. B.incorrect regarding transparency.

  4. C.incorrect regarding risk exposure.

Solution

  1. Incorrect. Stapleton’s comment is correct regarding transparency but incorrect regarding risk exposure. Passive factor-based strategies tend to be transparent in terms of factor selection, weighting, and rebalancing. The strategies can be easily replicated by other investors which can produce overcrowding and reduce the realized advantages of a strategy. Relative to broad-market-cap-weighting, passive factor-based strategies tend to concentrate risk exposures, leaving investors exposed during periods when a chosen risk factor is out of favor.
  2. Incorrect. Stapleton’s comment is correct regarding transparency. Passive factor-based strategies tend to be transparent in terms of factor selection, weighting, and rebalancing. The strategies can be easily replicated by other investors which can produce overcrowding and reduce the realized advantages of a strategy.
  3. Correct. Stapleton’s comment is incorrect regarding risk exposure. Relative to broad-market-cap-weighting, passive factor-based strategies tend to concentrate risk exposures, leaving investors exposed during periods when a chosen risk factor is out of favor.