5. Considering tracking your portfolio performance relative to specific benchmar

Question

5. Considering tracking your portfolio performance relative to specific benchmarks, Cramer says "diversification is the only free lunch". We also know that Fama/French/Carhart have empirically found that anomalies have existed in the secondary markets...and that CAPM may not fully capture all systematic/market risk. Our own FIN3460 students (West, Enzor, and Stinnett) have also found that a Low-Beta portfolio might offer a sustainable abnormal return. How might you react to the above, in terms of your understanding of the Efficient Market Hypothesis, and you attempting to diversify-out all unsystematic risk in your portfolio…and concurrently attempt to achieve a sustainable positive alpha across actively managed portfolios?

Explanation / Answer

CAPM effectiveness depends on the proxy used for the market. Using a diversified proxy such as the S&P 500 stille excludes many investment avenues for the investor, including the smaller stocks, commodities, real estate, foreign exchange, investing in education adn training, investing in their children etc. Also, the beta may vary across time periods hence using an invariant beta calculated using a trial period may not apply across the time period for which we are testing the data.

CAPM measures sensitivity of assets to the entire range of investment avenues (market portfolio) available to the investor, and defines the return as the sum of the risk free rate and this sensitivity multiplied by the excess of the market portfolio over the risk free rate. Hence it is efficient by definition. So errors are due to the proxies used for beta and the market return.

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