The relative asset pricing model: implications for asset allocation, rebalancing and asset pricing

The Capital Asset Pricing Model (CAPM) has been the backbone of asset market finance, even though many academic studies have revealed its limitations, both theoretical and empirical. This paper argues that including liability or benchmark considerations in investment decisions may provide a credible explanation for some of the limitations. In effect, the CAPM is an “absolute wealth”-centric model, driven by the assumption that investors derive utility from absolute wealth. In reality, investors first make investment decisions to ensure sufficient assets to meet obligations, such as future pension payment or future consumption (i.e., liabilities), and focus on relative wealth. Thereafter, many investors hire external managers and evaluate them on performance relative to assigned benchmarks. Interestingly, existing robust literature on, and product offerings for, “liability driven investing,” have not led to a shift in academic theories of asset pricing to reflect the liability perspective. After all, if asset owners choose investments to service liabilities (proxied by benchmarks), it is expected that liabilities or these benchmark proxies will impact asset prices.