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

An analyst notes that a low-volatility equity strategy has a market beta well below one yet outperformed the market on a risk-adjusted basis. Which interpretation is most consistent with the empirical evidence on the low-risk anomaly?

The best interpretation is that the strategy's CAPM alpha is partly explained by exposure to other factors such as value and quality, while a distinct low-risk effect still remains in much of the evidence. It does not confirm the CAPM, which would predict lower returns for low beta.

  1. AThe strategy's positive alpha relative to the CAPM can be partly explained by its exposure to other factors such as value and quality, but the anomaly still appears in many analyses as a distinct effectCorrect
  2. BThe result proves the CAPM holds, since beta below one implies return below the market
  3. CThe outperformance arises only from leverage embedded in the stocks
  4. DThe result is impossible because risk and return must be positively related across all assets

Explanation

Low-risk portfolios often load on value and quality factors, which explains part of their CAPM alpha, though evidence suggests a residual low-risk effect persists. The CAPM would predict lower return, so B is wrong, and C and D are unsupported.

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