Roll's critique is a famous analysis of the validity of empirical tests of the

capital asset pricing model In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. The model takes into ac ...

(CAPM) by

Richard Roll Richard Roll (born October 31, 1939) is an American economist and professor of finance at UCLA, best known for his work on portfolio theory and asset pricing, both theoretical and empirical. He earned his bachelor's degree in aerospace engineerin ...

. It concerns methods to formally test the statement of the CAPM, the equation :

E(R_i) = R_f + \beta_(R_m) - R_f \,

This equation relates an asset's expected return

E(R_i)

to the asset's sensitivity

\beta_

to the market portfolio return

R_m

. The market return is defined as the wealth-weighted sum of all investment returns in the economy. Roll's critique makes two statements regarding the market portfolio: 1. Mean-variance tautology: Any mean-variance efficient portfolio

R_p

satisfies the CAPM equation ''exactly'': :

E(R_i) = R_f + \beta_(R_p) - R_f,

. (A portfolio is mean-variance efficient if there is no portfolio that has a higher return and lower risk than those for the efficient portfolio.) Mean-variance efficiency of the market portfolio is equivalent to the CAPM equation holding. This statement is a mathematical fact, requiring ''no'' model assumptions. Given a proxy for the market portfolio, testing the CAPM equation is equivalent to testing mean-variance efficiency of the portfolio. The CAPM is tautological if the market is assumed to be mean-variance efficient. 2. The market portfolio is unobservable: The market portfolio in practice would necessarily include every single possible available asset, including real estate, precious metals, stamp collections, jewelry, and anything with any worth. The returns on all possible investments opportunities are unobservable. From statement 1, validity of the CAPM is equivalent to the market being mean-variance efficient with respect to all investment opportunities. Without observing all investment opportunities, it is not possible to test whether this portfolio, or indeed any portfolio, is mean-variance efficient. Consequently, it is not possible to test the CAPM.

Relationship to the APT

The mean-variance tautology argument applies to the

arbitrage pricing theory In finance, arbitrage pricing theory (APT) is a multi-factor model for asset pricing which relates various macro-economic (systematic) risk variables to the pricing of financial assets. Proposed by economist Stephen Ross in 1976, it is widely beli ...

and all asset-pricing models of the form :

E(R_i) = \alpha+ \beta_F_+...+\beta_F_.\,

where

F_,...,F_\,

are unspecified factors. If the factors are returns on a mean-variance portfolio, the equation holds exactly. It is always possible to identify in-sample mean-variance efficient portfolios within a dataset of returns. Consequently, it is also always possible to construct in-sample asset pricing models that exactly satisfy the above pricing equation. This is an example of

data dredging Data dredging (also known as data snooping or ''p''-hacking) is the misuse of data analysis to find patterns in data that can be presented as statistically significant, thus dramatically increasing and understating the risk of false positives. T ...

Discussion

Roll's critique has received a large number of citations in the financial economics literature, with tens of citations per year as of 2017–2019. The majority of these citations refer to the second statement of critique; few papers address the first statement. Many researchers and practitioners interpret Roll's critique as stating only that "the market portfolio is unobservable".

References

* {{citation , last=Roll , first=Richard , title=A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory , journal=Journal of Financial Economics , volume=4 , date=March 1977 , pages=129–176 , doi=10.1016/0304-405X(77)90009-5 , issue=2 Mathematical finance Financial economics