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

A researcher argues the low-risk anomaly persists because the cost of exploiting it is high for many institutions. Which is the best supporting argument?

Arbitrage of the anomaly is limited because exploiting it needs leveraged long positions in low-beta stocks, which face funding and margin constraints and large tracking error against the market for long periods. Agents with short evaluation horizons are therefore deterred, so mispricing persists.

  1. ALow-beta stocks have unlimited upside, so shorting them is costly
  2. BArbitrage is limited because capturing the anomaly requires a leveraged long position in low-beta stocks, with funding and margin constraints and substantial tracking error versus the market over long periods, deterring capitalCorrect
  3. CThe anomaly is guaranteed to reverse each year, so no capital is needed
  4. DExploiting the anomaly requires buying only high-beta stocks, which are illiquid

Explanation

To harvest the anomaly on a market-beta-neutral basis one must lever low-beta stocks. Funding limits, margin calls and long stretches of underperformance versus the market, which is painful for agents with short evaluation horizons, limit arbitrage capital. The other options are factually or logically wrong.

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