LDI : Does it Turn CAPM into RAPM?

CAPM came under a lot of scrutiny and attack as its simplicity also led to extensive testing which did not bear out the conclusions. This paper seeks to re-think CAPM in light of the broader trend in the institutional world to implement Liability Driven Investments (LDI) to see if this can help resolve some of the conflicts between the theory and the tests. The basic principle of investing is set by the famous Life Cycle Hypothesis (LCH); namely, that the reason to save and invest is to be able to finance a future stream of payments for consumption. Trends in demographics and global aging are increasing the importance of LDI.This paper asks whether this trend and approach to investing requires a rethink of asset pricing theory and especially asset allocation approaches investors are using. This requires a pivot from the current absolute theory of investing (or MVO and CAPM) to a new paradigm of relative asset pricing (or RAPM). Under RAPM, the value of an asset is driven by its relationship to a liability portfolio rather than just a market portfolio of risky assets. We develop a very simple one-period model in the vein of Markowitz-Sharpe and focus on the relative perspective. We believe and show that the CAPM is just a very specialized case of this more general approach. The practical implications are that one can potentially explain the exceptional bond performance of the last decade, and may forecast lower bond returns. The RAPM framework provides interesting implications for asset pricing, asset allocation, rebalancing and even risk-adjusted performance (and manager compensation). The simple expected return of assets has some additional terms that could be important, and we develop the concept of three fund separation