Asset Management:

3. Factors in Expected Returns and Asset Pricing Models

Felix Wilke
Nova School of Business and Economics
Spring 2024
Why did so many asset classes crash at the same time in 2008-2009?

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Asset classes vs. factors

• A factor is a variable which influences the returns of assets (it is only a question of
degree as to how a particular asset is affected).

• Exposure to factor risk over the long run yields a risk premium.

• The premium does not come for free: it is compensation for bearing losses during
bad times. Being exposed to the factor results in holding risk that other investors
seek to avoid.
• Types of factors:
1. Fundamental or macro-factors: economic growth, inflation, productivity risk, demographic
risk, political risk, volatility (usually non-tradable, at least not in scale).
2. Tradeable or investment factors: market portfolio, value-growth investing, momentum
investing, low-volatility investing, betting against beta.

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CAPM
One period mean-variance with N risky assets and a risk free asset rf

• Express mean and variance of the portfolio return using matrix notation:

E[rp ] = (1 − ι′ w)rf + w′ E[r] = rf + w′ E[re ]; Var[rp ] = w′ Σw

where w ∈ RN , ι = (1, . . . , 1)′ ∈ RN , r = (r1 , . . . , rN )′ ∈ RN , Σij = Cov(ri , rj ), Σ ∈ RN×N

• The problem becomes
γ ′
max w′ E[re ] − w Σw,
w 2
• the FOC is
E[re ] − γΣw = 0,
• and the solution is:
w∗ = γ −1 Σ −1 µ e , where µe = E[re ]
• Optimal portfolio for any γ: same relative weights in risky assets, same maximum
Sharpe ratio.

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The tangency portfolio and two-fund separation

• The mean-variance portfolio that is 100% invested in the N risky assets is the
tangency portfolio. To find wT from a given mean-variance portfolio w∗ , we have to
rescale the weights in w∗ such that they sum up to one:
1
wT = w ∗ ,
κ
′
where κ = w∗ ι denotes the sum of the elements in w∗ .
• Two-fund separation: given w∗ = κwt , the value of κ is the weight that w∗ puts on the
tangency portfolio (and 1 − κ the weight in the risk-free asset).
′ ′
κ = w∗ ι = γ −1 µ e Σ −1 ι
• Use the expressions for w∗ and κ in wT = κ1 w∗ to get
Σ −1 µe
wT = ′
µe Σ −1 ι
′
µe Σ −1 µe µeT ′
µeT = wT′ µe , Var[rT ] = wT′ ΣwT = , = µe Σ −1 ι
( µ e′ Σ −1 ι ) 2 Var[rT ] 4/34
From mean-variance to CAPM

• All ingredients to arrive at an asset pricing model. For all assets n = 1, . . . , N, we have:
µe µe Cov(r, rT ) e
Cov(r, rT ) = ΣwT = = ⇒ µe = µ
′
µe Σ −1 ι µeT Var[rT ] T
Var[rT ]
or,
E[rn − rf ] = β n,T E[rT − rf ]
• Under the CAPM assumptions, the tangency portfolio must be the market portfolio in
equilibrium: wT = wM
• All investors hold the same portfolio of risky assets.
• Just in different quantities depending on their risk aversion / desired expected return!
• The beta pricing relationship above is formally called the Security Market Line (SML).
• Any stock’ risk premium is proportional to the market risk premium.
• Beta (=CAPM’s measure of risk) involves diversification benefits. The lower the stock’s
beta, the lower the covariance with the market, and the higher the diversification benefits.

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CAPM assumptions

• CAPM is an equilibrium model which specifies risk-return trade-offs of

1. an individual stock relative to the market portfolio and
2. the market portfolio return and risk.
• Main assumptions:
• Single-period investment horizon.
• Individual investors are price takers.
• Investments are limited to traded financial assets.
• No taxes and transaction costs.
• Information is costless and available to all investors.
• Investors are rational mean-variance optimizers.
• Homogeneous expectations.
• Would you expect anomalous returns relative to the CAPM for strategies focused on
where these assumptions fail?

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Equilibrium concept

• The economic concept of diversification underlies the CAPM. Investors hold the
market portfolio because it diversifies away idiosyncratic risk.

• The CAPM is an equilibrium model: prices are set where supply = demand.

• Example: suppose everyone’s optimal portfolio assigns wIBM = 0

• This cannot be an equilibrium, someone must hold them!
• What happens? If no-one wants to hold it, IBM must be overpriced.
• IBM’s expected return is too low.
• What happens? Price falls (expected returns increase), until investors want to hold
exactly the number of IBM shares outstanding.
• Find prices so that supply = demand (equilibrium).

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CAPM Equilibrium and the Security Market Line

1. CAPM implies that all

assets and portfolios of
these assets line up on
the SML.
2. Only risk that matters is
systematic risk captured
by β n,M . Unsystematic
risk is not priced.

• Question: how does CAPM equilibrium work for assets A and B?

• A is overpriced, E[rA − rf ] too low for given risk. Investors will not want to invest in A, price
drops until E[rA − rf ] = β A,M E[rM − rf ].
• B is underpriced, vice versa.
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Six lessons from CAPM

1. Don’t hold an individual asset, hold the factor (market). The market portfolio
diversifies away all idiosyncratic risk of individual assets.

2. Each investor has her own optimal exposure of factor (market) risk.

3. The average investor holds the market.

4. The factor risk premium has an economic story.

5. Risk of an asset is factor (market) exposure = beta.

6. Assets paying off in bad times (assets with low betas) have low risk premiums.
• Bad time = low (negative) market return.
• Losses during bad times are more likely with high beta assets.
• High beta assets are risky and require high expected returns to be held in equilibrium.

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The CAPM in practice

• Although CAPM is firmly rejected in data . . .

• . . . remains workhorse model of finance: 75% of finance professors advocate using it,
and 75% of CFOs employ it in actual capital budgeting decisions (remaining 25% does
not necessarily advocate better methods, like payback period).
• Why? CAPM just fails miserably in some applications, but works approximately and
well enough in many applications.
• Part of the tenacious hold of the CAPM is the way that it conveys intuition of how risk
is rewarded.
• As a result of diversification: Risk is a property not of an asset in isolation, but how assets
co-move with the portfolio.
• Investors desire insurance for bad times, which in CAPM means low returns on the market
portfolio.
• High beta assets do not provide insurance → low price, high E(r).

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Empirical performance of the CAPM

1. Time series regressions:

• ren,t = αn + β n,M reM,t + ε n,t
• HTS0 : α1 = · · · = αN = 0
• αn > 0: asset/portfolio n is underpriced by CAPM!

2. Cross-sectional regressions: CAPM predicts that all cross-sectional variation in

expected returns is explained by variation in beta:
• E[ren ] = λ0 + λM β n,m + ηn .
• HCS e 2
0 : λ0 = 0, λM = E[rM ], R = 1.
• Two step procedure, because both sides unobservable.
1. Estimate individual factor exposures β̂ n,M in time series regressions: ren,t = αn + β n,M reM,t + ε n,t
2. Estimate λ̂0 and λ̂M as time series averages of parameters estimated in cross-sectional
regressions at each t: ren,t = λ0,t + λM,t β̂ n,M + ηn,t

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Fama and French evidence against the CAPM

• Portfolios are less noisy than single stocks. Form portfolios on β (left) or on
book-to-market (right) (Fama and French, 2004)

• Left: relation between excess returns and beta is flat.

• Right: CAPM does not even get the sign right!

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The CAPM failure

• The existence of strategies that consistently beat CAPM (size, book-to-market) may
be due to the presence of additional risk premiums.
• Consistent with CAPM assumptions being violated in real-life: investors interpret “bad
times” more broadly than just poor stock market returns.
• Cochrane (2005): Most investors do not just sit on a pile of wealth that they invest in
stocks and a risk-free bond. They are employed, and own houses, small businesses, and
other non-marketed assets. Investors worry about fluctuations in these assets.
• Multifactor models extend the measure of “bad times.”
• Profitability of size and book-to-market strategies may also be due to other CAPM
assumptions being violated.
• Imperfect and/or asymmetric information and behavioral effects (investors may like
certain assets for reasons other than how they change the mean-variance trade-off of
their portfolio).
• We discuss this possibility later.

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Multifactor models
A multi-factor asset pricing model (1/3)

• We present the model in the most general form to get intuition.

• Assume investors have exposure to a predetermined, non-tradable risk S.
• Let’s assume S is housing/real estate with return rS,t .
• Analogously, you can think of human capital or macro-factors that broadly capture
recession or consumption risk.
• With exposure q to the non-tradable risk, a fraction of wealth invested in stocks. The
investor’s portfolio return is

rp,t+1 = rf + w′ ret+1 + qrS,t+1 .

• Now, the investor must solve (ignoring terms that do not involve w):
γ( ′ )
max w′ µe − w Σw + 2w′ ΣS q
w 2
where ΣS is Cov(ret+1 , rS,t+1 ).

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A multi-factor asset pricing model (2/3)

• Solution combines standard mean-variance efficient demand with a

minimum-variance hedge demand:
w∗ = γ −1 Σ −1 µ e − Σ −1 Σ S q
• Hedge demand from the regression:
Σ−1 ΣS = bS from rS,t+1 = aS + bS ret+1 + eS,t+1
• rS,t+1 ↑ is good news (housing wealth increases) and consider a stock with
Cov(ren,t+1 , rS,t+1 ) > 0. Is this stock attractive as a hedge to the investor?
• No, therefore he will want less of this stock (relative to CAPM).
• As a result, equilibrium expected return should be higher (than in CAPM):
µe = γM ΣwM + γM ΣS qM
where γM and qM are the wealth-weighted risk aversion and exposure for the
aggregate market (representative agent).
• Both covariance with M and S are priced! 15/34
A multi-factor asset pricing model (3/3)

• If the exposure qM > 0 (many investors are exposed, perhaps heterogeneously), we

have that
1. Market portfolio ̸= tangency portfolio of stocks:
wM + wH = wT , where wH is a hedge portfolio that is long (short) stocks with a high (low)
covariance with the risk factor.
2. Expected returns satisfy a two-factor model:

E(ren,t+1 ) = β n,M E(reM,t+1 ) + β n,H E(reH,t+1 )

• Just like the single market factor in the CAPM, the additional risk factor(s) cannot be
diversified away and, in equilibrium, investors will require compensation for bearing
these risk(s).
• Positive risk premiums (E(ReH,t+1 ) > 0) compensate the investor for the exposure to
stocks that lose exactly when the investor is hit by an adverse shock to non-tradable
wealth!

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Interpreting multifactor models

• Theory: if investors interpret “bad times” more broadly than just poor stock market
returns (because they have human capital, own a house, a small business, fear
recessions etc.) there will be additional factors represented by hedge portfolios.
• Recall that expected returns can always be written as a function of exposure to the
tangency portfolio:
E(ren ) = β n,T E(reT )
• Multi-factor models answer the question: Do we really need to identify the true
tangency portfolio of all traded assets?
• No! If investors are exposed to additional risks, wT = wM + wx + ...
• All we need is to identify relevant collection of hedge portfolios from which the tangency
portfolio can be constructed.
• Hedge portfolios go long in some stocks and short in others (depending on their
exposure to risks other than the market).
• Weights sum to zero rather than one, s.t. investors hold the market portfolio in
equilibrium!
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A general multi-factor model

• This logic drove researchers to add portfolios with consistent outperformance

relative to the CAPM to the model.
• Such multi-factor models are generally written as:
E(Ren,t+1 ) = β n,M E(ReM,t+1 ) + β n,2 E(Re2,t+1 ) + . . . + β n,K E(ReK,t+1 )
• The first factor is the market portfolio.
• Factors jointly capture systematic risk or ”bad times”.
• Time-series:
• HTS
0 : αn = 0 for all n = 1, . . . , N
Ren,t+1 = αn + β n,M ReM,t+1 + β n,2 Re2,t+1 + . . . + β n,K ReK,t+1 + ε n,t+1
• Cross-sectional tests:
• HCS e
0 : λ0 = 0, λk = E(Rk,t+1 ) for all k = M, 2, . . . , K, and R = 1
2
e
E(Rn,t+1 ) = λ0 + λM β n,M + λ2 β n,2 + . . . + λK β n,K + an
• No arbitrage: if idiosyncratic risk can be diversified away, any portfolio with exposures
( β n,M , β n,2 , . . . , β n,K ) can be replicated by investing in the factor portfolios, such that
λk = E(Rek,t+1 ).

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The Fama and French (1993) model

• The Fama and French (1993) three factor model adds SMB and HML to the market
portfolio:
E[ren ] = β n,M E[reM ] + β n,SMB E[rSMB ] + β n,HML E[rHML ]

• SMB captures the historical outperformance of small versus large stocks.

• HML captures the historical outperformance of high book-to-market (b/m) stocks

relative to low b/m stocks.

• Note, average stock has zero exposure to SMB and HML, and unit exposure to the
market (not all stocks can be small..)

• SMB and HML are dynamic strategies that require rebalancing across stocks every
period, differently from the market factor.

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Interpretation

• FF3M widely used, but how to motivate SMB and HML economically?
• Fama-French allude to interpretation as hedge portfolios.
• Small and Value stocks outperform on average, but have episodes with large losses that
broadly coincide with ”bad times”/recessions.
• The verdict is still out: not so easy to exactly identify what (quantity of) risk these
strategies expose the investor to.
• Size premium not robustly present in international stock markets and considerably
smaller over the last two decades.
• Data mining, trading?
• Value-growth premium very robust over time and across asset classes (Graham and Dodd
started teaching value investing in 1928!).
• A popular risk-based explanation: growth firms (high market to book firms like Google,
Facebook) have lots of human capital. Hence, they can relatively easily adjust to changing
market conditions (produce a different product, fire employees). Thus, macroeconomic risk and
E(r) will be lower.

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The origin of a premium is important!

• Academics strive to understand where premiums come from.

• Allows us to test economic theories, which helps us to understand markets, but…
• … certainly also important for investors!
• For instance, if value stocks do poorly when many investors experience a bad time, many
should shun value stocks.
• This is exactly where the risk premium comes from!
• If these times are ”not that bad” for you, increase exposure and capture the value premium.
• Various anomalies (relative to the CAPM) have explanations that arise from a rational
risk-based story or a behavioral story
• Rational: high expected returns compensate for negative returns during certain periods.
The key is defining what those bad times are.
• Behavioral: high expected returns result from agents’ under- or over-reaction to news
and/or the inefficient updating of beliefs. Behavioral biases persist because there are
barriers to the entry of capital.
• Investor should not care if the source is rational or behavioral.
• Is she different from average investor who is subject to rational/ behavioral constraints?
• Is the source of returns expected to persist in the future?
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Six lessons from multi-factor models

1. Diversification works! Tradable factor diversifies away idiosyincratic risk.

2. Each investor has her own optimal exposure of each factor risk.

3. The average investor holds the market: but wM ̸= wT

4. Market risk premium and non-zero factor risk premiums.

5. Risk of an asset is measured in terms of factor exposures (factor betas) of that asset.

6. Assets paying off in bad times are attractive, and these assets have low risk
premiums.

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Macro factors
Economic growth

• When economic growth slows, all firms and investors in the economy are affected.
• Most consumers dislike low growth, more likely to be laid off.
• All asset returns are much more volatile during recessions or periods of low growth.

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Inflation

• Consumers dislike inflation because Less able to afford same basket of

goods/services.
• High inflation bad for both stocks (surprising because equity is a claim on real,
productive assets of firms) and bonds (instruments with fixed payments, lower value
in real terms).
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Volatility

• Stocks do badly when volatility is

rising.
• Leverage effect: when stock
returns drop, financial leverage of
firms increases (equity value falls,
debt value approximately
constant). Equity gets riskier.
• CAPM: as market volatility
increases, investors require higher
return and stock prices decline
(high future returns).

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Investment factors
Simple and dynamic factors

• Simple investment factors.

• Equities, bonds.
• Cheap index management delivers these long-only factors at essentially zero cost in very
large size.
• Based on market capitalization weights; represent the aggregate average investor.

• Dynamic factors.
• Take long position in securities with similar characteristics, which tend to comove with
each other, and offsetting short positions in securities with the opposite characteristics.
• The market portfolio, by definition, has no dynamic factor exposure.
• Classic premia: Value-growth (value minus growth stocks), size (small minus large stocks),
momentum (winning minus losing stocks).
• Other premia: Illiquidity (illiquid minus liquid securities), credit risk (high default risk
minus with low default risk securities), low volatility (low volatility minus high volatility
stocks).

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Value vs. growth

• Value stocks: “Stocks that are out of favor with the investment community selling at
relatively low prices in relation to their earnings or book value. These stocks typically
produce above-average dividend income.”
• Growth stocks: “Stocks of companies with above-average prospects for growth based
on measures like revenue, earnings and book value. Generally produce little
dividend income and tend to trade at high prices relative to earnings or book value.”
• Any rational story of a strategy having unconditionally high expected returns is those
high expected returns compensate the investor for losing money during bad times.
• Applied to value investing:
• Value stocks have high expected returns because they are risky during bad times. Value
stocks tend to lose money during bad times and require high risk premia to induce
investors to hold these stocks.
• Growth stocks have low returns because they tend to pay off during bad times and are
less risky.

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Value vs. growth: behavioral theories

• Most behavioral explanations of value center around

over-reaction/over-extrapolation.
• Investors over-extrapolate past growth rates into the future.
• Growth firms have had high past growth rates. Prices of these firms are bid up too high
reflecting excessive optimism.
• When growth does not materialize, prices fall so returns are low relative to value firms.
• Value stocks are NOT fundamentally riskier.

• Story first put forward by Lakonishok, Shleifer and Vishny (1994).

• Crucial assumption: naive investors over-extrapolate and prices reflect the

over-reaction. Contrarian (value) investors outperform by taking the opposite side.
• Why don’t more value investors enter the market and bid up the prices of value stocks
removing the value premium?

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Size

Disappearance of the size effect:

• Original discovery of size premium
data mining? Effect appears
significant in sample but fails out
of sample. Size effect might never
have truly existed and finding was
pure luck.
• Other explanation: size effect was
there and actions of rational,
active investors, acting on news of
the finding, bid up the price of
small cap stocks until the effect
was removed.

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Momentum

• Jegadeesh and Titman (1993)

momentum.
• Buy winner stocks that went up in
the past (e.g. 12 months) and short
loser stocks.
• Value investing is stabilizing.
Momentum investing is
destabilizing.
• Carhart (1997) four factor, or FFCM,
model.

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Momentum: behavioral theories

• Behavioral explanations of momentum come in two main flavors:

• Under-reaction: good news comes out but investors under-react. Then, prices slowly drift
upwards to the rational price.
• Over-reaction: irrational investors over-react to positive news. This over-reaction is
gradual, so stock prices display momentum for a period of time but then eventually
reverse and return to fundamental value.
• Most combine elements of under- and over-reaction.

• The under-reaction captures momentum, while the over-reaction captures long-term

mean reversion.

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Momentum: risk theories

• Momentum is hard to explain with a risk story. But, there seem to be some risk
components of momentum profits.

• Downside risk components to momentum profits.

• Momentum crashes (Daniel and Moskowitz, 2012).
• 11 historical events: 7 in the Great Depression (1930), 1 in 2001, and 4 in the Great Financial
Crisis.
• Momentum performs particularly bad when governments intervene to cap losers’ prices:
monetary policy and government risk during extraordinary times.

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Back to the initial question:
Why did so many asset classes crash at the same time in 2008-2009?

• Factors matter more than asset classes: exposure to the same factors.

• Over long periods, assets risk premia are high to compensate for low returns during
bad times.

• Many asset labels can provide you with the illusion of being diversified when actually
you are not.

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References

• Ang, Asset Management: A Systematic Approach to Factor Investing, Ch. 6-7

• Articles
• Carhart, 1997, On Persistence in Mutual Fund Performance, Journal of Finance
• Daniel and Moskowitz, 2016, Momentum crashes, Journal of Financial Economics
• Fama and French, 1992, The Cross-Section of Expected Stock Returns, Journal of Finance
• Fama and French, 1993, Common Risk Factors in the Returns on Stocks and Bonds, Journal of
Financial Economics
• Fama and French, 2004, The Capital Asset Pricing Model: Theory and Evidence, Journal of Economics
Perspectives
• Hong and Stein, 1999, A Unified Theory of Underreaction, Momentum Trading, and Overreaction in
Asset Markets, Journal of Finance
• Jegadeesh and Titman, 1993, Returns to Buying Winners and Selling Losers: Implications for Stock
Market Efficiency, Journal of Finance
• Lakonishok, Shleifer, Vishny, 1994, Contrarian Investment, Extrapolation, and Risk, Journal of Finance
• AQR podcast: the curious investor
• Face the factors Momentum Superstar-Investors

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