A Critical Evaluation of the use of CAPM and Beta If there is one lesson that the investment market has

learned over the last 4 years, probably more than any other time in their recent history is that financial models used to reduce risk in forecasting share performances is risky business.

When Markowitz (Markowitz, 1952) first suggested through his portfolio theory that investors could select a portfolio of companies that would return a high likelihood of expected return for a known amount of risk, it spawned an enormous interest from academia and the investor market as a whole.

Capital Asset Pricing Model (CAPM) emerged from the work of William Sharpe (Sharpe, 1964) who finally published his paper introducing the risk free rate as an additional element to portfolio theory in 1964 from a paper written in 1962. When Lintner (Lintner , 1965) and Mossin (Mossin ,1966) independently arrived at similar conclusions to Sharpe it helped establish CAPMs acceptance in economic theory circles as a major breakthrough to managing market risk through a diversified portfolio, incredibly earning Markowitz and Sharpe a Nobel Memorial Prize in Economic Sciences in 1990.

CAPm is a model to calculate the expected return on a capital asset in relation to a related market, a risk free rate and the Beta () (Beta is an individual relationship of the security market line (SML) risk and expected return of the asset).

To demonstrate the use of this model and to comment on the statistical information extracted from the raw data, I have taken five years of monthly share values of HSBC PLC and the FTSE All share index. To ensure that I follow the CAPm requirement for a geometric mean I have

Converted the arithmetical share values to geometric by the use of natural logs (figure 1).

Figure 1. Table of Share prices and Calculated Natural Logs

Descriptives

Descriptive Statistics N Statistic RF RM 59 59 Range Statistic .3936374000 .2350537950 Minimum Statistic -.1976959400 -.1441181700 Maximum Statistic .1959414600 .0909356250 Sum Statistic -.4950981500 -.1274840621

Descriptive Statistics N Statistic RF RM Valid N (listwise) Descriptive Statistics Mean Statistic -.008391494068 -.002160746815 Std. Error .0100262307260 .0065947846935 Std. Deviation Statistic .0770129395083 .0506555024063 Variance Statistic .006 .003 Skewness Statistic .224 -.506 Std. Error .311 .311 Statistic .680 .232 Kurtosis Std. Error .613 .613 59 59 59 Range Statistic .3936374000 .2350537950 Minimum Statistic -.1976959400 -.1441181700 Maximum Statistic .1959414600 .0909356250 Sum Statistic -.4950981500 -.1274840621

Correlations

Correlations RF RF Pearson Correlation Sig. (2-tailed) Sum of Squares and Cross-products Covariance N RM Pearson Correlation Sig. (2-tailed) Sum of Squares and Cross-products Covariance N **. Correlation is significant at the 0.01 level (2-tailed). .344 .006 59 .633
**

RM 1 .633** .000 .143 .002 59 1

.000 .143 .002 59 .149 .003 59

Regression
Descriptive Statistics Mean RF RM -.008391494068 -.002160746815 Std. Deviation .0770129395083 .0506555024063 N 59 59

Correlations RF RM

Pearson Correlation

RF RM

1.000 .633 . .000 59 59

.633 1.000 .000 . 59 59

Sig. (1-tailed)

RF RM

RF RM

Variables Entered/Removed Model 1

Variables Entered RM
a

Variables Removed

Method . Enter

a. All requested variables entered. b. Dependent Variable: RF Model Summaryb Std. Error of the Model 1 R .633
a

R Square .400

Adjusted R Square .390

Estimate .0601590807227

a. Predictors: (Constant), RM b. Dependent Variable: RF Model Summaryb Change Statistics R Square Change .400 a. Predictors: (Constant), RM b. Dependent Variable: RF ANOVAb Model 1 Regression Residual Total a. Predictors: (Constant), RM b. Dependent Variable: RF Sum of Squares .138 .206 .344 df 1 57 58 Mean Square .138 .004 F 38.050 Sig. .000a F Change 38.050 df1 1 df2 57 Sig. F Change .000 Durbin-Watson 2.066

Coefficientsa Standardized Unstandardized Coefficients Model 1 (Constant) RM B -.006 .962 Std. Error .008 .156 .633 Coefficients Beta t -.805 6.168 Sig. .424 .000

Variables Entered/Removed Model 1

Variables Entered RM
a

Variables Removed

Method . Enter

a. Dependent Variable: RF

Coefficients

95.0% Confidence Interval for B Lower Bound -.022 .650 a. Dependent Variable: RF Upper Bound .009 1.274 .633 Zero-order

Correlations Partial Part

Collinearity Statistics Tolerance VIF

.633

.633

1.000

1.000

Coefficient Correlationsa Model 1 Correlations Covariances a. Dependent Variable: RF RM RM RM 1.000 .024

Collinearity Diagnosticsa Variance Proportions Model 1 Dimension 1 2 a. Dependent Variable: RF Eigenvalue 1.043 .957 Condition Index 1.000 1.044 (Constant) .48 .52 RM .48 .52

Residuals Statisticsa Minimum Predicted Value Residual Std. Predicted Value Std. Residual -.144943192601 -.1328763663769 -2.802 -2.209 Maximum .081159777939 .1851410716772 1.838 3.078 Mean -.008391494068 .0000000000000 .000 .000 Std. Deviation .0487265471040 .0596382130771 1.000 .991 N 59 59 59 59

Scatter Graph and Trend line

RMarket = 0.4162(Ret HSBC) + 0.0013 R = 0.4003

CAPM formula takes the form of Ri = Rf + (Rm - Rf) i Where Ri = the return on the asset, Rf = The risk free rate, which I have decided will be the 1yr 5% Tr 12 RED which is currently .40 % which equates to .033% RFR (Monthly) using Monthly RFR = ( 1 + .0040)(1/12) 1 = 0.00033. Rm = the average return on the market (Geometric Mean) which has been calculated to be -0.002. i = The Beta which has been calculated using SPSS for the HSBC share value to be 0.962, however Thompson analytics was 1.12.

Ri = Rf + (Rm - Rf) i 0.00033 + (-0.002 0.00033)0.962 = -0.00191, however due to the low Rm we are using (Ri - Rf )i to calculate the expected rate of return (ERR) of 0.00152

Results

The CAPm calculation and statistical analysis resulted in a mixed bag of results, due to the very low return on the market of -0.002 the Market premium of -0.0023 is a negative value to the risk free rate, indicating that investment in the FTSE market overall is barely worth the risk, and that there is a good argument not to do anything other than purchase gilts. For the expected return on HSBC I have used beta x Equity Risk Premium, the Risk Premium calculates at -0.25 providing a expected rate of return for January at -0.16 (Annual non compounded rate = -1.92 (compounded) = -1.9) The analysis returned a beta for HSBC of 0.962 indicating that this is a lower risk portfolio company but very close to the market combined with a negative ERR would not excite short term investors at all, and barely turn the heads of long term investors who would normally be attracted by this company, perhaps the dividend is amazing. Higher kurtosis of the tails in the HSBC shares than that of the market, suggesting that the market has a more evenly probability of distribution than that of the company, and that there is more chance that good and bad days occur within the company share price than that in the general FTSE market. However there is also skewness in both distributions, negative in the market and positive in HSBC suggesting that there are more bad days occurring in the market than of the company. There is also a high correlation to the market and HSBC share prices, suggesting that changes within the market affect the company shares, and vice vesa.

Roll's critique
mean-variance efficient

Assumption The risk free rate is Arithmetical, the other rates were converted to geometric

The combination of risky assets and a risk free asset gave investors a basis to calculate a capital market line that provides lending and borrowing and when Markowitz

As the efficient frontier only includes the portfolio of risky assets, a risk free asset with a zero risk return can be combined with risky assets added to the efficient portfolio and investors can then go beyond the frontier by borrowing and lending at risk free rate. A capital market line that used to linearly predict the market return can be drawn by lining up a point of a portfolio with only risk free rate to the other point that touches the efficient frontier, known as a tangency portfolio. The tangency portfolio explains that investors separate their decisions in investing and financing the investment as suggested by

Investors were CAPM

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Benchmark Issue in CAPM Jeffry Merril Liando (2007) Capital Asset Pricing Model (CAPM) has been widely used for finding a suitable required rate of return of a share or portfolio. However, the assumption of using a major share market index as the benchmark becomes an issue. This essay aims to discuss this issue related to the good theoretical assumptions, the problems arising in the CAPM, the distortion in its application, the

practice of seeking alpha in responding the distortion and the impact of distortion for the New Zealand context. CAPM and efficient portfolio CAPM assumes that a major stock index can be used as a benchmark to determine risk premium and beta for calculating the required rate of return of a stock. The formulae can be shown as follows, Rs = Rf + Beta ( Rm Rf ), or by noticing the future expectation as this: E(Rs) = Rf + Beta ( E(Rm) Rf ). To see the relationship between share and market returns, it can be formulated as follows: E(Rs) Rf = Beta ( E(Rm) Rf ). The benchmark index assumed in the CAPM is promoted as the market proxy of the efficient portfolio of risky assets. The benchmark index is then set artificially to be a manifestation of a whole market reflecting the acceptable portfolio chosen by investors within the efficient frontier. Markowitz (1952)[1] suggests that rational investors would choose minimum risk and maximum return in diversification and with any combination of weight the optimal portfolio lies on the efficient frontier. This is such an excellent portfolio theory so that Sharpe (1964)[2], Lintner (1965)[3] and Mossin (1966)[4] further modelled it to include the risk free rate. As the efficient frontier only includes the portfolio of risky assets, a risk free asset with a zero risk return can be combined with risky assets added to the efficient portfolio and investors can then go beyond the frontier by borrowing and lending at risk free rate. A capital market line that used to linearly predict the market return can be drawn by lining up a point of a portfolio with only risk free rate to the other point that touches the efficient frontier, known as a tangency portfolio. The tangency portfolio explains that investors separate their decisions in investing and financing the investment as suggested by Tobin (1958)[5]. In a sense of linear prediction of an individual share return, CAPM is then modelled with a security market line, in which a shares rate of return can be predicted given the market return, risk free rate and beta. The line is plotted by the expected rate of return of a share with its beta to the market return. The issue of benchmark index can be seen at this point. If there is a benchmark error, CAPM cannot estimate the correct beta and risk premium properly thus cannot calculated the expected rate of share return correctly. Benchmark error Benchmark error using CAPM for evaluating portfolio performance according to Ross (1980,1981)[6] can be seen in two ways when the market index produces an incorrect beta for the share and when it produces incorrect estimation for the market premium optimised to the risk free rate (see figure 1 and 2). The problem is not due to statistical variation but rather to the

cause that the market index is not a good predictor of mean/variance efficient portfolio.

Figure-1. Incorrect beta

Figure-2. Incorrect market premium A further study by Green (1986)[7] shows that benchmark errors are continuous behaviour and different for different indexes, thus, share or portfolio performance is sensitive to the choice of benchmark for the market index. We may now say that as beta assumed equals to one, the expected rate of return should be higher as we choose any benchmark that produces a higher market risk premium, and lower for any benchmark that produces a lower premium. Benchmark errors are also considered in the context of global investment. Reilly and Akhtar (1995)[8] found that there is a variation of beta when using a domestic index, global index or a diversified global stock and bond portfolio. The beta of domestic equity index is lower than the world equity index and much larger for the diversified global stock and bond portfolio. Market proxy, beta and risk premium problems The root of benchmark error was based fundamentally on Rolls critique (1977)[9] that found that market index is efficient per se, not for the individual shares or portfolios. Ross (1978)[10] also added that market proxy is not ex ante mean-variance efficient and individual preference in portfolio selection may be judged with a different market index and then will be penalised by shares beta according to the different market index. Roll and Ross (1994)[11] found that the market proxy may be located within 22 bps below the efficient frontier (Figure-3).

Figure-3. Market proxy and efficient frontier Using the true market proxy of the value weighted portfolios of all US shares, Fama and French (2004)[12] tested CAPM by plotting the annualised monthly return and beta of every stock in NYSE, AMEX and NASDAQ from 1928 to 2003 and to be compared to the returns predicted with CAPM. The result is telling us further problem other than benchmark error and market proxy problem, that is, beta inconsistency.

Figure-3. Beta inconsistency. Figure-3 shows an inconsistency of beta in CAPM. Low beta shares that are predicted to have low returns are in fact too high whereas high beta shares that are predicted to have high returns are in fact too low, as seemingly the line rotates. The inconsistency of beta was identified a decade before by Fama and French (1992)[13] as suggested a three-factor model by adding size and book to market ratio (B/M) to CAPM. They concluded that value shares with high dividend yield, high B/M, low P/E tend to have bigger expected return than growth shares with low dividend yield, low B/M, high P/E. Again using the true market proxy and the three-factor CAPM, Fama and French (2006)[14] tested whether the value premium exists in CAPM pricing. The result is rejecting CAPM pricing for portfolio based on size, B/M and beta as concluding that size and B/M, not beta, reward the expected return. The evidence shows that expected return does not compensate beta variation unrelated with size and B/M for both small stocks and big stocks. We may say that if CAPM is fine a good benchmark index should contain both small stocks and big stocks. Alpha Market proxy distortion opens an opportunity to have a better portfolio performance than the market itself which was earlier suggested by Jensen (1969)[15] with alpha as a performance indicator: Alpha = Rs - Rf + Beta ( Rm Rf). However, one can say that even a passive portfolio can beat the benchmark. Bowden (2000)[16] further argued that alpha relates to market timing and cannot be observed by conventional performance measures and suggested ordered mean difference (OMO) as an alternative measure, which is a function of a running mean of the difference between asset/portfolio and benchmark returns that is ordered by values of the benchmark. Recently, Fama and French (2006)[17] discussed about a portable alpha as a way to add a portfolio consisting risk free rate and index funds with an additional hedge position that generates alpha. Moreover, an alternative indexing has been suggested by Arnott (2005)[18] in fundamental indexation to solve the distortion in value weighted index with some alternative weighting constraints, such as book value, cash flow, revenues, gross sales, gross dividend and total employment. New Zealand context In order to see the impact of benchmark distortion in the New Zealand context, there are some market characteristics need to be considered (Bowden, 2005, p.133-168)[19], as follows, narrow true market proxy, large foreign capitalisation, high dividend yield, high risk free rate, low holding period return and low prospect dominance.

A consensus for share market proxy in NZ is the NZX-50 index that can be seen in every business page and news and the NZX-All for the true market proxy. However, there is a significant proportion of investment taking in the form of farming shares as the grass root of the NZ economy as a whole. For example, a rich Waikato Fonterra farmer may see a comparable investment choice between investing in Fonterra shares and NZX-50 shares, thus she needs a broader efficient frontier for the true market proxy other than just NZX-All. In fact, Fonterra only issues capital notes and none of its capitalisation in the share market. The top ten capitalisations in the NZX-50 hold around 37.5% of foreign capitalisation. Since beta domestic equity market after influenced by beta foreign equity market may change, then the return of individual shares may be predicted below or above the original security market line. High dividend yield and low P/E make NZ shares considered as value shares. Value shares may have a higher expected rate of return, thus a higher cost of capital, than growth shares according to the CAPM test by Fama and French (1992). If the CAPM holds, it is likely that the correct benchmark used would be the gross index, not the capital index which is widely used in the other market. A promotion to use the gross index to international investors may attract them to choose NZ equity. High risk free rate may increase the cost of capital with a condition that there is no false market risk premium estimation in the benchmark. However, if benchmark error deviates to a lower market return then the market risk premium would be narrow and the security market line may rotate. Low holding period return for NZ shares may be compensated by high risk free rate so that at some period the return of NZ shares is in fact is lower than government bond return. Under CAPM prediction, if NZ benchmark consists mainly of such shares, of course the market risk premium would be negative and the expected share return would be below the risk free rate. The NZX-50 benchmark is dominated by larger companies with low growth prospect. That is why investors may have the opportunity of seeking alpha and beat the index with some shares like Michael Hill, Fisher and Paykel, Cavalier, Dorchester, etc. If tested with CAPM, there would be a big deviation from the predicted return of such shares. Conclusion CAPM assumes a major share market index as the best market proxy for efficient portfolio to predict the required rate of return. Despite the good theory background of mean (return) variance (risk) efficient portfolio, the linear CAPM prediction using such proxy could be far from the reality of historical returns. As Fama and French (2004, p.44) suggested, But we also

warn students that despite its seductive simplicity, the CAPMs empirical problems probably invalidate its use in applications. References

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[19] Bowden, Roger and Jennifer Zhu. (2005). Kiwicap: an introduction to New Zealand capital markets. (2nd ed.). Wellington: Kiwicap Education.