Style investing and the ICAPM

Abstract

Empirical multifactor models of excess returns are theoretically grounded in Merton’sICAPM. Merton modeled investors who maximize expected utility of their own consumption. Multiplepriced factors arise as “hedge portfolios” most closely correlated with state variables that driveintertemporal changes in the investment opportunity set. It is puzzling that empirically useful factorshave not been convincingly identified as those portfolios, despite massive e ort. But the majorityof asset demand now arises from style investors, i.e. institutionally managed funds that try to eithermeet (index funds) or beat (actively managed) returns from style-specific benchmark portfolios. Sowe modify Merton’s derivation to incorporate the aggregate demands derived from style investors’di erent objective functions. In addition to resolving the aforementioned puzzle, we show that thisstyle investing version of the ICAPM is more consistent with recent empirical evidence documentingcomovement among assets held in a style benchmark. Finally, the model casts doubt on the widespreadbelief that individual investors will necessarily benefit from funds with positive multifactor alpha.