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Mauro Andriotto and Emanuele Teti identify 90 factors that explain almost completely the returns of 4,500 companies in the last 10 years and suggest an asset pricing model alternative to CAPM

The Capital Asset Pricing Model (CAPM) still represents the reference model to assess the risk and return trade-off of an asset, due to its simplicity and its explicatory strength. Different scholars have tried to improve the CAPM considering that equity returns are affected by a variety of factors.

Mauro Andriotto and Emanuele Teti (Department of Finance), in Beyond CAPM: An Innovative Factor Model to Optimize the Risk and Return Trade-Off, (forthcoming in Journal of Business Economics and Management)indicate that the one used by the CAPM doesn't seem to be the only explicatory factor of the risk of an asset, thus the return variance can be explained by the iteration of a multiplicity of factors. In particular, analysing the historical series of more than 300,000 factors (macroeconomic, market indexes, prices etc.) and the returns of over 9,000 companies listed in the main 15 European countries, over a time horizon of 50 years, they find that in the last 10 years just 90 factors would be enough to explain almost completely the returns of more than 4,500 companies. Furthermore, in line with results of other researchers, they state that the key factors are the macroeconomic ones.

The novelty of the work is represented by the identification of the key explanatory factors for each of the 9,000 historical series examined. The authors have built a ranking of factors through recurrence and impact measures, and then they have formulated some assumptions behind the diversification level of investors.

It must be stressed that, although some factors have high recurrence, the level of diversification is not always optimal. Even though the scholars have not tested the relating reasons, they believe that they can be multiple. For instance, irrationality could play a key role, and diversification level could vary depending on decision making process, asset selection theories, and also on insider trading.

Andriotto and Teti have observed that in the light of the factorial analysis, many investors hold portfolios that are not fully diversified. This situation makes it possible to further reduce risk for the same return (or increase return for the same risk) through an optimization process first based on the diversified selection of underlying factors rather than asset selection.

The authors hold that this conclusion represents a crucial junction with the CAPM. In fact, from the factorial perspective, the market could be explained as the biggest portfolio that could be built, in which all the existing factors join and diversify. If diversification were perfect, the market explanatory factors should be the same as those explaining all other returns, then the market return could be - as defined by the CAPM - the unique key variable, being a proxy of all the other underlying factors.

As a result, the factorial model does not exclude the CAPM, quite the opposite it could be a key contribution for asset pricing and asset allocation theories.

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