Lecture 4: CAPM and empirical evidence

Investments

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Introduction

In the last 20 years or so, a large body of empirical evidence has

surfaced that challenges some of the basic assumptions of
finance theory.
Specifically, researchers have found evidence that challenges the
capital asset pricing model.
This evidence has been interpreted as saying that modern
finance theory is wrong, markets are not efficient or investors
are not rational.
The goal of this lecture is to review some of this evidence and
understand what it implies for modern portfolio theory.

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Who cares?
The CAPM is the most often used model for figuring out the appropriate
compensation for risk.
It is widely used in
a) Corporate Project Valuation
b) Portfolio Management
c) Evaluating Portfolio Managers
d) Cost-of-capital determination

Most of the evidence we will see challenges the CAPM.

, The failure of the CAPM implies that the market portfolio is not efficient.
, To understand what portfolio is efficient, you need to understand how it
fails.

We will revisit the question of the appropriate discount rate in a couple of

lectures.
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Assumptions behind the CAPM

The CAPM is an economic model that specifies what expected
returns (and therefore prices) should be as a function of
systematic risk.
What is the argument that makes it hold? It is based on a proof
by contradiction:
1. Suppose that it didnt hold.
2. Investors would get rewarded for bearing non-systematic risk.
3. Non-systematic risk can, by definition, be diversified away.
4. Investors would be getting something for nothing.
5. Everyone should follow these strategies.
6. Prices will eventually adjust and the anomalies disappear.

Notice that there is an additional set of hidden assumptions.

What are they?

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CAPM and the data

If the CAPM is true, then all securities should lie in the SML.

E(ri ) = r f + i [E(rm ) r f ]

, The relation of expected return and i is linear

, Only i explains differences in returns among securities.
, E(R) of an asset with a = 0 is r f .
, E(R) of an asset with a = 1 is the expected return on the
market.

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CAPM and the data

How can we test the CAPM? 2 Approaches:

1. Test i = 0 in

Ri,t r f = i + i (Rm,t r f ) + i,t

2. Given, E(Ri,t r f ) and i , test 0 = 0, 1 > 0 and ui = 0 in

E(Ri,t r f ) = 0 + 1 i + ui

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CAPM and the data: A first test

1. Collect the data.
, We will use monthly data on 100 largest stocks
2. Estimate i and E(Ri,t r f ).
, use a first-pass regression to estimate i
, use historical average for E(Ri,t r f )
3. Set up a second-pass regression in Excel.
, The dependent variable: yi = E(Ri,t r f )
, The independent variable: xi = i
4. Results:
Estimate

0
1
R2

6.01%
0.17%
2%

Standard Error

t-stat

1.8%
1.7%

3.5
0.1

5. What do these numbers mean?

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CAPM and the data: A first test

Average returns vs Betas for top 100 market-cap stocks.
0.7

SML

Historical Return
Forecasted Return
0.1 0.2 0.3 0.4

0.5

0.6

QCOM

VRTS
ORCL

NT
AA

AOL

CMCSK

HD

DOW

SUNW
EMC

AMGN

0.0

IP

-0.1

BK
BAC
ONE
UN
SWY WB

-0.3

LMT MO
WMI

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

Beta

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CAPM and the data

To test the CAPM one needs to specify what the market portfolio
is.
a) Only 1/3 non governmental tangible assets are owned by the
corporate sector.
b) Among the corporate assets, only 1/3 is financed by equity
c) What about intangible assets, like human capital?
d) International markets?

Measurement error in

, Can be avoided by grouping stocks into portfolios.

Measurement error in expected returns.

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CAPM and the data: A better test

We can get around the measurement error problem by looking at

diversified portfolios.
We can sort firms into portfolios based on characteristics that we
think should explain risk premia.
Lets try this with market beta:
1. For every year t , use past 5 years of data to estimate market beta.
2. At the beginning of the year sort firms into 10 portfolios based on
their estimated beta.
3. Track the performance of these portfolios over the next year.
4. At year t + 1 repeat.

This test was done by Black, Jensen and Scholes.

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BJS Portfolio selection technique

First Year:
-5

-4

-3

-2

-1

Portfolio Estimation Period

(obtain pre-ranking beta)
Portfolio Formation Date

Calculate Portfolio Returns

Second Year:
-5

-4

-3

-2

-1

Portfolio Estimation Period

(obtain pre-ranking beta)
Portfolio Formation Date
Calculate Portfolio Returns

Combine Sets of Returns:

-5

-4

-3

-2

-1

Calculate Portfolio Beta

(post-ranking beta)

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predicted by the traditional form of the asset pricing model. At the same time, the low-

BJS: Results
risk securities earned more than the amount predicted by the model.
Table 2
Summary of Statistics for Time Series Tests, Entire Period (January, 1931-December, 1965)
(Sample Size for Each Regression =420)
Portfolio Number

Item*

"
" 10
t (" )

,R
M)
r(R

10

RM

1.5614

1.3838

1.2483

1.1625

1.0572

0.9229

0.8531

0.7534

0.6291

0.4992

1.0000

-0.0829 -0.1938 -0.0649 -0.0167 -0.0543

0.0593

0.0462

0.0812

0.1968

0.2012

-0.4274 -1.9935 -0.7597 -0.2468 -0.8869

0.7878

0.7050

1.1837

2.3126

1.8684

!!0.9625

0.9875

0.9882

0.9914

0.9833

0.9851

0.9793

0.9560

0.8981

r (e t , e t"1) ! 0.0549 -0.0638

0.0366

0.0073 -0.0708 -0.1248

0.9915

0.1294

0.1041

0.0444

0.0992

" (e )
R
"

! 0.0393
! 0.0213

0.0197

0.0173

0.0137

0.0124

0.0152

0.0133

0.0139

0.0172

0.0218

0.0177

0.0171

0.0163

0.0145

0.0137

0.0126

0.0115

0.0109

0.0091

0.0142

0.1445

0.1248

0.1126

0.1045

0.0950

0.0836

0.0772

0.0685

0.0586

0.0495

0.0891

! monthly excess returns, " = standard deviation of the monthly excess returns, r = correlation
* R M = average
!
coefficient.
!
!

The significance tests given by the t values in Table 2 are somewhat

inconclusive, since only 3 of the 10 coefficients have t values greater than 1.85 and, as
we pointed out earlier, we should use some caution in interpreting these t values since
the normality assumptions can be questioned. We shall see, however, that due to the
existence of some nonstationarity in the relations and to the lack of more complete
aggregation, these results vastly understate the significance of the departures from the
traditional model.

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BJS: Results

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The Small Firm Effect

A number of researchers, starting with Keim (1981) and Banz
(1981) found that differences in firm size explained differences in
expected returns.
1. firm size was defined as total market capitalization.
2. Small stocks (i.e. small cap stocks) outperformed large stocks (i.e.
large cap stocks).

In order to minimize measurement error, we will form portfolios of

stocks based on their past market capitalizations
Dec

MKCap(m$)

NYSE

10
9
8
7
6
5
4
3
2
1

511,391
10,486
4,428
2,237
1,387
889
534
353
198
95

172
172
172
172
172
172
172
172
172
172

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# of Stocks
AMEX
NASDAQ
5
3
5
5
5
11
15
32
73
412

80
81
136
166
217
254
251
400
551
1,399

CAPM and empirical evidence

Total
257
256
313
343
394
437
438
604
796
1,983
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The Small Firm Effect

Excess portfolio returns, historical average (1926-2007)
16

14

Excess return, % (historical average)

12

10

0
1

10

MKCAP Decile

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The Small Firm Effect

Is this evidence inconsistent with the CAPM?
Smaller firms tend to have higher s
Size-1
(Smallness)

Market Beta

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The Small Firm Effect

To resolve this, Fama and French (1992) do a double sort, first on
size, then on market .
1/Size ("Smallness")

Market Beta

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The Small Firm Effect

They find that the relation between average returns and market
within size decile is generally negative.

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The Small Firm Effect

Other researchers have criticized these findings:

1. Other measures of firm size, such as book value of assets, or
number of employees have no similar predictive power.
2. The size effect has more or less disappeared over the last 10-15
years.

Because the effect is mostly there for small stocks, it could be

due to a liquidity premium: Small stocks are less liquid (i.e. they
have higher transaction costs) so investors may require higher
rates of return in order to hold them.

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The Value Effect

Some researchers, starting with Graham and Dodd in the late

1930s, noticed that value stocks outperformed growth stocks.

, Definition: A value stock is a stock with a low market price

relative to the book value of assets.
Some people believe these stocks are undervalued by the market
and thus should present good investment opportunities.

, Definition: A growth stock is a stock with a high market price

relative to the book value of assets.
Some people believe that these stocks are glamor stocks that
are overvalued by the market, and as such the expected returns
form holding them will be poor.

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The Value Effect

Sort all stocks into 10 portfolios based on the ratio of book value of equity to the
market value of equity.
Re-balance portfolios every year.

Sort

Lo
6.77
(2.22)
19.98

2
8.01
(2.13)
19.16

(t)
MKT
(t)
R2 (%)

-1.01
(0.74)
1.01
(0.02)
89.80

0.42
(0.60)
0.98
(0.02)
92.74

E(Ri ) r f

10 portfolios sorted on book-to-market equity, 1926-2007

3
4
5
6
7
8
7.85
7.98
8.93
9.37
9.66
11.41
(2.07)
(2.34)
(2.18)
(2.39)
(2.59)
(2.70)
18.59
21.06
19.60
21.46
23.29
24.22
0.53
(0.59)
0.95
(0.02)
91.86

-0.23
(0.73)
1.06
(0.04)
89.94

1.38
(0.78)
0.98
(0.03)
88.02

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1.13
(0.87)
1.06
(0.04)
87.23

0.92
(1.04)
1.13
(0.06)
83.44

2.46
(1.14)
1.16
(0.07)
80.80

CAPM and empirical evidence

9
12.12
(2.95)
26.48

Hi
13.17
(3.62)
32.49

Hi-Lo
6.40
(2.57)
23.10

2.43
(1.34)
1.25
(0.05)
79.38

1.97
(1.84)
1.45
(0.10)
70.35

2.98
(2.30)
0.44
(0.11)
12.89

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The Value Effect

Puzzle is more pronounced in the post-war period

Sort

Lo
3.95
(2.67)
18.01

2
5.59
(2.42)
16.35

(t)
MKT
(t)
R2 (%)

-2.07
(1.05)
1.10
(0.02)
86.02

-0.04
(0.73)
1.03
(0.02)
91.34

E(Ri ) r f

10 portfolios sorted on book-to-market equity, 1962-2007

3
4
5
6
7
8
6.07
6.29
6.28
7.28
8.33
8.67
(2.39)
(2.37)
(2.22)
(2.21)
(2.21)
(2.19)
16.14
16.00
15.01
14.90
14.92
14.78
0.54
(0.76)
1.01
(0.02)
90.27

0.95
(0.95)
0.97
(0.03)
85.63

1.38
(1.01)
0.89
(0.03)
81.92

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2.38
(0.92)
0.90
(0.03)
83.31

3.63
(1.10)
0.86
(0.03)
76.58

4.05
(1.12)
0.84
(0.03)
75.20

CAPM and empirical evidence

9
9.64
(2.37)
16.01

Hi
11.11
(2.73)
18.46

Hi-Lo
7.16
(2.28)
15.39

4.66
(1.23)
0.91
(0.04)
74.27

5.71
(1.71)
0.99
(0.05)
65.82

7.78
(2.44)
-0.11
(0.06)
1.07

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Size and Value Effect together

25 portfolios sorted on Size and Book to Market
Average excess portfolio returns vs market beta (1962-2007)
18
Small Value

Average excess return (%)

16
14
12
Large Value
10
8
Large Growth
6
Small Growth
4
2
0.7

0.8

0.9

1.1

1.2

1.3

1.4

1.5

1.6

Market beta

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Explanations?

Some potential explanations:

distress risk Value stocks tend to be stocks that have
underperformed in the past. A lot of them are in the
verge of bankruptcy and may be particularly risky.
Investors may require an additional risk premium in
order to hold them.
liquidity risk Small stocks are more illiquid and may thus
command a higher premium.
Are these plausible?

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Related patterns
Value and size effects are only the tip of the iceberg.
The literature has documented a number of other patterns:

, Firms with high investment rates under-perform firms with low

investment rates
Titman, Wei and Xie (2003)

, Firms that issue new shares under-perform that do not.

Loughran and Ritter (1995)

, Firms that repurchase their shares over-perform that do not.

Ikenberry, Lakonishok and Vermaelen (1995)

, Firms with high idiosyncratic volatility under-perform firms with low

idiosyncratic volatility
Ang, Hodrick, Xing, and Zhang (2009)

Are these separate phenomena?

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Short-Term Momentum

In a 1993 Journal of Finance article, Jagadeesh and Titman show

that firms with high (low) returns in the previous year tend to have
higher (lower) returns in the following few months.

The momentum effect seems short-lived in the data, lasting for

only a few months.

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Short-Term Momentum
Form portfolios of stocks selected on their past return over the last 12 months.
We will rebalance these portfolios every month.

Lo
0.31
(3.70)
33.24

10 portfolios sorted on previous 12 month returns (1926-2007)

2
3
4
5
6
7
8
9
5.18
5.12
6.72
6.80
7.58
8.68
10.30
11.47
(3.13)
(2.70)
(2.50)
(2.31)
(2.26)
(2.17)
(2.09)
(2.20)
28.15
24.24
22.41
20.77
20.33
19.51
18.78
19.78

Wi
15.37
(2.52)
22.64

Wi-Lo
15.07
(2.94)
26.44

(t)
MKT
(t)
R2 (%)

-11.52
(1.65)
1.53
(0.08)
74.95

-5.08
(1.31)
1.33
(0.07)
78.61

7.48
(1.33)
1.02
(0.06)
71.90

19.01
(2.44)
-0.51
(0.13)
13.05

Sort

E(Ri ) r f

-3.91
(1.12)
1.17
(0.06)
82.24

-1.77
(0.94)
1.10
(0.04)
85.01

-1.18
(0.79)
1.03
(0.04)
87.30

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-0.39
(0.66)
1.03
(0.02)
90.93

1.09
(0.70)
0.98
(0.02)
89.64

3.05
(0.70)
0.94
(0.02)
88.34

CAPM and empirical evidence

3.97
(0.81)
0.97
(0.03)
85.09

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Short-Term Momentum

At the moment, the momentum effect is one of the most studied

anomalies in Finance.
On the surface, momentum appears to challenge the efficient
market hypothesis.
This has led behavioral finance advocates to declare victory.
They propose several behavioral explanations:
1. under-reaction: bad news travels slowly.
2. over-reaction: positive feedback.
3. disposition effect: investors are reluctant to sell loser stocks.

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Short-Term Momentum

Momentum also exists among different asset classes, not just

individual stocks.
It also exists among:

, Commodities
, Currencies
, Sovereign bonds
, Industry indices

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Post-Earnings Announcement Drift

Bernard and Thomas in the 1989 article in Journal of Accounting

Research found evidence that stock prices were predictable
based on past earnings announcements.
1. They found that firms that had better than expected earnings had
higher returns over the next few months.
2. Firms that had worse than expected earnings in the past had
lower returns going forward.

They interpret this as evidence of market inefficiency due to

investor under-reaction to earnings announcements.
They formed portfolios of stocks based on past earnings
surprises and tracked their performance.

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Post-Earnings
Announcement
Drift
VICTOR L. BERNARD AND JACOB K. THOMAS
10
......................................................................................................

post-announcement period

pre-announcement period

i SUE
,ideciles

event time in trading days relative to earnings announcement day

FIG. 2.-Cumulative abnormal returns (CARs) for SUE portfolios: all announcements.

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The Profitability Effect

A closely related pattern to the post-earnings announcement drift is the so-called
profitability effect.
Form portfolios of firms sorted on the past ratio of earnings before income and tax
(EBIT) to book assets.
Rebalance portfolios every year.

(%)

Lo
-0.19
(-0.04)
36.38

2
2.52
(0.69)
24.55

10 portfolios sorted on return on assets, 1962-2007

3
4
5
6
7
8
5.69
5.17
6.73
6.96
4.42
6.63
(1.67)
(1.54)
(2.35)
(2.70)
(1.66)
(2.57)
22.83
22.45
19.23
17.28
17.84
17.28

9
4.43
(1.77)
16.75

Hi
6.26
(2.27)
18.53

Hi-Lo
6.46
(1.59)
27.97

(%)
(t)
MKT
(t)
R2 (%)

-7.81
(-2.17)
1.52
(7.31)
56.79

-3.46
(-2.01)
1.20
(9.51)
76.89

0.18
(0.10)
1.10
(8.91)
75.47

0.01
(0.01)
0.88
(22.69)
90.14

1.69
(1.36)
0.91
(12.63)
79.02

9.50
(2.42)
-0.61
(-2.52)
15.32

Sort

E(R) r f (%)

-0.05
(-0.02)
1.04
(7.79)
70.07

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2.28
(1.23)
0.89
(8.58)
69.54

2.51
(2.54)
0.89
(13.34)
85.77

-0.14
(-0.14)
0.91
(13.69)
84.62

2.11
(2.20)
0.90
(14.89)
88.72

CAPM and empirical evidence

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The Roll Critique

The only test of the CAPM is whether the market portfolio is
mean-variance efficient.
CAPM will always hold if the market proxy that is used is MVE.
If proxy is not MVE, relationship between E(R) and will not
hold.
Capital Market Line
0.13
0.12
0.11

Assets
Minimum Var Frontier
CML
MVE Portfolio
BMVE Combinations

C
B

Expected Return

0.1
0.09

Market Portfolio
A

0.08
0.07

0.06
0.05
0.04
RiskFree Asset
0.03
0

0.05

0.1

0.15
0.2
Return Standard Deviation

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0.25

0.3

CAPM and empirical evidence

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The Roll Critique

Roll points out that, since the market portfolio is not identifiable,
we cannot really test the CAPM.
, The market proxies that we use do not include
a) Real Estate
b) Human Capital

Roll concludes the CAPM is useless because it is not testable

, Roll instead advocates the use of the APT, which we will see next.
However, perhaps the usefulness of the Roll critique is in
reminding us that if we find that the CAPM tests do not hold, then
the so-called market (or really market proxy) is not MVE and,
unless you have very special reasons for doing so, you should not
hold the market proxy!

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Implications for portfolio choice

If we believe these anomalies we should feed this information into

the Black-Litterman model.
Violation of the CAPM means that the market portfolio is not
MVE.
We can beat the market!
Hedge funds have been doing exactly that for the last 15 years.
We will do this in the next lecture.

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The state of affairs

Is modern finance theory useless?
Not really. Maybe just the CAPM...

, ...or the version that we can test.

We can use the same principles about the risk-return tradeoff to
guide us into better models.
These models will help us understand better these patterns in
expected returns.
1. If these are indeed anomalies, there is no reason why they should
persist in the future.
2. If there is a rational explanation, then these patterns may persist,
but are not necessarily free money.

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Infinite monkey theorem

Infinite monkey theorem: Given enough time, a hypothetical
chimpanzee typing at random would, as part of its output, almost
surely produce one of Shakespeares plays (or any other text).

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