Free CFA Level III: Portfolio Management Index-Based Equity Strategies Practice Questions
Index-based equity strategies on CFA Level III cover index construction methodologies, full and stratified replication, tracking error management, and factor-based (smart beta) index strategies.
Sample Questions
Question 1
Easy
Cash drag in an index fund refers to the performance impact of:
Solution
C is correct.
Cash drag occurs when an index fund holds uninvested cash from received dividends, new investor subscriptions, or pending corporate actions. Because the index assumes full investment at all times, the fund's cash position creates a return difference. In rising markets, cash drag causes underperformance; in declining markets, it can provide a small buffer.
Cash drag occurs when an index fund holds uninvested cash from received dividends, new investor subscriptions, or pending corporate actions. Because the index assumes full investment at all times, the fund's cash position creates a return difference. In rising markets, cash drag causes underperformance; in declining markets, it can provide a small buffer.
Question 2
Medium
Compared to market-cap-weighted indices, factor-based indices typically have:
Solution
C is correct.
Factor-based indices require periodic reconstitution to update factor scores and rebalance to target weights. As stocks' factor characteristics change (e.g., a value stock becomes fairly valued, a momentum stock reverses), the index must add and remove constituents, generating higher turnover than a market-cap-weighted index, which is largely self-rebalancing (prices adjust weights automatically).
Factor-based indices require periodic reconstitution to update factor scores and rebalance to target weights. As stocks' factor characteristics change (e.g., a value stock becomes fairly valued, a momentum stock reverses), the index must add and remove constituents, generating higher turnover than a market-cap-weighted index, which is largely self-rebalancing (prices adjust weights automatically).
Question 3
Hard
Using the factor weights, volatilities, and pairwise correlations in Exhibit 2, the expected standard deviation of the factor-return component of Sharma's multi-factor smart beta sleeve is closest to:
Solution
A is correct. Portfolio variance for three factors is Variance terms: ; ; . Covariance terms: V-Q = ; V-LV = ; Q-LV = . Total variance = 10.24 + 2.25 + 3.24 + 0.96 − 2.304 + 1.62 = 16.006, so The negative Value-Low Vol correlation meaningfully reduces combined factor-return volatility, illustrating the diversification benefit of combining factors with offsetting cyclical behavior.