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

A portfolio manager observes that, historically, US equities in the lowest-beta quintile have delivered risk-adjusted returns higher than those of the highest-beta quintile, contradicting the CAPM prediction. Which statement best describes this empirical finding, commonly called the low-risk anomaly?

The low-risk anomaly is the empirical finding that low-beta and low-volatility stocks have earned higher risk-adjusted returns, such as higher Sharpe ratios and positive alphas, than high-beta stocks. This contradicts the CAPM, which predicts that returns rise proportionally with beta, so the market line is flatter than theory suggests.

  1. ALow-beta and low-volatility stocks have earned higher Sharpe ratios than high-beta and high-volatility stocksCorrect
  2. BHigh-beta stocks have earned higher raw returns and higher Sharpe ratios than low-beta stocks
  3. CLow-beta stocks have earned negative alphas relative to the security market line
  4. DLow-volatility stocks have earned lower raw returns and lower Sharpe ratios than the market in every period

Explanation

The low-risk anomaly is the finding that the security market line is too flat in practice: low-risk stocks have delivered better risk-adjusted performance (higher Sharpe ratios and positive alphas) than high-risk stocks. The second option states what CAPM-consistent or high-risk-premium logic would predict. The third reverses the sign of low-beta alpha, and the fourth is too absolute and untrue.

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