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

One explanation for the persistence of the low-risk anomaly is that many investors face leverage constraints. How does this explanation imply that exploiting the anomaly should work?

Constrained investors bid up high-beta stocks to gain market exposure without borrowing, so high-beta stocks are overpriced and low-beta stocks relatively cheap. Investing in low-beta stocks, with leverage if allowed, then earns higher risk-adjusted returns because the security market line is flatter than CAPM predicts.

  1. AConstrained investors bid up high-beta stocks to get more market exposure, so high-beta stocks are overpriced and low-beta stocks are relatively cheapCorrect
  2. BConstrained investors prefer low-beta stocks, which makes them overpriced and lowers their future returns
  3. CLeverage constraints raise the market risk premium but leave the security market line unchanged
  4. DLeverage constraints affect only arbitrageurs, who are forced to buy high-beta stocks

Explanation

Investors who cannot borrow reach for higher returns by overweighting high-beta stocks, pushing their prices up and their future risk-adjusted returns down. Low-beta stocks become relatively underpriced, so a strategy that levers low-beta holdings earns the premium. The security market line becomes flatter, not unchanged.

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