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

A study of equity returns shows that low-beta stocks have historically delivered higher risk-adjusted returns than high-beta stocks, contrary to CAPM. Which explanation is most commonly cited for the low-risk anomaly?

The most common explanation is that leverage-constrained investors overpay for high-beta stocks to get more market exposure, which depresses their subsequent returns relative to low-beta stocks and flattens the security market line, producing a positive alpha for low-beta stocks.

  1. ALow-beta stocks carry higher systematic risk that CAPM understates
  2. BLeverage-constrained investors bid up high-beta stocks to gain market exposure, making them overpriced relative to low-beta stocksCorrect
  3. CTransaction costs are lower for high-beta stocks, raising their net returns
  4. DLow-beta stocks have higher idiosyncratic volatility, which is rewarded by the market

Explanation

Investors who cannot use leverage or who seek lottery-like payoffs overweight high-beta stocks, lowering their expected returns and flattening the security market line. The other options contradict the observed pattern or the evidence.

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