Rethinking CAPM
Oct 10th, 2006 | Filed under: CAPM / Alpha TheoryBy: Joel Chernoff, Pensions & Investments
Published: October 2, 2006
This month, William Sharpe releases “CAPM v2.0″ to the world in the form of a new book updating the much-heralded Capital Asset Pricing Model (Investors and Markets: Portfolio Choices, Asset Prices and Investment Advice) . But before you throw-out CAPM v1.0, please note that v2.0 is only a patch to fix apparently critical security flaws in the previous release. According to Pensions & Investment:
“…the book eschews mean-variance analysis — the mathematically complex formula that relates rewards to risks of securities or portfolios — in favor of a state/preference approach that relies on an easy-to-understand simulation.”
Sharpe’s legacy to the world of finance has come under fire in recent years by, for example, the hedge fund community which questioned the central assumption that returns were normally distributed. Many hedge funds tend to display asymmetric return distribution that are skewed to one side or have “fat tails”. This confounds the usefulness of the Sharpe Ratio and has led to the emergence of new measures (e.g. the “Omega Ratio”) that does not require that return distributions follow a nice symmetrical variance around a mean. Version 2.0 addresses these problems.
Lest we forget, CAPM first introduced us to the concept of “beta”. And “beta” leads us to “alpha”, the reason we’re all here. In fact, as Pensions & Investments reminds us:
“The idea of an index fund — passively tracking the entire market — came directly out of CAPM and the efficient market hypothesis unveiled a year later by Eugene F. Fama in his doctoral dissertation at the University of Chicago’s Graduate School of Business.”
Instead of relying on the mathematical elegance of mean-variance analysis, CAPM v2.0 makes use of simulations based on large numbers of possible states of the world (called “state/preference” theory) – a feature that makes it more flexible and better able to cope with the imperfect realities of the world in which we live (similar to the way you can price an option using a lattice tree instead of using Black-Scholes).
Harry Markowitz, inventor of the mean-variance analysis Sharpe used in v1.0 isn’t too keen on this development. “I find (the state/preference approach uses) a very general set of assumptions out of which very little specific can be deduced…” he tells P&I.
But CAPM 2.0’s ability to model a plethora of imperfect, non-normally distributed possible outcomes also means it can account for non-economic players such as the ones Max Darnell suggests might be on the other side of alpha-generating trades. Says P&I:
“Unlike a mean-variance analysis, however, the simulator finds that it does make sense for some investors to take non-market risk. For example, someone living in Silicon Valley might want to underweight technology stocks to reduce risk, Mr. Sharpe explained.”
Alpha Male suggests we all put this one on our Holiday gift list because, as Russell Fogler of Fogler Management and Research tells P&I:
“I think what Sharpe is giving us is an asset that is positively skewed with absolutely no downside for $39…”
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