A new paper argues that factor investing challenges the decades-old Capital Asset Pricing Model (CAPM), according to an article in Institutional Investor.
The paper’s co-author, Northern Trust Asset Management’s head of quantitative strategies Michael Hunstad, said in an interview: “CAPM asserts that if you want more return you take more risk. But also in the same vein, nothing generates a higher risk-adjusted return than a market-cap portfolio, typically thought of as a market cap-weighted benchmark.” But factors, he said, have demonstrated that they can generate higher risk-adjusted returns than cap-weighted benchmarks. “CAPM was a valiant first start,” he added, “But that was 1964. We’re in 2019. These theories have to evolve.”
While factors can suffer long periods of underperformance and present a risk for investors, Northern Trust recommends that investors diversify across factors and eliminate hidden and uncompensated risks in their factor-based funds. The article cites the example of the price-to-book metric, which historically has been used to define a value stock: “Using that today would lead an investor to overweight financial stocks, which can add significant risks during certain market environments.”
On CAPM, Hunstad asserts, “It’s fascinating how these ideas are ingrained in the common knowledge of the industry.”