Impact of Factor Correlation on Quantitative Equity Strategies

Very Hard Active Equity Investing Quantitative Strategies

As a portfolio manager at an investment firm, you are tasked with evaluating a quantitative equity strategy aimed at generating excess returns over the benchmark by utilizing factor models. The strategy focuses on identifying stocks exhibiting strong value and momentum characteristics. Recently, data analysis has shown that the correlation between value and momentum factors has increased, raising concerns about the stability and efficacy of the strategy during varying market conditions. In light of this, you must consider how the interaction of these factors may impact the overall risk-return profile of the strategy.

Given this situation, which of the following statements about the potential impacts of increased correlation between value and momentum factors in a quantitative equity portfolio is most accurate?

Increased correlation between value and momentum factors is likely to enhance the portfolio's risk-adjusted returns by providing diversification benefits.

Higher correlation between value and momentum factors may lead to increased concentration in certain stocks, thereby increasing idiosyncratic risk and potential drawdowns.

The growth in correlation will likely have no impact on the strategy since both factors are independently effective in generating alpha.

Hint

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