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

A pension fund considers a low-volatility equity strategy and notes it often has large sector concentrations and a long-run beta below one. Which implementation risk should the risk manager highlight?

The risk manager should flag relative underperformance in strong bull markets, sector concentration, and the valuation risk from crowding as many investors buy low-volatility stocks. The anomaly offers no guaranteed outperformance, and tracking error against a benchmark remains measurable.

  1. AThe strategy may underperform sharply in strong bull markets and may become expensive if many investors crowd into itCorrect
  2. BThe strategy has guaranteed outperformance in all market regimes because volatility is persistent
  3. CThe strategy has higher beta than the market in rising markets by construction
  4. DThe strategy cannot be measured against a benchmark because tracking error is undefined

Explanation

Low-beta portfolios lag in strong rallies, and sector tilts create tracking error. Crowding can raise valuations of low-risk stocks and reduce future returns. No strategy guarantees outperformance, beta is not higher by construction, and tracking error can be measured.

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