Arun Muralidhar

The Relative Asset Pricing Model: Implications for Asset Allocation, Rebalancing, and Asset Pricing

The Capital Asset Pricing Model (CAPM) has been the backbone of asset market finance, even though many academic studies have revealed its limitations, both theoretical and empirical. This paper argues that including liability or benchmark considerations in investment decisions may provide a credible explanation for some of the limitations. In effect, the CAPM is an “absolute wealth”-centric model, driven by the assumption that investors derive utility from absolute wealth. In reality, investors first make investment decisions to ensure sufficient assets to meet obligations, such as future pension payment or future consumption (i.e., liabilities), and focus on relative wealth. Thereafter, many investors hire external managers and evaluate them on performance relative to assigned benchmarks. Interestingly, existing robust literature on, and product offerings for, “liability driven investing,” have not led to a shift in academic theories of asset pricing to reflect the liability perspective. After all, if asset owners choose investments to service liabilities (proxied by benchmarks), it is expected that liabilities or these benchmark proxies will impact asset prices.

Asset Pricing Anomalies: Two Hedge Factors with Negative Risk Premia Embedded in Portfolios!

The primary purpose of this research is to empirically test a new asset pricing model, the Relative Asset Pricing Model (RAPM), and to confirm whether hedge portfolios on two new risk factors highlighted in that model, and embedded in all portfolios, have negative and significant risk premia. In a number of specifications, this first test of RAPM appears to validate the importance of these two ubiquitous risk factors: (i) a liability proxy or Strategic Asset Allocation (SAA); and (ii) an index of traditional rebalancing back to the SAA (REBAL). A secondary goal of the research is to then examine what RAPM and the inclusion of these two risk factors mean for other commonly used factors (like Value Premium, Capitalization Premium, and Momentum Premium) that are increasingly being added to portfolios in a new trend called “factor-based investing”. In many regressions, adding these two new factors either individually or together causes traditional factors like Capitalization and – in fewer cases – Momentum to lose their significance. Valuation continues to be significant even in tests where the SAA is heavily biased to include Value indices. These findings have interesting implications for improving portfolio performance especially in a low-yielding environment. Investors would do well to consider an intelligent approach to managing portfolio drift. With respect to factor-based investing, two results stand out: (i) Valuation seems to be a very robust strategy; and (ii) early movers probably benefit before these strategies get incorporated into the industry-wide SAA and then lose significance – a seemingly obvious result but validated in the context of a robust asset pricing model, thereby also serving as a first test of (a special case of) the Adaptive Markets Hypothesis.

A Very Simple Goals - and Risk-Based Asset Pricing Model (or Asset Pricing with Heterogeneous Investors)

Prof, Andre Perold has shown how the Capital Asset Pricing Model (with implications for asset pricing and risk-adjusted performance) can be derived from maximizing the Sharpe ratio as opposed to the traditional approach of assuming that investors maximize the utility of wealth. More recently, Goals-based Investing (GBI) is becoming the norm for investors and Prof. Robert Merton has suggested that theory needs to accommodate the fact that investors maximize relative (wealth divided by the present value of the goal) and not absolute wealth. Individuals save for a range of goals (e.g., retirement, a child’s college expenses) and each has a unique set of cash flows. The paper first argues for the creation of a new class of relative risk-free fixed income securities for each goal as proposed for a number of countries by Prof. Merton. These instruments will typically be interest-only real bonds (linked to the appropriate inflation index), with a forward start date, and pay coupons for the period required for the respective goal. The second contribution of this paper is to use the Perold approach and show that with two such goals/instruments and the traditional risk-free asset, all risky assets can be priced and optimal asset allocation recommendations derived, without requiring a formal utility function, risk aversion parameter or market portfolio. All that is needed is the assumption that investors maximize risk-adjusted returns relative to the goal-replicating asset and specify risk goals much like traditional investors would specify. The asset pricing model is derived from the simple idea that a relatively risk-free asset for one goal is a risky asset for another, and hence these two assets, plus the absolute risk-free rate allow us to triangulate to establish returns for all other assets. This approach also lends itself easily to an asset pricing model with heterogeneous investors and effective risk-adjusted performance measures.

The Most Basic Missing Instrument in Financial Markets: The Case for Forward Starting Bonds

There is a looming retirement crisis globally with the three pillars of retirement threatened because of insufficient funding, improper investment decisions, and transferring risk to individuals who are least capable of bearing such risk. This paper argues that the introduction of a unique financial instrument, basically an inflation linked bond which pays coupons when you need it, might help ameliorate this crisis. The Life Cycle Hypothesis (LCH) demonstrated why people save; namely, they try to set aside resources during their working lives, to be able to tap into them to ensure retirement income when labor income stops. Modern Portfolio Theory (MPT) attempted to help individuals make optimal investment decisions on these savings by investing in stocks, bonds and other assets to ensure sufficient retirement wealth. There are three problems with using MPT approaches for retirement planning: (a) MPT ignores the uses of funds; (b) focuses on wealth as opposed to retirement income maximization; and (b) none of these assets is an ideal hedge for a desired retirement income. As a result, seemingly safe MPT assets are risky from a retirement income perspective (because the Capital Asset Pricing Model (CAPM) is a specific case of a more general Relative Asset Pricing Model (RAPM)). The need for our bond is simple: the riskless retirement asset is an inflation-indexed, coupon-only bond that defers payment until retirement and pays till death. All attempts to recreate this profile through traditional stocks and bonds, or purchase such a profile through annuities are sub-optimal, risky, complex or expensive thereby threatening retirement security. The paper goes further to demonstrate that there is a potentially willing supplier of such bonds, and that this bond offers the perfect offsetting cash flow profile to infrastructure projects, thereby completing the market. It also addresses challenges, issues and opportunities surrounding such an instrument and examines issues relating to the creation of a market for FSBs.