Monday, November 26, 2012

The CAPM Debate and the Search for "True Beta"

What has happened is that we’ve used these assumptions for so long that we’ve forgotten that we’ve merely made assumptions, and we’ve come to believe that the world is necessarily this way.”
                                                                        ~Resistance is Futile: The Assimilation of Behavioral Finance

Conventional investment theory states that when an investor constructs a well-diversified portfolio, the unsystematic sources of risk are diversified away leaving the systematic or non-diversifiable source of risk as the relevant risks. The capital asset pricing model (CAPM), developed by Sharpe (1964), Lintner (1965) and Black (1972) [zero-beta version], asserts that the correct measure of this riskiness is its measure known as the "beta coefficient" or just "beta".

Effectively, beta is a measure of an asset’s correlated volatility relative to the volatility of the overall market. Consequently, given the beta of an asset and the risk-free rate, the CAPM should be able to predict the expected return for that asset, and correspondingly the expected risk premium as well.

This explanation is textbook. However, unbeknownst to most, there has been a long running argument in academic circles on the CAPM and other pricing models, even within the milieu of traditional investments. Without going into the details of this debate, certain empirical studies have revealed "cross-sectional variations" in the CAPM questioning the validity of the model.

In response to Fama and French's (1992) challenge, Jagannathan and Wang (1996) theorized that “…the lack of empirical support for the CAPM may be due to the inappropriateness of some assumptions made to facilitate the empirical analysis of the model. Such an analysis must include a measure of the return on the aggregate wealth portfolio of all agents in the economy.”

Financial institutions have not been left behind by these evolving academic theories. Index creation and benchmarking has become standard fare. Since the introduction of 'exchange traded funds' (ETFs), a veritable industry has developed around the "multiple beta" concept. But by no means has the plethora of these instruments captured every aspect of the aggregate wealth portfolio of the global economy, although given new product development it would seem this is the undeclared objective.

Such backdrop is the principal context which gives impetus to the notion of "exotic betas". The term, a relatively recent addition to the investment lexicon which evolved from ideas advanced by proponents of alternative investments, suggests that certain alternative investment assets and/or strategies, representing commonly pursued market paradigms, can be identified, tracked and replicated employing a predefined passive approach/model similar to traditional index construction.

This leaves open the question as to whether institutions, through sophisticated financial engineering, can truly capture in a passive way all possible sources of return in the global economy. Or, does some aspect which the industry loosely calls alpha (i.e., skill-based returns) always remain outside the grasp of such institutions’ arbitrary models of beta?

Jagannathan - The CAPM Debate

Black, Fischer (1972). “Capital Market Equilibrium with Restricted Borrowing” Journal of Business 45, July, pp. 444-455.

Fama, Eugene F.; French, Kenneth R. (1992). “The Cross-Section of Expected Stock Returns” Journal of Finance 47, June, pp. 427-465.

Jagannathan, Ravi; McGrattan, Ellen R. (1995). “The CAPM Debate” Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 19, No. 4, Fall 1995, pp. 2-17

Jagannathan, Ravi; Wang, Zhenyu (1993). “The CAPM is Alive and Well” Research Department Staff Report 165. Federal Reserve Bank of Minneapolis

Jagannathan, Ravi; Wang, Zhenyu (1996). “The Conditional CAPM and the Cross-Section of Expected Returns” Journal of Finance, Vol. 51, No. 1, March, pp. 3-53.

1 comment:

Andrew Finlay said...

Maybe it was just my early 90's masters class, but I remember hand in hand with learning Black and Scholes, the topic of Efficient Market Hypothesis.

Few seem to ever discuss the latter, or the acceptance to those that validated (or not) the curve that it was of course fundamentally flawed as owed significant value to the quality, availability, dispersal of rich information.

Yes CAPM was convenient and simpler to assume was 'just right' as most of my fellow economists at the time to be frank could not do the quants so accepted the model as defacto.

VaR is and has been for some time flawed - but for those who exploit the herd it very lucrative.