We are reviewing the underlying assumptions made by the Capital Asset Pricing Model (CAPM). Recall from last time the assumption that returns are distributed normally (i.e. a bell-shaped curve) and how this fails to account for skew and fat tails. Today we’ll look at CAPM’s assumption that there is but a single source of priced systematic risk: market beta.
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We left off last time showing how the Security Characteristic Line indicates the beta of an asset under Harry Markowitz’s Modern Portfolio Theory (MPT). We are now ready to discuss asset pricing models, and we’ll begin by documenting the Capital Asset Pricing Model (CAPM). This model was developed in the 1960’s by several independent researchers, including Sharpe, Treynor, Lintner and Mossin, building on Markowitz’s previous work.
CAPM is an equation that indicates the required rate of return (ROR) one should demand for holding a risky asset as part of a diversified portfolio, based on the asset’s beta. If CAPM indicates a rate of return that is different from that predicted using other criteria (such as P/E ratios or stock charts), then one should, in theory, buy or sell the asset depending on the relationship of the different estimates. For instance, if stock charting indicates that the ROR on Asset A should be 13% but CAPM estimates only a 9% ROR, one should sell or short the asset, which cumulatively should drive the price of Asset A down. Continue reading “Capital Asset Pricing Model, Part One – Normal Distribution” »
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We continue our journey into the wonderland of alpha, taking up with leverage and the Efficient Frontier. We documented last time that a mix of a risky portfolio and the risk-free rate (Rf) yields a linear Capital Asset Line (CAL) within risk-return space. When the mix is varied to decrease the amount of Rf, the riskiness and expected return of the portfolio increase. The mirror image occurs as we increase the relative percentage of Rf in the portfolio mix. We can even borrow at the risk-free rate to purchase additional risky assets for our portfolio – one form of a practice known as leverage. Continue reading “Modern Portfolio Theory – Part Two” »
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Our risk/return series continues with a review of Modern Portfolio Theory (MPT). We’ve already looked at alpha, beta, efficient markets, and returns. Our ultimate goal is to evaluate the role of alpha in hedge fund profitability, how to replicate hedge fund results without needing alpha, and finally how you can start your own cutting-edge hedge fund using beta-only replication techniques.
MPT suggests that a portfolio can be optimized in terms of risk and return by carefully mixing individual investments that have widely differing betas. Recall that beta is return due to correlation with an overall market (known as systematic risk). To take a trivial example, if you hold equal long and short positions in the S&P 500 index, your portfolio would have an overall beta of (.5 * 1 + .5 * -1) = 0. There would be no risk, but in this case, there would be no return either, except for the slow drain of commissions, fees, etc.
Continue reading “Modern Portfolio Theory – Part One” »
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If you have been following our recent blogs, you are by now familiar with the concepts of alpha, beta, and the Efficient Market Hypothesis. Our final goal is to evaluate the role of alpha in hedge fund investing, and to look at trading strategies that do not rely on alpha. Before we can discuss these topics, we need to better understand financial asset pricing models, the role of alpha and beta within these models, and how the models apply specifically to hedge funds. In this installment, we’ll review the concept of rate of return (ROR).
Continue reading “Rate of Return” »
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In previous blogs, we discussed the concepts of alpha and beta in the context of hedge fund investment returns. Recall that alpha refers to that portion of total return attributable to an investment manager’s skill; beta is simply the return due to an investment’s exposure to market risks. A third component, random fluctuations, essentially goes to zero over time and is usually ignored in this discussion. One of the biggest questions in the hedge fund industry today is the role, if any, of alpha in investment returns, and how much is the alpha contribution worth?
Continue reading “Investment Risk and Return: Efficient Markets, Rational Investors” »
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