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

A portfolio manager observes that, over a long sample, US stocks in the lowest-beta quintile earned risk-adjusted returns higher than those predicted by the CAPM, while the highest-beta quintile earned lower. Which statement best describes this finding, known as the low-risk anomaly?

The low-risk anomaly is a security market line flatter than CAPM implies. Low-beta stocks plot above the line and earn positive alpha, while high-beta stocks plot below it and earn negative alpha, so higher market risk was not rewarded proportionally.

  1. AThe security market line is flatter than the CAPM predicts, so low-beta stocks show positive alpha and high-beta stocks show negative alphaCorrect
  2. BThe security market line is steeper than the CAPM predicts, so high-beta stocks show positive alpha
  3. CBeta is unrelated to returns, and low-beta stocks earn exactly the risk-free rate
  4. DLow-beta stocks earn higher alpha only because they have higher idiosyncratic volatility

Explanation

The low-risk anomaly means the empirical relation between beta and return is flatter than the CAPM line. Hence low-beta assets plot above the line (positive alpha) and high-beta assets below it (negative alpha). A steeper line would imply the opposite pattern.

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