ur survey of portfolio theories continues; we have already evaluated Modern Portfolio Theory, the Capital Asset Pricing Model and the Arbitrage Pricing Theory in earlier blogs, and now turn to a series of articles on Behavioral Portfolio Theory (BPT).

Having previously discussed them, let’s compare them. How does the Arbitrage Pricing Theory (APT) stack up against the Capital Asset Pricing Model (CAPM)?

Arbitrage Pricing Theory (APT) is a multi-factor model in which a series of input variables, such as macroeconomic indicators and market indices, are each assigned their own betas to determine the expected return of a target asset.

Arbitrage Pricing Theory (APT) is a multi-factor model conceived by Stephen Ross in 1976. It is a linear equation in which a series of input variables, such as economic indicators and market indices, are each assigned their own betas to determine the expected return of a target asset. These factor-specific betas (b) fine-tune the sensitivity of the target asset’s rate of return to the particular factor.

Our risk/return series continues with a review of Modern Portfolio Theory (MPT). We’ve already looked at alpha, beta, efficient markets, and returns. Our ultimate goal is to evaluate the role of alpha in hedge fund profitability, how to replicate hedge fund results without needing alpha, and finally how you can start your own cutting-edge hedge fund using beta-only replication techniques.

MPT suggests that a portfolio can be optimized in terms of risk and return by carefully mixing individual investments that have widely differing betas. Recall that beta is return due to correlation with an overall market (known as systematic risk). To take a trivial example, if you hold equal long and short positions in the S&P 500 index, your portfolio would have an overall beta of (.5 * 1 + .5 * -1) = 0. There would be no risk, but in this case, there would be no return either, except for the slow drain of commissions, fees, etc.