Passive Investing’s Foundations
Building upon the work of Harry Markowitz, the trio of John Lintner, William Sharpe and Jack Treynor are generally given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). It was developed in the early 1960s.
The CAPM provided the first precise definition of risk and how it drives expected returns. Another benefit of the CAPM, and of later asset-pricing models as well, is that it allowed us to understand if an active manager who outperforms the market has generated alpha, or whether that outperformance could be explained by exposure to some factor.
The CAPM looks at risk and return through a “one-factor” lens—the risk and the return of a portfolio are determined only by its exposure to market beta. This beta is the measure of the equity-type risk of a stock, mutual fund or portfolio relative to the risk of the overall market.
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