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

A fund manager argues that the low-risk anomaly persists because many institutional investors are evaluated against a market-capitalization benchmark with a fixed tracking-error limit, and are not allowed to use leverage. Which behavior does this most plausibly produce?

Benchmarked managers who cannot use leverage and want to outperform tend to overweight high-beta stocks to gain extra market exposure. That crowding overprices high-beta stocks and lowers their subsequent risk-adjusted returns, sustaining the low-risk anomaly.

  1. AManagers overweight low-beta stocks to reduce tracking error
  2. BManagers who want to outperform overweight high-beta stocks rather than lever the benchmark, since they cannot take beta through leverageCorrect
  3. CManagers short high-beta stocks to arbitrage the mispricing
  4. DManagers hold only cash to avoid benchmark risk

Explanation

Benchmarked, unlevered managers seeking to beat the index must take extra market exposure through high-beta stocks. This demand overprices them and lowers their expected returns. Low-beta overweighting would reduce expected outperformance, so it is not what these constraints encourage.

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