Portfolio Inefficiency and the Cross Section of Expected Returns

Abstract:     
The Capital Asset Pricing Model implies (i) the market portfolio is efficient and (ii) expected returns are linearly related to betas. Many do not view these implications as separate, since either implies the other, but we demonstrate that either can hold nearly perfectly while the other fails grossly. If the index portfolio is inefficient, then the coefficients and R squared from an ordinary least squares regression of expected returns on betas can equal essentially any values and bear no relation to the index portfolio's mean variance location. That location does determine the outcome of a mean beta regression fitted by generalized least squares.

JEL Classification: G11

Accepted Paper Series