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

A portfolio manager at an asset management firm wants to exploit the low-risk anomaly by building a long-only equity fund. Which approach is most consistent with the way the anomaly is typically implemented in practice?

A long-only low-risk strategy overweights low-beta or low-volatility stocks relative to the benchmark. Historically these stocks have delivered higher risk-adjusted returns than CAPM implies, while high-beta and high-idiosyncratic-volatility stocks have tended to underperform on a risk-adjusted basis.

  1. AOverweight stocks with low beta or low volatility relative to the market-cap-weighted benchmarkCorrect
  2. BOverweight stocks with the highest betas to capture the greatest equity risk premium
  3. CHold an equal-weighted portfolio of the highest-volatility stocks to capture lottery-like payoffs
  4. DConcentrate in the stocks with the highest idiosyncratic volatility to increase tracking error

Explanation

The low-risk anomaly says low-beta or low-volatility stocks have earned higher risk-adjusted returns than the CAPM predicts. Long-only implementations therefore tilt toward low-beta or low-volatility stocks. The other options tilt toward high-risk stocks, which have historically delivered poorer risk-adjusted returns.

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