The CAPM: 'Reports of My Death Have Been Greatly Exaggerated'

Abstract

What does it mean to assert that the CAPM is "dead?" Like Fama and French (1995), we focus on the practical issue of whether betas defined with respect to commonly-employed market proxies provide useful information about expected returns. The possibility that a more comprehensive market index might yield different results is recognized, but not pursued here. We present evidence on the ability of beta and size to explain cross-sectional variation in average returns for 100 portfolios ranked on size and then beta. In particular, the extent to which size is incrementally helpful in explaining average portfolio returns is assessed. We find that, the incremental benefit of size, given beta, while statistically significant, is economically small in estimating expected portfolio returns. We review the evidence indicating that the book-to-market (B/M) effect documented in previous research is exaggerated due to selection biases. Survivor biases are unlikely in large firm samples. Among these firms, the B/M effect is considerably smaller than that observed by Fama and French (1992), consistent with survivor/selection biases leading to an overstated B/M effect. The B/M effect is correlated with past returns, firm size, bid-ask spreads and, possibly, shifts in the investment opportunity set. Therefore, B/M might proxy for rationally priced factors not modeled in the basic CAPM, and average returns will likely continue to be related to B/M in future, although less strongly than in the historical relation.

JEL Classification: G11, G12