A high-net-worth client with a long-term investment horizon and an aggressive risk tolerance is considering adding a new Canadian small-cap equity fund to their diversified portfolio. The portfolio currently holds large-cap Canadian equities, global fixed income, and a real estate allocation. Which type of risk is the fund manager primarily trying to mitigate by selecting a small-cap fund with low correlation to the existing large-cap holdings?

Question: A high-net-worth client with a long-term investment horizon and an aggressive risk tolerance is considering adding a new Canadian small-cap equity fund to their diversified portfolio. The portfolio currently holds large-cap Canadian equities, global fixed income, and a real estate allocation. Which type of risk is the fund manager primarily trying to mitigate by selecting a small-cap fund with low correlation to the existing large-cap holdings?

Answer options:

• Interest rate risk, by diversifying across different asset classes.
• Systematic risk, by selecting assets with higher individual volatility. ✅ Unsystematic risk, by adding an asset class that is less correlated with current holdings.
• Liquidity risk, due to the generally higher trading volume of small-cap stocks.

Correct answer: Unsystematic risk, by adding an asset class that is less correlated with current holdings.

Explanation: Unsystematic risk (or diversifiable risk) is reduced by combining assets that are not perfectly positively correlated. By adding a small-cap fund with low correlation to existing large-cap holdings, the portfolio manager aims to diversify away some of the specific risks associated with the large-cap exposure, thus reducing overall unsystematic risk.