Style Investing and the ICAPM

Abstract

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