One way in which it is wrong is that returns are only weakly related to beta. Take, for example, the 27 main FTSE sectors. In the last five years, the correlation between sectors' betas with respect to monthly changes in the All-Share index and their returns has been only weakly positive, with a correlation coefficient of 0.14. For example, the best-performing sector in the last five years has been IT hardware, although it has had a beta of less than one. And two of the highest-beta sectors - banks and miners - have delivered poor returns, contrary to the CAPM's prediction that high beta should mean high returns in a rising market.
Granted, if we ignore these three sectors, the correlation between beta and returns is nicely positive. But then all correlations are strong if we ignore exceptions.
In this respect, the last five years are not unusual. In the previous five, the correlation between sectors' beta and returns was actually negative across the 27 sectors.
There's another way in which the CAPM is false. Everyone now agrees that market risk isn't the only systematic risk affecting returns. Nobel laureate Eugene Fama and his colleague Ken French point out that value and size risk also matter, in part because they are indicators of shares' sensitivity to recessions. This helps explain the low correlation between beta and returns. Five years ago, 'cyclical' sectors such as industrials and retailers were lowly priced because investors feared a deep recession. As these fears receded, such stocks did very well even though many had only average betas.
However, there's another sense in which the CAPM is true. It's that market risk is a big risk for all sectors. On average across our 27 sectors, variations in the All-Share's monthly returns can explain almost half the variation in sectors' returns - much the same proportion as in the previous five years. This proportion ranges from less than 20 per cent (tobacco, healthcare and utilities) to over 70 per cent (life insurance and support services).
This is especially true in the worst times for the market. If we look at the 10 worst calendar months for the All-Share since 2000, we see that most sectors fell in every one of these months. Pharmaceuticals was the least crash-prone, rising (slightly) in three of these months.
The message here is important: you can't escape market risk, especially in bad times.
So, where does this leave us? Judged by the highest standards of accuracy, the CAPM is a failure. However, in a looser sense it is still useful, as it carries two big messages: that systematic risk matters, even though market risk isn't the only flavour of this; and that market risk can't be avoided. Theories don't have to be completely true to be useful.
