CAPM is C.R.A.P.: Dresdner Kleinwort Economist
Jan 31st, 2007 | Filed under: CAPM / Alpha Theory“CAPM is CRAP, or, The Dead Parrot Lives”
By: James Montier, Dresdner Kleinwort
Published: January 29, 2007, John Mauldin’s “Outside the Box”
John Mauldin is a big fan of James Montier, the 34 year old Dresdner Kleinwort economist who literally wrote the book on behavioral finance. Montier also wrote a chapter in Mauldin’s 2006 book “Just One Thing” and Mauldin re-printed Montier’s musings a couple of times on his website last year. Montier seems like an interesting guy and we enjoy his irreverent take on modern finance – like this one…
In this comprehensive yet very readable article Montier rails against the CAPM, calling it “(C)ompletely (R)edundant (A)sset (P)ricing”. While his facts are irrefutable, their interpretation leaves room for disagreement. In other words, the exact fecal count of CAPM remains unknown. But whether you agree with his conclusion or not, you will probably find this essay an interesting read.
Montier points to Fama & French’s 2004 research showing that high beta stocks performed no better than low beta stocks since 1928. Indeed, the abstract to that study says:
“Unfortunately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications…the failure of the CAPM in empirical tests implies that most applications of the model are invalid.”
In that study, Fama & French goes on to describe two anti-CAPM camps: the “behavioral irrational pricing” camp (which believes prices aren’t rational at all) and the “rational risk story” camp (which aims to find a better CAPM mousetrap):
“Among those who conclude that the empirical failures of the CAPM are fatal, two stories emerge. On one side are the behavioralists. Their view is based on evidence that stocks with high ratios of book value to price are typically firms that have fallen on bad times, while low B/M is associated with growth firms… The behavioralists argue that sorting firms on book-to-market ratios exposes investor overreaction to good and bad times… When the overreaction is eventually corrected, the result is high returns for value stocks and low returns for growth stocks.”
“The second story for the empirical contradictions of the CAPM is that they point to the need for a more complicated asset pricing model. The CAPM is based on many unrealistic assumptions. For example…it is reasonable that investors also care about how their portfolio return covaries with labor income and future investment opportunities, so a portfolio’s return variance misses important dimensions of risk. If so, market beta is not a complete description of an asset’s risk, and we should not be surprised to find that differences in expected return are not completely explained by differences in beta. In this view, the search should turn to asset pricing models that do a better job explaining average returns.”
Naturally, Fama & French fall into the second camp, the “better mousetrap” camp. But they also concede that CAPM may never be proven or disproven since the “market portfolio” is impossible to define (see related posting on Rob Arnott’s Fundamental Indexation)
“…the market portfolio at the heart of the model is theoretically and empirically elusive. It is not theoretically clear which assets (for example, human capital) can legitimately be excluded from the market portfolio, and data availability substantially limits the assets that are included. As a result, tests of the CAPM are forced to use proxies for the market portfolio…The strong rejections of the CAPM described above, however, say that researchers have not uncovered a reasonable market proxy”
Still, they hold out hope:
“It is, however, always possible that researchers will redeem the CAPM by finding a reasonable proxy for the market portfolio…”
Montier also cites research from Arrowstreet’s Toumo Vuolteenaho showing that low beta stocks have more alpha that high beta stocks. But Vuolteenaho doesn’t totally discard beta. In fact, he doubles up:
“…returns on the market portfolio have two components, and that recognizing the difference between these two components can eliminate the incentive to overweight value, small, and low-beta stocks.”
“An intuitive way to summarize our story is to say that beta, like cholesterol, has a bad variety and a good variety. The required return on a stock is determined not by its overall beta with the market, but by its bad cash-flow beta and its good discount-rate beta.”
Montier goes on to cite recent research by GMO (Oct. 2006, page 7 chart: “Why is Sharpe wrong on beta?”) showing the same thing: that contrary to CAPM, low beta stocks outperform high beta stocks. And he cites a recent article by Roger Clarke and Harindra de Silva that also calls into question the central conclusions of CAPM.
But wait, there’s more. He cites Rob Arnott’s Fundamental Indexation research as further proof of the CAPM’s fatal flaws. (perhaps no surprise then that Arnott advises two funds for Dresdner Kleinwort sister company PIMCO).
So who (or what) is to blame for our obsession with alpha? Montier’s answer: the media, of course. Montier presents the following chart to illustrate the media’s recent love affair with portable alpha.
Montier goes on to say that any discussion of alpha is based on a foundation of CAPM (i.e. that portable alpha is, in his words, based on a foundation of “CRAP”).
And that’s where he may have gone a little too far for many of his CAPM-questioning compatriots. After all, Fama & French identify with the “better CAPM” camp, Vuolteenaho has just released a study called “Beta Arbitrage As An Alpha Opportunity“, GMO has a paper (cited on this blog) called “Portable Alpha: a How-to Guide“, and Roger Clarke’s Analytic Investors posts a paper called “Market Neutral: It’s All About Alpha (Not Beta!)”. (No kidding. Great title, eh?) Even Dresdner Kleinwort’s sister company Allianz Dresdner Asset Management (a.k.a. PIMCO, now “Allianz Global Investors”) published an article in the Journal of Investing entitled “Engineering an Alpha Engine” which recommends the search for alpha actually drive organizational structure.
Perhaps Montier is just trying to counter excessive CAPM-hype with over-the-top anti-CAPM hype. In any case, it does make for very interesting reading (and for great headlines).
Read Full Article from John Mauldin’s “Outside the Box” Newsletter
Read Fama & French’s 2004 research challenging CAPM
Read Rob Arnott’s Fundamental Indexation Article in the Financial Analyst’s Journal
Read Arrowstreet’s Tuomo Vuolteenaho on “Good Beta” and “Bad Beta”
Read GMO’s Jeremy Grantham on Why Sharpe is “Wrong on Beta” (free registration required)
Read Clarke & de Silva’s article on global market factors in the Journal of Portfolio Management
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From a loyal AllAboutAlpha reader: This scatalogical piece is very interesting and in general I agree with it. His conclusion does bring us back to the central thesis of alpha centric investing though, which is irrefutable in its logic and is expressed so well by Ineichen. Problem is that every discipline has to start off with a straw man. Economists use “perfect competition”, geographers, the “isotonic plane” and lawyers, the “rational” man. We have CAPM based on “efficient markets”. The point is that we need a standard of perfection to tear down piece by piece to better understand how a system works. The danger is believing the straw man is reality… (AM: excellent point…and *superb* usage of the rather rare word “scatological”)
[...] Dresdner Kleinwort economist James Montier refered to this article in a recent piece. As Montier pointed out, Vuolteenaho argues that low beta stocks outperform higher beta stocks on a risk-adjusted basis (according to Montier’s own research, they may even outperform on an absolute basis). Vuolteenaho makes the logical step from this conclusion to the construction of a beta-neutral portfolio consisting of long positions in low beta names and short positions in high beta names. If this portfolio has a positive gross return, then “CAPM is C.R.A.P.” (to use Montier’s technical jargon). As this chart copied from the report shows, the CAPM seems especially stinky recently (the “late sample” = 1963-2001 while the “early sample” = 1927-1963). [...]
[...] The weekly investment newsletter “Outside the Box” picks up where a previous edition left off – with James Montier’s assertion that “CAPM is CRAP“. This week’s edition contains an interview with Peter Bernstein and James Montier conducted by Kathryn Welling.  As newsletter editor John Mauldin correctly observes, the article is “double the length of normal”.  Mauldin bills the interview as “Bernstein taking on (Montier’s) criticism of CAPM”. But unfortunately for those pining for a grudge-match (like us), there seems to be a lot of agreement between Montier and Bernstein. [...]
Anybody who has done any kind of quantitative research and portfolio construction especially in the equity space knows CAPM falls flat on its face, I don’t see anything new here.