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

A long-only low-volatility equity strategy tends to be overweight utilities and consumer staples and has a market beta well below 1. Which is the key risk an investor should expect when benchmarking the strategy to a cap-weighted index?

The investor should expect sizeable tracking error and probable lagging in strong bull markets led by high-beta stocks. Sector concentration and low beta make the strategy differ from the cap-weighted benchmark, so relative performance can be poor even if absolute risk-adjusted returns are attractive.

  1. ALarge tracking error and likely underperformance in strong bull markets driven by high-beta stocksCorrect
  2. BGuaranteed outperformance in every market environment
  3. CZero tracking error because of the low beta
  4. DHigh exposure to the size factor through large-cap growth stocks

Explanation

Sector and beta tilts create active risk relative to a cap-weighted index. In sharp rallies led by high-beta stocks, a low-beta portfolio typically lags. Low beta lowers market sensitivity but does not eliminate tracking error, and no outperformance is guaranteed.

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