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

A portfolio manager notes that, historically, low-beta stocks have delivered higher risk-adjusted returns than high-beta stocks, contrary to CAPM. Which explanation for this low-risk anomaly relies on investors who cannot or will not use leverage but still want higher expected returns?

Leverage aversion or constraints explain the anomaly: investors who cannot lever low-beta assets buy high-beta stocks instead, bidding up their prices and reducing their future returns, which flattens the security market line relative to CAPM.

  1. ALeverage aversion or constraints push investors to overweight high-beta stocks, bidding up their prices and lowering their subsequent returnsCorrect
  2. BLow-beta stocks are exposed to greater default risk, which is compensated by higher returns
  3. CTransaction costs are lower for high-beta stocks, so they are traded more efficiently
  4. DAnalysts systematically underestimate the earnings of high-beta firms

Explanation

Investors who are leverage constrained reach for higher return by buying high-beta stocks instead of levering low-beta ones. This extra demand overprices high-beta assets and flattens the security market line. The other options are not the leverage-constraint explanation.

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