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FRM Part II · FRM Exam Part II · Alpha (and the Low-Risk Anomaly)

A common behavioral and institutional explanation for the low-risk anomaly is that many investors face leverage constraints. Which of the following is the most consistent implication of this explanation?

Leverage-constrained investors cannot borrow to scale up a diversified portfolio, so they overweight high-beta stocks to chase return. This demand overprices high-beta stocks and lowers their subsequent returns, while low-beta stocks are relatively underpriced, producing the flat security market line.

  1. AConstrained investors overweight high-beta stocks to reach target returns, bidding up their prices and lowering their future returnsCorrect
  2. BConstrained investors overweight low-beta stocks, raising their prices and lowering their future returns
  3. CConstrained investors hold only the risk-free asset, so betas are irrelevant
  4. DConstrained investors short high-beta stocks, causing them to be underpriced

Explanation

Investors who cannot lever up seek higher return by tilting toward high-beta stocks. This extra demand raises their prices and reduces expected returns, flattening the security market line. The low-beta overweight option gets the direction wrong.

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