Volume 6 page 208 BB 9 Q 2 :

Process based on timing the fund’s exposure to systematic risk Which BM is suitable?

I do not understand this q- how does it relate to BM and factors?

Thanks in advance.

The systematic risks targeted by the equity manager are represented by Factors. For example, you could be targeting Market factor and Size factor. And let’s say your expectations is the broad equity market will rise (so you will want to hold a portfolio with Market Beta > 1) and small caps will outperform large caps (so your portfolio will have Beta(SMB) > 1.

So to construct your benchmark, you will select stocks with higher market risk and small caps (the universe of stocks that fits your investment mandate), then run the regression to get the model for the benchmark , say:

Ri = 0.03 + 1.1 x RMRF + 1.2 x SMB

In your case, if you strongly believe stocks with higher market risk and small caps will outperform, then you will pick a portfolio such that (coefficients are arbitrary, look at the overweighting):

Rp = 0.03 + 1.3 x RMRF + 1.4 x SMB

So your portfolio will outperform the benchmark if your expectations are correct.

If somehow, along the way, your expectations have changed and now you think large caps will outperform small caps then your coefficient to SMB has to be lower than 1.2 if you want your portfolio to outperform the benchmark. The ability to time the factor exposure is what creates alpha.