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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, contrary to the CAPM. Which explanation for this low-risk anomaly is based on investors who cannot or will not use borrowing to increase market exposure?

Leverage constraints explain the anomaly: investors unable to borrow overweight high-beta stocks to reach return targets, pushing their prices up and future returns down, while low-beta stocks are relatively underpriced and offer higher risk-adjusted returns.

  1. ALeverage constraints cause investors to overweight high-beta stocks to reach target returns, bidding up their pricesCorrect
  2. BInvestors systematically underestimate the dividends of low-beta stocks
  3. CLow-beta stocks carry higher default risk, so their higher returns are fair compensation
  4. DTransaction costs are always lower for high-beta stocks, which raises their expected return

Explanation

If investors cannot lever up, they seek higher expected return by tilting to high-beta stocks. This extra demand raises their prices and lowers their future returns, flattening the security market line. The other options are not the leverage-constraint argument.

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