The Capital Asset Pricing Model is broken. Now, a new group of academics is trying to fix it, looking at the role of professional money managers in setting stock prices.
The biggest problem the researchers have identified: Money managers' incentives don't always align with those of their clients, leading the managers to pile into riskier stocks, driving their prices up and, perversely, leading to lower expected returns.
Managers have a huge incentive to retain the business of sophisticated institutional clients, which generates an annuity-like payment of fees. Several years of sustained underperformance can lead to that business walking out the door, observed Brad Cornell and Richard Roll, two finance professors at the University of California at Los Angeles' Anderson Graduate School of Management.
Thus, managers try to pick stocks that outperform a given benchmark and limit volatility of tracking error to that benchmark, instead of picking the optimal portfolio, according to a paper by Messrs. Cornell and Roll that was published in the January/February 2005 issue of the Financial Analysts Journal.
Jason Karceski, an academic at the University of Florida's Warrington College of Business, Gainesville, takes a different tack. He argues that active managers "tilt their portfolios toward high-beta stocks. In equilibrium, this bump in demand for high-beta stocks pushes their prices higher and expected returns lower," he wrote in a December 2002 paper published in the Journal of Financial and Quantitative Analysis.
Together, the papers establish a framework for modifying CAPM to make it a closer approximation to reality. However, much more research needs to be conducted to turn this new Capital Asset Pricing Model into a workable tool for investors.