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

A mutual fund manager is evaluated against a benchmark using tracking error and receives bonuses for outperforming the index. Which behavior, associated with benchmarking, helps explain the persistence of the low-risk anomaly?

Benchmarked managers with limited leverage and relative-return incentives tilt toward high-beta stocks to try to beat the index. This extra demand overprices high-beta stocks and depresses their subsequent risk-adjusted returns, so the low-risk anomaly persists because benchmarking constrains arbitrage.

  1. AManagers overweight low-beta stocks because they reduce tracking error against the benchmark
  2. BManagers with limited ability to lever tilt toward high-beta stocks to beat the benchmark, since low-beta stocks seldom outperform it in rising markets, and this pushes up prices of high-beta stocksCorrect
  3. CManagers hold equal-weighted portfolios to match the index's volatility
  4. DManagers short high-beta stocks aggressively to exploit mispricing

Explanation

Benchmarked managers are rewarded for relative outperformance and often cannot use leverage, so they buy high-beta stocks to gain excess return. This demand overprices high-beta stocks. Option A states the opposite behavior, and arbitrageurs shorting high-beta stocks would remove the anomaly.

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