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

An asset owner is considering a long-only minimum-variance equity strategy to capture the low-risk anomaly. Which implementation risk is most characteristic of this approach?

The characteristic risk is interest-rate sensitivity and crowding. Minimum-variance portfolios load on defensive, bond-like stocks whose valuations can become stretched as capital flows in, so they can suffer when rates rise or the trade unwinds. They typically lag in strong rallies.

  1. AExposure to rising interest rates and crowding, because the portfolio holds bond-like defensive stocks that may become expensive when many investors adopt the strategyCorrect
  2. BGuaranteed outperformance in rising equity markets because of its low beta
  3. CLarge negative exposure to the value factor by construction
  4. DInability to reduce drawdowns in bear markets

Explanation

Low-volatility portfolios hold bond-proxy stocks, so they are sensitive to interest rate rises and valuation expansion from crowded inflows. They usually lag in strong bull markets, not outperform. Value exposure is not systematically negative, and drawdown reduction is the typical benefit.

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