The CAPM : Empricial Evidence

1. In this figure the authors sort US stocks according to their betas to form ten beta sorted
portfolios (the first portfolio is comprised of stocks with the lowest betas and the last
portfolio is comprised of stocks with the highest betas). They compute the average
annualized return of these beta sorted portfolios from 1928 to 2003 and compared them to
their predicted expected returns according to CAPM. They find that the empirical
relationship between the beta and expected stock returns is linear but too flat compared to
the CAPM. In other words, returns on low beta stocks are too high while returns on high beta
stocks are too low. This implies that the market premium is too high in the CAPM model, i.e.
that the market portfolio is not the tangency portfolio.

2. In this figure US stocks are sorted into ten portfolios according to their Book-to-Market
ratios. The average annualized monthly return of these ten portfolios is computed and
compared to the expected return predicted by the CAPM. While the returns on the portfolios
increase monotonically with the Book-to-Market ratio, Book-to-market ratios are inversely
related to a beta, which leads to high beta stocks having lower returns. The CAPM
relationship is thus inversed. This implies that the factors other than the beta can explain
expected stock returns and thus the market portfolio is not mean-variance efficient.

Betting against beta

1. FP2013 find empirically that financial assets with lower betas deliver higher excess returns
(alpha) compared to high beta assets. They construct long short portfolios that are long low
beta securities and short high beta securities and find that these portfolios produce positive
(and often significant) excess returns. This contradicts the standard CAPM assumptions.

2. FP2013 suggests that this phenomenon is due to the leverage constraints faced by many
types of investors. The idea is that, because of these constraints, investors overweight risky
securities instead of leveraging the tangency portfolio to adjust their risk. This leads to a
market portfolio with a lower Sharpe ratio then the tangency portfolio and hence a flatter
security market line than predicted by the CAPM. FP2013 consider a leverage CAPM model
that takes into account these restrictions and test its implications.