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I'm reading through Active Portfolio Management, and I can't get my head around the APT.

As far as I can tell, the statement in equation 7.2 translates into:

"If you can get better than consensus estimates on what qualities will outperform, and if you can get an intentional excess exposure to these qualities, and you turn out to be right - you will achieve some outperformance"

For example, if I have insight that "manufacturing industry" will outperform, and I have some basket of assets that will give me above-market exposure to "manufacturing", and both my insight and my portfolio are correct (in its outperformance and exposure respectively) then I'll outperform.

My questions is... isn't that rather, trivial?

There is a fair amount of mathematics that expresses the above as a linear equation, but it doesn't seem to "add" anything. Maybe it's all a procedure to construct a portfolio given assumed perfectly estimated parameters?

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  • $\begingroup$ not able to get to link for Active Portfolio Managment $\endgroup$ May 20 at 13:53
  • $\begingroup$ Ralph: remove the two asterisks at the end of the link, and you should be able to get it $\endgroup$
    – nbbo2
    May 21 at 0:39

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The key restriction of the APT equation (7.2) is that the constant alpha term is zero. One can view this as a multifactor generalization of the single factor CAPM expression. In principle the factors should describe some deep risk factors and the equation says that a stock's expected return is determined by its exposure to these risk factors and the risk premia associated with each factor.

Because the alpha is zero the model implies that you cannot "overperform" the market once exposure to these risk factors is accounted for. It is more about understanding how expected returns should be determined. However, as pointed out by @nbbo2, APT is agnostic about the correct risk factors, a potential weakness.

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    $\begingroup$ Agreed. The key insight was that CAPM could be generalized so that there would be multiple factors not just one. It was the start of the multifactor approach so common today. A weakness was that it did not tell us what these factors would be, that was left for further research. $\endgroup$
    – nbbo2
    May 22 at 17:12

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