FRM Part II · FRM Exam Part II · Alpha (and the Low-Risk Anomaly)
Which explanation for the low-risk anomaly is based on investors being unable or unwilling to borrow to lever up low-beta assets, so they instead overweight high-beta assets to reach their target return?
Leverage constraints explain it. Investors who cannot borrow to scale up low-beta assets tilt toward high-beta stocks to reach target returns, bidding up their prices and lowering their future returns, while low-beta stocks become relatively underpriced and earn positive alpha.
- ALeverage constraintsCorrect
- BMean reversion in earnings
- CTransaction cost asymmetry in bond markets
- DThe size premium
Explanation
If investors cannot use leverage, those wanting higher returns bid up high-beta stocks, lowering their subsequent returns, while low-beta stocks become relatively cheap. This is the leverage-constraint explanation (as in Frazzini-Pedersen betting against beta).
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