Under CAPM, there is only one type of risk – ‘market’ or systematic risk – which is not diversifiable. You can outperform during a bull market if you have a high beta to the market. In this case, the riskadjusted return should be penalised as the outperformance is due to excess market risk. Similarly, a low beta portfolio should be given credit for lower market risk exposures.
Given the above CAPM definition, there is a more modern view of risk. It is now widely accepted that there are two categories or qualities of risk. There are l ow- qualit y r i sk f actors which a re unavoidable but explain the variability in our portfolio ret urns. These would include interest rate risk, credit risk, currency risk, sector risk etc. They are called low-quality risks because you don’t get anything in return for taking on these risks. They just add unavoidable volatility to your portfolio.
Then there are high-quality risks which compensate us for taking on additional risk to general market risk. For example, ‘value-risk’ is seen as a worthwhile risk because, by buying low-PE stocks with a high dividend yield, we earn an excess return to the market over time (also known as the value risk-premium).
Other well documented risks that provide excess returns include small-cap and momentum risk-premia. All of these risks on average, over the long-run, provide us with excess ret urn but with