Free CFA Level III: Portfolio Management Index-Based Equity Strategies Practice Questions

B 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.
A is incorrect because borrowing to fund derivatives is a leverage decision, not cash drag.
C is incorrect because management fee payments reduce NAV but are a separate cost, not cash drag per se.

B 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).
A is incorrect because while some factor characteristics exhibit persistence, they are not perfectly stable. Significant reconstitution occurs, particularly for momentum-based indices.
C is incorrect because market-cap-weighted indices have inherently low turnover (the primary driver being index additions/deletions and corporate actions), while factor indices have additional turnover from factor score changes.

A is correct. A multi-factor approach that combines factors with low inter-factor correlation (value and momentum are historically negatively correlated) and uses equal risk contribution achieves diversification across factor premiums. This tends to reduce maximum drawdown compared to any single factor index and provides more consistent performance across different market environments because individual factor underperformance is offset by other factors.
B is incorrect because combining factors with low correlation typically reduces concentration. Stocks that score high on value may score low on momentum, so the resulting portfolio is more diversified.
B is incorrect because while multi-factor portfolios deviate from cap-weighted benchmarks, the diversification among factors tends to reduce aggregate tracking error compared to concentrated single-factor bets.