Does specialization in security analysis and portfolio management explain deviations from the CAPM?

Abstract

The Capital Asset Pricing Model (CAPM), which relates the risk of an individual security to its expected return, is frequently cited in investments textbooks and the academic literature as a centerpiece of modem finance theory. The main prediction of the CAPM is that investors are compensated in the form of expected return only for bearing systematic or market risk, which is the portion of a security's risk that cannot be diversified away. That investors demand reparation for and only for systematic risk is a consequence from the pivotal assumption that all investors have identical information for the entire universe of publicly traded securities. In actuality, professional active money managers rarely invest in a portfolio broad enough to be considered the market portfolio. Instead, the asset management industry has self-organized over time according to a top-down investment process, where asset allocators provide capital to security selectors who specialize in high-yield bonds, large-cap value stocks, and the like. Any losses in diversification benefits resulting from this theoretically suboptimal two-phase investment strategy are deemed an unavoidable cost of obtaining accurate forecasts through specialization in security analysis and portfolio management.

(cont.) This research paper extends the ideas of the CAPM to formulate an equilibrium security pricing model that attempts to account for the top-down approach followed by investors in the real-world.