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

A manager runs a long-only minimum-volatility strategy that has delivered a positive alpha against the market over the past decade. A risk officer regresses the strategy's excess return on market, value, size, momentum and quality factors. The market beta is 0.70, and the alpha becomes statistically insignificant once the quality and profitability loadings are included. What is the most appropriate conclusion?

The outperformance is largely explained by exposure to other known factors such as quality and profitability, so it does not demonstrate independent skill. Once those loadings are included the alpha is insignificant, showing the strategy captures factor premia rather than unexplained excess return.

  1. AThe strategy's outperformance is largely explained by exposure to other known factors, so it is not evidence of independent skillCorrect
  2. BThe strategy has no risk exposure because its beta is below 1
  3. CThe original alpha must be correct, and the multi-factor regression is misspecified
  4. DThe strategy will necessarily outperform in all market regimes going forward

Explanation

When alpha vanishes after adding factors, the return is compensation for factor exposures rather than unexplained skill. Low-risk portfolios often load on quality and profitability, so this is a common finding. A low market beta does not mean absence of other risks, and nothing guarantees future outperformance.

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