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

A portfolio manager observes that, historically, stocks with low market beta have delivered higher risk-adjusted returns than high-beta stocks, contradicting the CAPM's prediction. Which explanation based on investor constraints is most consistent with the leverage-aversion argument for the low-risk anomaly?

The leverage-aversion explanation says investors who cannot or will not borrow reach for higher returns by buying high-beta stocks. That demand overprices high-beta stocks and lowers their risk-adjusted returns, leaving low-beta stocks relatively cheap and flattening the security market line.

  1. AInvestors who cannot or will not use leverage bid up high-beta stocks to reach higher expected returns, making them overpriced relative to low-beta stocksCorrect
  2. BInvestors prefer low-beta stocks because they pay higher dividends, so low-beta stocks are overpriced
  3. CInvestors with unlimited leverage sell low-beta stocks short, driving their prices down and returns up
  4. DRegulators require all institutions to hold low-beta stocks, which raises their prices and lowers subsequent returns

Explanation

Leverage-constrained investors seeking higher returns overweight high-beta stocks instead of levering low-beta ones. This extra demand pushes high-beta prices up and their risk-adjusted returns down, flattening the security market line. The other options describe effects that would not produce the observed anomaly or misstate the mechanism.

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