They really do that…

I like to tell the anecdote that when I studied economics and finance, I was taught about the CAPM. Having already a postgrad degree in physics and maths in my pocket and working in physics at the time, I thought to myself that this is a nice sandbox model for students to understand the basic concept of a risk-return trade-off but surely no investment firm would ever use such a simple model to describe financial markets…

After all, the premise of the CAPM is that all the interactions of millions of individuals, their different beliefs and risk preferences can all be summed up in a linear (!) model where an asset class with twice the systematic risk earns twice the excess return over the safe investment. To believe it borders on insanity, in my view. Yet despite tons of evidence against it, many people still use it in the real world.

And how much the CAPM is still in use can be assessed by reading the rather depressing study of Spencer Couts and his colleagues. Not that the authors or their research is depressing, but their results certainly are.

They look at the capital market assumptions of major asset managers and institutional investment consultants from 1987 to 2022 and find that 65% of the variation in risk premia across asset classes is driven by a single factor (and you can guess which one). The chart below, for example, shows the average risk premium for US equities as forecast by these experts vs. the earnings yield calculated as the inverse of the Shiller PE (or cyclically adjusted PE, CAPE). Is it a coincidence that the earnings yield and the expected risk premium on stocks move in lockstep? I think not.

Expected risk premium and earnings yield for US stocks

Source: Couts et al. (2023)

Yet, while two thirds of the variation in risk premia across asset classes can be explained by a single risk factor, not all capital market assumptions from different asset managers and investment consultants are the same. There is an entire cottage industry of research about capital market assumptions out there and once every year, you will find multi-asset fund managers poring over the different forecasts of different houses to come up with an idea of how much return to expect for stocks, bonds, and other asset classes.

But while this variety of forecasts can look like a difference in opinion, Couts and his collaborators find that 80% of these differences between asset managers and investment consultants are driven by one thing only: Their initial estimate of how big the compensation for systematic risk is.

Once they have settled at a risk premium per unit of beta in their CAPM, all they do is calculate the beta of every asset class and then multiply that with the risk premium per unit of beta. The methods they use may look sophisticated, but in practice, it all boils down to a simple CAPM with a few bells and whistles to justify the fees. It really is a declaration of bankruptcy, in my view, in particular for investment consultants who charge lots of money for their strategic asset allocation advice.