(March 17, 2014) — The Capital Asset Pricing Model (CAPM) needs a revision—to one based on liabilities and funded status, according to AlphaEngine Global Investment Solutions.
The firm’s Arun Muralidhar, along with Kazuhiko Ohashi of Hitotsubashi University and Hung Hwan Shin of the Korea Fixed Income Research Institute, wrote a paper arguing that the old model based on “pure wealth” and “market portfolio” may no longer best serve institutional investors.
The report argued that like the five blind men each examining parts of an elephant in a Buddhist parable, the current state of CAPM embraces only “a two-dimensional slice of an at least three-dimensional problem,”.
“A shift from a ‘market portfolio’-centric to a ‘liability-centric’ world will create a Relative Asset Pricing Model (RAPM), with the CAPM as a very specialized case of this model, thereby not only validating CAPM’s contributions, but also reconciling divergent views on its validity,” they said.
As investors increasingly make investment decisions to match their specific liabilities, the asset pricing model must change accordingly to derive accurate asset allocation recommendations and risk-adjusted performance, the report argued.
“The difference in perspective needs to be made when a regulator imposes strict rules on what an entity must do to recognize and mark-to-market liabilities, and these liabilities are explicitly proxied, modeled, measured, and monitored,” the paper said.
In changing the direction from CAPM to a liability-based model, the authors contended the focus should be on funded status maximization for various reasons.
The research found regulations and reporting regarding funded status were strict in many countries, including the US, often with sanctions following lower funding ratios.
But funded status, according to the authors, is a “stock concept,” rather than a flow concept and is most likely used to evaluate the financial health of institutions. Finally, a stronger focus on funded status—and less on surplus and deficits—allows for “consumption-based asset pricing models…that have been the palette of investment finance,” the report said.
The paper also asserted that RAPM could provide a reference point to the Market Portfolio Theory, link risk-aversion to funded status, and still preserve the risk-return trade-off from CAPM.
The newly proposed model could also be useful to investors as more institutions move to more explicit liabilities proxies, the authors contended. Public pension funds could be pressured to change over to discount rates used by US corporate funds and rating agencies could continue to change funding evaluations, thereby having an effect on funds’ credit ratings.
“RAPM highlights the tug-of-war in predicting returns between the reward required for pure asset risk and the compensation resulting from the liability hedge of a particular asset,” the authors said. “In effect, assets with a strong correlation to liabilities, within the risky asset bucket, would earn a lower rate of return that those that do not have this attractive property.”
The paper also argued RAPM’s flexibility and relativity could help bridge differences in investing ideology by accommodating CAPM, Prospect Theory, Fama-French and other factors, Benchmarking Theory, and even the Home Bias phenomenon.
“If one considers a relative world, which appears to reflect the truism that in reality most decisions are relative, not absolute, then we have to move to an at least three-dimensional view of asset pricing, with three basic dimensions being mean, variance, and correlation,” it said.
Read the full paper here.
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