Swedroe: Passive Investing's Foundations

December 08, 2014

Building upon the work of Harry Markowitz, the trio of John Lintner, William Sharpe and Jack Treynor are generally given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). It was developed in the early 1960s.

The CAPM provided the first precise definition of risk and how it drives expected returns. Another benefit of the CAPM, and of later asset-pricing models as well, is that it allowed us to understand if an active manager who outperforms the market has generated alpha, or whether that outperformance could be explained by exposure to some factor.

The CAPM looks at risk and return through a “one-factor” lens—the risk and the return of a portfolio are determined only by its exposure to market beta. This beta is the measure of the equity-type risk of a stock, mutual fund or portfolio relative to the risk of the overall market.

The CAPM was the financial world’s operating model for about 30 years.

However, like all models, it was by definition flawed or wrong. If such models were perfectly correct, they would be laws, like we have in physics. Over time, anomalies that contradicted the CAPM began to surface. The model, researchers found, was only able to explain about two-thirds of the differences in returns between diversified portfolios.

Among the biggest problems for the model were issues related to size and value. Academics were publishing papers showing that small-cap and value stocks were outperforming, even after accounting for their higher betas.

Fama-French And Beyond

For example, in a 1992 paper, Eugene Fama and Ken French proposed that, along with the market factor of beta, exposure to the factors of size and value explain the cross section of expected stock returns. The Fama-French model greatly improved upon the explanatory power of the CAPM, accounting for more than 90 percent of the differences in returns between diversified portfolios. However, there were still some significant anomalies, with momentum being perhaps the most important.

In 1997, Mark Carhart—in his study, “On Persistence in Mutual Fund Performance”—was the first to use momentum, together with the Fama-French factors, to explain mutual fund returns. The addition of momentum to the model further improved its explanatory power.

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