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

An analyst argues that the low-risk anomaly persists because many professional managers are evaluated against a benchmark using tracking error, and are rewarded for outperformance relative to it rather than for absolute risk-adjusted returns. Which implication follows from this explanation?

Benchmarked managers face tracking-error risk when holding low-beta stocks, so they shun them and chase higher-beta names for relative outperformance. This weak demand leaves low-beta stocks underpriced and high-beta stocks overpriced, allowing the anomaly to persist.

  1. AManagers will tend to avoid low-beta stocks, since holding them risks large deviations from the benchmark in rising markets, leaving them underpricedCorrect
  2. BManagers will overweight low-beta stocks, driving their prices above fair value
  3. CArbitrageurs will be unable to profit from any mispricing because benchmarks remove risk
  4. DThe anomaly should be strongest among investors with no benchmark

Explanation

Benchmarked managers with tracking-error limits find low-beta overweights costly because they produce benchmark deviation, and they have little incentive to buy them. Reduced demand leaves low-beta stocks cheap, sustaining the anomaly. Overweighting them would eliminate it.

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