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Expected Returns: An Investor's Guide to Harvesting Market Relations By Antti llmanen, Wiley-Blackwell: 2011, 594 Pages
*Asset pricing theory has dramatically changed over the past 30 years. It has moved beyond the restrictive single factor Capital Asset Pricing Model (CAPM), efficient markets, and constant expected returns framework. Antti Ilmanen's "Expected Returns" chronicles this development and offers practical insights. He outlines the multiple factors driving returns. Investors must diversify across these factors to harvest returns, and not just to reduce risk. Also, he highlights that diversification concerns risk factors, not securities. Traditional diversification failed during the financial crisis when most correlations went to one. This was because the multiple structured securities and other alternative investments were exposed to the same common risk factor. The complex nature of these investments blurred their true risk characteristics.
Returns are largely unrelated to standalone asset volatility. Instead, they relate to when the losses occur. Cyclical losses are priced higher because they occur in bad states when they have the worst impact. This fact was illustrated during the financial crisis. Investors following a pro-cyclical investing strategy suffered greatly. These factors reflect both rational (bad model) and behavioralist/irrational (bad prices) considerations. Various anomalies discovered over the past years may actually be state variables in an intertemporal asset pricing model corresponding to nondiversifiable macroeconomic risk.
The Fama-French three factor model, which adds size and value factors to the single factor CAPM, provides an improved explanation of returns. A fourth factor possibly related to liquidity risk, momentum, is frequently added. These additional...