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

A fund compares two low-risk implementations for a benchmark with market beta 1.0. Fund A is long-only, holds low-volatility stocks with beta 0.7, and earns an alpha of 1.5% over the CAPM benchmark. Fund B is a BAB long-short fund with a zero beta. Risk-free rate is 2%, market premium is 6%, and Fund A's total return is 7.7%. Which statement is correct?

Fund A's CAPM-expected return is 2% plus 0.7 times 6%, or 6.2%, so its 7.7% return implies alpha of 1.5%. The fund still bears 0.7 market beta, which a market-neutral long-short BAB construction would hedge away.

  1. AFund A's CAPM-expected return is 6.2%, its alpha is 1.5%, and it still carries 0.7 market exposure that a long-short design would hedgeCorrect
  2. BFund A's CAPM-expected return is 6.2%, so its alpha is 1.5% and its market exposure is zero
  3. CFund A's CAPM-expected return is 8.0%, so its alpha is negative
  4. DFund A's CAPM-expected return is 4.2%, so its alpha is 3.5%

Explanation

Expected return = 2% + 0.7×6% = 6.2%. Alpha = 7.7% - 6.2% = 1.5%, consistent with the data. The fund still has beta 0.7, so market risk remains; a market-neutral BAB design removes that exposure. Option 3 uses beta 1, option 4 omits the risk-free rate.

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