26 Pages Posted: 8 Nov 2011
Date Written: April 1994
A plot of expected returns versus betas obeys virtually no relation to an inefficient index portfolio's mean-variance location. 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 desired values. The mean-variance location of the index does determine the properties of a cross- sectional mean-beta relation fitted by generalized least squares (GLS). As the index portfolio moves closer to exact efficiency, the GLS mean-beta relation moves closer to the exact linear relation corresponding to an efficient portfolio with the same variance. The goodness-of-fit for the GLS regression is the index portfolio's squared relative efficiency, which measures closeness to efficiency in mean-variance space.
Suggested Citation: Suggested Citation
Kandel, Shmuel and Stambaugh, Robert F., Portfolio Inefficiency and the Cross-Section of Expected Returns (April 1994). NBER Working Paper No. w4702. Available at SSRN: https://ssrn.com/abstract=1956408