Jun

23

 I was looking at this interesting take on the CAPM as it pertains to mutual funds from Stanford University over the weekend. They used mutual funds for their study but I found it promising that they use a fund's fee changes in the study.

"Assessing Asset Pricing Models Using Revealed Preference"

We propose a new way of testing the validity of an asset pricing model. Instead of following the common practice in the literature which relies on moment conditions related to returns, we use mutual fund capital flow data. Our study is motivated by revealed preference theory: if the asset pricing model under consideration correctly prices risk, then investors must be using it, and must be allocating their money based on that risk model. Consistent with this theory, we find that investors' capital flows in and out of mutual funds does reliably distinguish between asset pricing models. We find that the CAPM outperforms all extensions to model, which implies, given our current level of knowledge, that it is the best method to use to compute the cost of capital of an investment opportunity. Perhaps the most important implication of our paper is that it highlights the usefulness and power of mutual fund data when addressing general asset pricing questions. Mutual fund data provides insights into questions that stock market data cannot. Because the market for mutual funds equilibrates through capital flows instead of prices we can directly observe investors' investment decisions. That allows us to infer their risk preferences from their actions. The observability of these choices and what this implies for investor preferences has remained largely unexplored in the literature.


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