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

A manager's portfolio has a monthly alpha of 0.20% from a single-factor regression on the market. Adding value, size and momentum factors to the regression reduces the estimated alpha to 0.02% and it becomes statistically insignificant. What is the most appropriate conclusion?

Most of the original alpha was actually compensation for exposure to value, size and momentum factors, which is alternative beta rather than skill. Alpha is measured relative to the factor model, so when more factors are included the unexplained return shrinks.

  1. AThe manager's skill is confirmed because the market-model alpha was positive
  2. BMost of the original alpha was compensation for exposure to systematic factors, i.e., alternative betaCorrect
  3. CThe multi-factor model is misspecified because alpha should not change when factors are added
  4. DThe manager generated alpha purely from market timing

Explanation

Alpha is the return unexplained by the chosen benchmark factors. When added factors absorb it, the earlier alpha reflected factor premia (smart or alternative beta) rather than skill. Alpha depends on the model, so a change is expected, not a flaw.

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