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

A pension fund wants to explain why the low-risk anomaly may persist despite being well known. Which explanation is most consistent with the literature on the anomaly?

The anomaly can persist because leverage-constrained and benchmarked investors overweight high-beta stocks to reach higher returns. This extra demand overprices high-beta stocks and lowers their subsequent risk-adjusted returns, while low-beta stocks are relatively underpriced, so the security market line stays flatter than CAPM predicts.

  1. AInvestors who face leverage constraints or benchmark mandates overweight high-beta stocks to boost return, bidding up their prices and lowering their subsequent risk-adjusted returnsCorrect
  2. BLow-beta stocks have systematically higher exposure to the market factor, which compensates investors with higher returns
  3. CArbitrageurs can implement the strategy costlessly with unlimited leverage, so the anomaly is mainly a data-mining artifact
  4. DHigh-beta stocks are priced at a discount because investors dislike lottery-like payoffs

Explanation

Leverage constraints and benchmarking push investors toward high-beta securities, overpricing them and flattening the security market line; this is the main behavioral/structural explanation. The second option contradicts the definition of low beta. The third assumes unconstrained arbitrage, which is precisely what is absent. The fourth is wrong in direction: lottery preference leads to overpricing, not discounting, of high-risk stocks.

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