Explain why the market portfolio proxy may not be efficient

What will be an ideal response?

The true market portfolio consists of all traded investment wealth in the economy. It therefore contains much more than just stocks - it includes bonds, real estate, art, precious metals, and any other investment vehicles available. Yet, we cannot include most of these investments in the market proxy because they do not trade in competitive markets. Instead, researchers use a proxy portfolio like the S&P 500 and assume that it will be highly correlated to the true market portfolio.

If the true market portfolio is efficient but the proxy portfolio is not highly correlated with the true market, then the proxy will not be efficient and stocks will have nonzero alphas. In this case, the alphas merely indicate that the wrong proxy is being used; they do not indicate forgone positive-NPV investment opportunities.

Another possibility is that the true market portfolio is inefficient - investors might care about characteristics other than the expected returns and volatility of their portfolios.