CFA Institute

Sorting out Risks Using Known APT Factors Author(s): Michael A. Berry, Edwin Burmeister, Marjorie B. McElroy Source: Financial Analysts Journal, Vol. 44, No. 2 (Mar. - Apr., 1988), pp. 29-42 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4479100 Accessed: 23/10/2009 04:12
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by Michael A. Berry, Edwin Burmeisterand MarjorieB. McElroy

Sorting

Out

Risks

Using

Known

APT

Arbitrage PricingTheory(APT)differs fromthe Capital Asset PricingModel(CAPM)in hypothesizing thatactualandexpected securityreturns aresensitive,not tojust one typeof nondiversifiable risk (i.e., betaor market risk), but to a varietyof different typesof risk. Prior testing has shown the CAPM to be inferiorto an APT modelthat incorporates unanticipated changesin five macroeconomic variables-default risk, the termstructure of interestrates, inflationor deflation,the long-runexpected growthrate of profitsfor the economy and residualmarket risk. It is possible to estimatethesensitivities or portfolios of individual securities to thesefive riskfactors.Suchmeasurements allowone to explore variations in sensitivities to different typesof riskacrossbothequitymarket sectorsand industries.Theresultingriskexposure profiles do not dependon any particular market index. APT riskprofiles maybe usedfor eitheractiveor passiveportfolio management. Passive managers wishingto reduce theirportfolios' riskcharacteristics systematic mightconsider a technique termed "risksterilization"; hereassetswithdifferent riskprofiles arecombined so as to negate,or sterilize,exposure to selected riskfactors. activemanagers Alternatively, can attempt to achieveexcess returns by constructingportfoliosin accordance with their forecasts of riskfactorrealizations.
HE CAPITALASSET PRICINGModel (CAPM) predicts that only one type of nondiversifiablerisk influences expected security returns-namely, "market risk." In contrast, ArbitragePricingTheory (APT)explicitly recognizes that a variety of risks may affect expected returns.1 In particular, five different
T

types of risk factors have been shown to have significantinfluence on expected returns: * risk of changes in default premiums, * risk that the term structureof interest rates may change, * risk of unanticipated inflation or deflation, * risk that the long-run expected growth rate of profits for the economy will change, and * residual market risk, or any remaining risk needed to explain a market index such as

1. Footnotes appear at end of article.

Michael Berryis AssistantProfessor of Business Administration at theDarden School of the University of Virginia. EdwinBurmeister is Commonwealth Professor of Economics at the Universityof Virginia.Marjorie McElroyis Professor of Economics at DukeUniversity. Theauthorsare grateful for a research grantfrom the Institute of Quantitative Research in Finance, and ProfessorsBurmeister andMcElroy acknowledge support fromthe NationalScience Foundation Theauthors (SES-8618403). thank Richard W. McEnally and Stephen A. Rossfor their valuable comments, andMarkT. Finn, President of Delta Financial, Inc., for his investment management insights.

the S&P500.
This articleexamines the importance of these five different types of risk factors.2 By definition, a risk factor is an element of surprisesuch as unanticipated inflation, which arises because the actual value of inflation may depart from its expected value.3 We discuss below how to measure the five risk factors and how exposure to them varies across different industries. The large differences in risk exposure profiles

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 29

across economic sectors and industries suggest several strategies for managing risks so as to achieve superior portfolio returns. Arbitrage Pricing Theory APT assumes that arbitrageprofit opportunities are quickly eliminated through competitive forces. That is, an investor cannot earn a positive expected rate of return on any combination of assets without incurringsome risk and without making some net investment. (Thisassumption is essentially an equilibrium condition for capital markets analogous to "supply equals demand.") APT models the discrepancy between the actual (realized) return on any asset and its expected return as a linear function of the realizationsof relevant risk factors, plus returns resulting from asset-specificevents. The expected return for any asset, in turn, is equal to the sum of the quantities of different types of risk inherent in that asset, times their respective risk "prices."4(The measurement of risk quantities and prices is discussed in more detail later.) Previous technicalwork on APThas indicated that the five types of risk identified at the outset of this articleare highly significantfor determining realized and expected returns.5 In other words, the five different types of risk have nonzero APT prices; they are relevant risks, influencing equilibriumreturns. The present article extends the previous work by identifying and measuring, over various economic sectors and industries, the risk exposures associated with these relevant risks. The implicationsfor practitioners are twofold: (1) Practitioners can use APT risk exposure profiles to manage their own risk exposures and (2) they can do so without having to implement the full, and complex, APT machinery.

factorsin an APTframework? Economicvariables that are legitimate risk factors must possess three important properties: (1) At the beginning of every period, the factor must be completely unpredictable to the market. (2) Each APT factor must have a pervasive influence on stock returns. (3) Relevant factors must influence expected return; i.e., they must have non-zero prices. Property (1) means that, for the market as a whole, a risk factor cannot be forecast either from its own past value or from any other publiclyavailableinformation.Thus, at the start of every time period (day, week, month or other period), the expected value of the factoris zero. For example, the rate of inflation is not a legitimate APT risk factor because it is partially predictable.Unexpected inflation, however, is a legitimatefactor;unexpected inflationby definition cannot be predicted because it is the difference between the actual rate of inflation over the period and the rate that had been expected at the beginning of the period. Similarly, the growth rate of GNP is not a legitimate factor because its value in a given period can be predicted partially from realizations in prior periods; the unpredictable portion, however, could be used as a factor. (Of course, good forecasters on average may be able to predict the realizationsof certainfactorsbetter than the market as a whole; if so, provided they pursue an active APT portfolio strategy, they will be rewarded by earning larger-than-average returns.) Property (2) means that firm-specific events do not constitute legitimate APT factors. An investor might earn excess returnsif he or she is able to identify firms with favorablefirm-specific events (such as the development of a profitable new product), but this fact is not relevant for APT-basedportfolio management strategies in which distinctly different types of economywide risks are managed in particularways and firm-specificrisks are diversified away. Property(3) is an empiricalissue that can only be answered by careful econometricwork, such as that cited above. How does an investorknow if he or she has a correctset of APT factors, or if thereare missing factors?First, there is no one "correct" set of factors;there are many equivalent sets of correct

Three Common Questions About APT and Risk Factors

stockreturns any Do APTriskfactors helpexplain indexsuchas thana model usingonlya market better the S&P 500? Rigorous statistical testing has shown that there is virtually zero probability that the five risk factorsidentified above add no new information over and above that already embodied in the S&P500.6 The APT model with these five risk factors is vastly superior to both the marketmodel and the CAPMfor explaining stock returns. risk qualifyas legitimate Whatkindsof variables

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 30

factors, all of which give rise to equivalent empirical results.7 Intuitively, a factor such as "unexpected change in the money supply" might work, as well as the factor "unexpected inflation"; a set of factors with "unexpected change in the money supply" substituted for "unexpected inflation" would give equivalent results. The choice of a set of "correct"factors can be made on empiricalgrounds: The factors should adequately explain asset returns; they should pass the statistical tests necessary to qualify as legitimate APT factors; the actual asset returns should exhibit plausible sensitivities to the realizations of these factors;and the factors should have non-zero APT prices. Extensive testing demonstrates that, by these criteria, our five factors work very well indeed. Another equivalent set of factors would do as well, but it would not do better. Second, the worry over possible missing factors is substantiallyresolved by using a residual marketfactor.8The residual marketfactoris that part of the S&P500 return not explained by the other four factors. Any missing factoris embodied in this residual market factor in exactly the same manner that all factors are embodied in the market return for the market model or the CAPM. Moreover, our work suggests that no important factors are missing, although the search continues.

ties of the five different types of risk inherent in the ith asset. These quantities are also called sensitivity coefficients or factor loadings. Thus, for example, b1lx f1is that part of the discrepancy between the actual and expected rate of returnfor the ith asset that is due to a non-zero realizationfor the first risk factor, f1. Finally, ei denotes the asset-specific error term for the ith asset; it also has a beginning-of-periodexpected value of zero. Equation (1) holds for every time period.9 Note that the beginning-of-period expectation of the right-hand side of Equation (1) is zero. Thus taking beginning-of-periodexpectationsof both sides of the equation yields the logically necessary conclusion that, at the beginning of the period, investors expect the actual return at the end of the period to be Eri. APT predicts that the expected rate of return on the ith asset equals the riskless rate of return plus the sum of the quantities of different types of risk inherent in the ith asset times their respective prices. In this study, the riskless rate of return is measured by the 30-day Treasury bill rate, which we denote by TB. The prices of the five differenttypes of risk are denoted by P1, P2, P3, P4 and P5. The expected rate of return for the ith asset may thus be written as follows:
Eri = TB + bil x P1 + bi2x P2 + bi3X P3 + bi4X (2) P4 + b5 x P5.

Equations of APT
APTis based on the premise that the discrepancy between the actual (realized) return on an asset and its expected returnis equal to the sum of the quantities of different types of risk inherent in that asset multiplied by the realizations (actualend-of-periodvalues) of the corresponding risk factors, plus an asset-specific error term. This premise is expressed by Equation(1):
ri-

Eri= bil x f1 + bi2 X + bi5 x f5+ ei.

f2+

bi3x f3+ b4 X f4

The left-hand side of Equation (1) is the discrepancy between the actual and expected returnfor the ith asset. Here "ri"denotes actual return and "Eri" expected return. The factor realizations for the five different types of risk are denoted by fl, f2, f3, f4 and f5. Later,we will describe how these factor realizations are measured; for now, it is important to remember that, at the beginning of each period, the expected value of every factor is zero. The coefficients b11,bi2,bi3,bi4and bi5denote the quanti-

Over time periods where the means of the factor realizationsare zero, this expected rate of return equals the mean of realized returns plus the mean of asset-specific errors. Substitutingthe value of Erifrom Equation(2) into Equation (1) gives the full APT. Econometric estimation of this nonlinear model has shown that the five risk prices are highly significant, with t-statisticsof 4.27, 4.76, 1.83, 2.21 and 3.21, respectively, and are thus relevant for determining expected (equilibrium)returns.10 Suppose, for example, there is a portfolio (call it portfolio "q") that has one unit of type-1 (default)risk and no other type of risk associated with it. In this case we have
bql = 1 and
bq2 = bq3 = bq4 = bq5 = 0.

FromEquation(2) we see that the expected rate of return on this special portfolio is
Erq = TB + P1or P1 = Erq- TB.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 31

This last relation holds generally: The price of any particular risk is equal to the expected excess rate of return on a special portfolio that has one unit of exposure to this risk and zero exposures to all other types of risk. Practitionerscould develop numerous investment strategies using the expected rates of return predicted by APT. There are, however, simpler but important APT-based investment strategies that involve only the management of different types of relevant economy-wide risks in well-diversifiedportfolioswhere firm-specific influences on returns have been diversified away. No matter what valuation approach an investor employs to pick individual stocks, these picks will exhibit our five different types of risk. If a portfolio manager ignores these risks, erratic return performance will result in times of large factor realizations.

because GB is the return on a 20-year portfolio while TB1 is the return on a 30-day portfolio. The third and fourth risk factors are constructed from the GNP accounts. The third risk factoris unexpected deflation, measured as follows:

rate of inflation expected at the beginning of the month minus the actual rate of inflationrealized at the end of the month.14 The fourth factor uses the growth rate in real final sales as a proxy for the long-run growth rate in profits for the economy. First,a series for monthly real final sales (excluding services) is obtained through detailed calculationsbased on monthly and quarterly data available in the GNP accounts. Then the expected growth rate in real final sales is calculated from its lagged values and from real disposable income. Finally, for every month the fourth factor is defined as follows: the long-rungrowth rate in real final sales (profits) expected at the beginning of the month minus the long-run growth rate in real final sales (profits)expected at the end of that month.
f4=

f3 -the

Measurement of Factors
The first two risk factor measures are constructed from time series of returns on portfolios of corporatebonds, government bonds and Treasurybills. These total monthly returns are denoted by CB, GB and TB, respectively.11 The returnon Treasurybills, TB, is especially important. We take TB as the measure of the riskless rate of return because it is known at the beginning of each month and is free of default risk.12 The first risk factor measures any unusual spread between the total monthly returns on government and corporatebonds:
f,= GB - CB + C,

A positive realization for the factor f4 thus means that investors revised downward their expectation for the long-run growth rate of real final sales and profits. The fifth and final factor is the residual market factor, defined as follows:
f5=

where C is a constant chosen to make the beginning-of-month expected value of f, equal to zero.13 This factor measure reflects a default premium; the government and corporatebond portfolios both have 20-year maturities, but government bonds are essentially free of default risk. When fl is positive, the spread between government and corporate bond returns exceeds its long-run average. The second risk factor is the spread between the total monthly returns on government bonds and Treasurybills:
f2=

that part of the S&P 500 return not explained by f1, f2, f3 and f4.

By definition, stock returns are positively correlated with the realizationof f5. Extensive statistical tests reveal that none of these five monthly factors (f1, f2, f3, f4 or f5) can be predictedeither from past values or from any other publicly available information.15 However, we would not claim unpredictabilityfor all these factors if they are measured on a daily or weekly basis. And, of course, it is possible that some of these factors can be forecast on a monthly basis using private information.

GB

TB1,

where TB1is the return on Treasurybills for the next month, which is first learned at the end of the currentmonth. This second factormeasures the slope of a total returns curve; it is related to changes in the term structure of interest rates,

Quantities of Different Types of Risk in the S&P 500

In order to estimate the quantities of the first four differenttypes of risk inherent in the excess returnon the S&P500 (denoted by rm - TB),we estimated an ordinary-least-squaresregression

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 32

for the following equation:

rm - TB = a + bm1 x f1 + bm2x f2 + bm3 X f3 + (3) bm4 x f4 + u,

ties of different types of risk in the S&P500 are estimated to be:

bin1= -1. 33, bin3= 2.29, bn4 = -0.93.

where u is an errorterm. The following results were obtained for a monthly sample beginning in January1972 and ending in December 1982:
rm- TB = 0.0022 - 1.33 x f1 + 0.56 x f2 +

(4.96) (-3.94) (0.62) 2.29 x f3 - 0.93 x f4. (-2.27) (1.99)

(4)

Thus, for example, the quantity of type-2, or term-structure,risk inherent in the market as measured by the S&P 500 is estimated to be:
bn,2= 0.56,

which indicates that a realizationfor f2 of 1 per cent per month, when all other factor realizations are zero (f1 = f3 = f4 = 0), will raise the

excess rate of return on the S&P500 by 0.56 per cent per month. Analogously, the other quanti-

The numbers in parentheses below Equation (4) are t-statistics and are used to calculate the probabilitythat any particulartype of risk factor is not significant for explaining the S&P 500 return.16 These probabilitiesare 0.0001, 0.0001, 0.049 and 0.025, respectively, for the first four types of risk;all are within the standardstatistical significancelevel of 0.05. Thus our first four risk factors have significant explanatorypower, and together they account for approximately one-quarter of the variation in the S&P 500 return. These estimated coefficients, which measure the quantities of the four different types of risk, also help to predict the effect of various scenarios on the excess return for the S&P 500. For example, what happens to the excess return on the S&P500-that is, the return on the S&P500

Table I Quantities of Different Types of Risk for Seven Economic Sectorsa

Sector Name

Type-iRisk (default)

Risk Type-2 (term structure)

Risk Type-3 or (inflation deflation)

Risk Type-5 Risk Type-4 (unexpected (residual in market change risk) growthrate of profits)
-1.04 (-3.64) [2] -0.92 (-3.57) [3] -0.22 (-0.93) [7] -0.83 (-1.75) [4] 0.23 (0.87) [6] -1.13 (-2.53) [1] -0.56 (-1.57) [5] 1.14 (18.47) [3] 1.28 (23.05) [2] 0.74 (14.20) [6] 1.14 (11.12) [4] 0.62 (11.03) [7] 1.37 (14.24) [1] 0.99 (12.86) [5]

R2 (adjusted R-squared)

DW (DurbinWatson statistic)
1.67

Cyclical

Growth

Stable

Oil

Utility

Transportation

Financials

-1.63 (-6.93)b [4]c -2.08 (-9.80) [2] -1.40 (-7.09) [5] -0.63 (-1.62) [7] -1.06 (-4.93) [6] -2.07 (-5.65) [3] -2.48 (-8.44) [1]

0.55 (6.97) [6] 0.58 (8.21) [4] 0.68 (10.25) [3] 0.31 (2.42) [7] 0.72 (10.02) [2] 0.58 (4.75) [4] 1.00 (10.21) [1]

2.84 (3.55) [4] 3.16 (4.38) [3] 2.31 (3.43) [5] 2.19 (1.65) [6] 1.54 (2.11) [7] 4.45 (3.57) [1] 3.20 (3.21) [2]

0.77

0.84

1.94

0.73

1.81

0.50

1.79

0.67

1.84

0.66

2.01

0.72

1.85

a. An equally weighted portfoliowas formed for the stocks in each sector, then sector total monthly returnswere calculatedfrom the data tapes produced by the Center for Researchin SecurityPrices at The Universityof Chicago. The growth, cyclical,stable and oil sector and in which specificindustryeffectswere identified;the utility,transportation definitionswere takenfromresearchperformedby Farrell financialsectors were taken from the Standard& Poor's 1982 manual. The growth sector is defined to be "representedby companies exposureto the rateof secularexpansion."Cyclicalstocksare defined as those with an above-average expectedto show an above-average vagariesof the economy. Stablefirmsare those whose earningspower is less affectedthan the averagein the economy. (See. JL. Farrell, May/June1975.) Journal, Analysts Jr., "HomogeneousStock Groupings,"Financial b. Numbersin parenthesesare t-statistics. type of risk exposureacrossthe seven c. The numbersin squarebracketsreportthe rankorderof the (absolutevalue of) the corresponding economicsectors. Thus, for example, financialsranked 1st in exposureto type-1 and type-2 risks.
FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 C 33

Figure A

Risk Exposures

for Economic

Sectors, 1972-1983

4.50 4.00 3.50 -

3.00-

2.50-

2.00-

1.50

^bA~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Eh
0.500.00 -I Stable

Cyc.
E

Grow.

Oil

Utility

Trans.

Fin.

S&P

Inflation

Default

LII Market

U Profits

[ Term Structure

in excess of the return on Treasury bills measured by TB-if there is an unexpected inflation of 0.5 per cent per month (6.17 per cent at a compound annual rate) and nothing else changes? To answer this question, we calculate the following:
bm3 X f3 =

Risks by Sectors and Industries

If all portfolios had the same risk profile, there would be no benefit to using a portfolio management strategy that takes into account different types of risk. In fact, however, different stocks offer very different profiles of risk exposure. For example, unexpected inflation would have only a minor effect on profits (hence on returns) in those industries where it is easy to pass on inflationary costs in the form of higher product prices. In other industries, however, unexpected inflation could have devastating effects on profits. Table I reports the quantities of the five different types of risk exposure for seven sectors of the economy, as well as their rank orderings. Figure A illustrates how risk profiles differ across the seven economic sectors and provides the risk profile of the S&P 500 for comparison. These risks were calculated by running ordinary-least-squares regressions analogous to Equation (4), where the left-hand-side variables

(2.29) x (-0.005)

= -0.0115.

We thus predict that, in this scenario, the excess return on the S&P 500 would fall by 1.15 per cent per month (14.6 per cent at a compound annual rate), assuminmg that the realizations of the other three factors (fl, f2 and f4) are all zero. It is important to rememberthat, in this example, the inflation of 0.5 per cent per month inflation that is fully anticimust be unexpected; pated is presumed to be already capitalized into the beginning-of-month returns. The influence of the other risk factors on realized returns can be calculated in a similar way, as can the influence of more complicated combinations.

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 C] 34

were returns on equally weighted portfolios representing each sector. (The sample period was again January1972 to December 1982.) Wide differences in the risk exposures are evident. For example, the financial, growth and transportationsectors are especially sensitive to default (type-1) risk. Why? Because firms in these sectors are highly levered, any unanticipated widening of the spread between government and corporate bond returns increases these firms' appropriatediscount rate. We also see that the utility sector is relatively insensitive to both type-3 (unexpected inflation) and type-4 (unexpected change in growth rate of profits) risks. Utilities can pass through their cost increases more readily than firms in other sectors because utility prices are highly regulated to keep profits a constant share of the capital base. Regulationcushions the effects on utilities of unexpected inflation, and from Figure A and Table I we see that the utility sector has the lowest exposure to type-3 risk. Similarly, because profits are regulated, the utility sector has no risk exposure to unexpected changes in the growth rate of profits; for the utility sector, the estimated quantity of type-4 risk is not significantly different from zero. At the other extreme, the cyclical,growth and transportationsectors exhibit significant sensi-

tivities to both type-3 and type-4 risks. We might expect growth companies to be hurt by unexpected decreases in profit growth. These firms tend to use sophisticated capital-intensive technology and to grow by making highly levered investments in plant and equipment; unexpected declines in profit growth postpone the day when these investments produce positive cash flows. Moreover, growth companies tend to lack diversification.The sensitivity of cyclical and transportation sectors to unexpected changes in general prosperity is well known, and is reflected in the size (and the statistical significance)of our estimated quantitiesof type3 and type-4 risks for these sectors. Many other interesting patterns of risk exposure can be picked out from TableI. Sufficeit to say that our APT risk profiles for these sectors correspond closely to intuition regarding the distribution of different types of risk in the economy. Our work quantifies this intuition.

Industry Differences
Table II reports the risk exposures for 82 different industry classifications, as well as the rank orderings of these risk exposures. As required by the sector definitions, the risk sensitivities of the industries in Table II cluster around their respective sector sensitivities in

Table 11 Quantities of Different Types of Risk for 82 Industries

Industry Name

Type-I Risk (default)

Risk Type-2 (term structure)

Risk Type-3 or (inflation deflation)

Risk Risk Type-5 Type-4 (unexpected (residual market in change risk) growthrate of profits)
-1.18 (-2.10) [24] -0.59 (-1.31) [62] -1.15 (-2.86) [26] -1.31 (-2.23) [20] -1.47 (-1.94) [17] -0.86 (-1.14) [44] -0.54 (-1.08) [66] -0.57 (-1.17) [64] 1.32 (10.90) [23] 1.16 (11.91) [42] 1.04 (11.97) [57] 1.01 (7.98) [59] 0.92 (5.63) [68] 0.77 (4.71) [74] 0.95 (8.87) [65] 1.12 (10.73) [45]

R2 (adjusted R-squared)

DW (DurbinWatson statistic)
2.04

Aerospace

Auto, OEM

Auto Replacement Parts Auto, Truck Mfg.

Automobile

Beverages, Brewers Beverages, Distillers Beverages, Soft Drinks

-0.75 (-1.63)a [73]b -1.56 (-4.22) [43] -1.86 (-5.62) [28] -0.43 (-0.89) [78] -1.94 (-3.12) [26] -1.10 (-1.77) [64] -1.26 (-3.08) [59] -2.13 (-5.37) [16]

0.41 (2.65) [73] 0.40 (3.23) [75] 0.42 (3.83) [68] 0.52 (3.20) [54] 0.45 (2.20) [64] 0.41 (1.99) [70] 0.81 (5.93) [7] 0.68 (5.13) [24]

2.31 (1.47) [61] 4.76 (3.78) [21] 4.15 (3.70) [26] -1.30 (-0.79) [81] 2.92 (1.38) [45] 1.09 (0.52) [76] 2.46 (1.77) [57] 5.32 (3.94) [12]

0.49

0.57
0.60

1.71

2.03

0.35

1.87

0.24

1.88

0.15 0.48

2.01 2.12

0.57

1.94

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 U 35

Table II-

Continued Type-1 Risk (default) Risk Type-2 (term structure) Risk Type-3 or (inflation deflation) Risk Risk Type-5 Type-4 (unexpected (residual in market change growthrate risk) of profits) -0.76 (-1.19) [51] -0.88 (-1.27) [42] -0.64 (-1.04) [60] -1.05 (-2.92) [32] -1.05 (-2.38) [22] -0.94 (-1.04) [37] -1.13 (-3.09) [29] -0.48 (-1.45) [67] -1.51 (-2.11) [12] -0.36 (-1.04) [71] -0.83 (-1.89) [47] -0.45 (-1.08) [68] -0.77 (-1.65) [50] -0.69 (-1.26) [55] -1.19 (-2.84) [23] -0.91 (-2.71) [41] -0.58 (-1.29) [63] -1.47 (-3.27) [16] -1.23 (-2.73) [21] -1.17 (-1.93) [25] 1.09 (7.91) [51] 1.57 (10.47) [10] 0.90 (6.81) [70] 1.04 (13.44) [56] 1.04 (10.59) [37] 1.40 (7.17) [17] 1.36 (17.30) [20] 0.96 (13.45) [64] 1.19 (7.70) [34] 1.12 (14.88) [46] 0.95 (10.06) [66] 1.16 (13.07) [41] 1.00 (9.92) [62] 1.36 (11.59) [18] 1.21 (13.42) [31] 1.10 (15.19) [49] 1.08 (11.21) [52] 1.60 (16.48) [6] 1.34 (13.74) [22] 1.63 (12.37) [4] R2 (adjusted R-squared) DW (DurbinWatson statistic) 2.17 2.00

Industry Name

Building -2.41 Materials, (-4.62) Cement [9] Building -2.22 Materials, (-3.90) A/C& [15] Plumbing BuildingMaterials, -2.47 Roof & Wall (-4.91) [7] Chemicals, -1.98 Major (-6.70) [24] Chemicals, -0.90 Misc. (-2.12) [70] Coal, -3.04 Bituminous (-4.10) [2] Conglomerates -1.51 (-5.06) [46] Containers, -0.98 Metal & (-3.60) Glass [66] Containers, -0.96 Paper (-1.64) [68] Cosmetics -1.52 (-5.31) [45] Drugs, -0.98 Ethical (-2.72) [67] Drugs, -1.82 Medical& (-5.39) Hospital [32] Supply Drugs, -1.48 Proprietary (-3.87) [48] -2.71 EatingPlaces (-6.06) [4] Electrical & -1.57 Electronic, (-4.58) Major [41] Electrical -2.23 Equipment (-8.09) [14] Electrical & -1.78 Household (-4.86) Appliances [33] Electronics, -1.86 Diversified (-5.03) [29] Electronics, -1.63 Instruments (-4.41) [40] -2.49 Electronics, Semiconductors (-4.98) and [6] Computers

0.64 (3.68) [33] 0.65 (3.41) [28] 0.99 (5.91) [2] 0.54 (5.43) [50] 0.58 (4.15) [42] 0.98 (3.96) [3] 0.58 (5.86) [43] 0.56 (6.13) [47] 0.55 (2.82) [48] 0.69 (7.24) [20] 0.51 (4.27) [55] 0.70 (6.20) [17] 0.68 (5.35) [23] 0.47 (3.17) [59] 0.55 (4.78) [49] 0.56 (6.13) [45] 0.62 (5.08) [38] 0.70 (5.66) [19] 0.47 (3.82) [60] 0.35 (2.07) [78]

2.82 (1.59) [46] 6.29 (3.25) [8] 2.52 (1.47) [55] 3.84 (3.82) [33] 3.84 (0.84) [75] 2.07 (0.82) [66] 3.71 (3.65) [36] 3.00 (3.24) [44] 5.03 (2.52) [18] 2.71 (2.79) [50] 2.23 (1.82) [64] 2.55 (2.21) [54] 1.59 (1.22) [72] 6.64 (4.37) [6] 3.62 (3.10) [37] 4.22 (4.51) [24] 4.20 (3.37) [25] 5.07 (4.04) [16] 5.32 (4.23) [13] 3.47 (2.04) [39]

0.41 0.52

0.43 0.66 0.66 0.37 0.73 0.64 0.35 0.70 0.48 0.64

2.24 1.97 1.97 1.59 1.84 1.74 2.06 2.19 2.01 1.79

0.51 0.59 0.63 0.72 0.58 0.72 0.64 0.58

2.20 1.62 2.04 1.63 1.63 2.09 1.98 1.81

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 L036

Table II-

Continued Type-I Risk (default) Type-2 Risk (term structure) Type-3 Risk or (inflation deflation) Risk Risk Type-5 Type-4 (unexpected (residual market in change risk) growthrate of profits) -0.24 (-0.53) [75] -0.03 (-0.05) [77] -0.35 (-0.40) [72] -0.20 (0.53) [80] -2.52 (-2.85) [2] 0.12 (0.16) [79] -0.40 (-1.25) [69] -0.94 (-1.84) [36] -0.98 (-1.51) [34] -1.50 (-1.69) -0.04 (0.05) [78] -1.85 (-2.50) [5] -0.84 (-1.67) [45] -1.08 (-2.66) [31] -2.10 (-3.15) [4] -1.01 (-2.84) [33] -1.47 (-2.89) [15] -1.38 (-2.15) [18] -2.24 (-2.08) [3] -0.95 (-1.25) [35] -1.36 (-1.89) [19]
[141

Industry Name

R2 (adjusted R-squared)

DW (DurbinWatson statistic) 2.13 2.06 2.03 1.97 2.05 2.24 1.76 1.46 1.77 1.86 2.04 2.05 2.25 1.79

-1.20 Food, Canned Goods (-3.28) [60] -1.31 Food, (-3.18) Confec[54] tionary 0.04 Food, Corn & (0.05) Soybean Refiners [82] -1.54 Food, Dairy (-4.99) Products [44] -0.25 Food, Meat (-0.35) Packers [79] -0.94 Food, Sugar (-1.46) Refiners [69] -1.30 Food, (-4.90) Packaged [55] -2.28 Forest (-5.42) Products [12] -2.07 Home (-3.91) Furnishings [20] -2.13 Hotels & Motels (-2.91)
[16]

0.51 (4.19) [56] 0.29 (2.15) [81] 0.75 (3.18) [12] 0.65 (6.34) [26] 0.85 (3.51) [5] 0.67 (3.10) [25] 0.69 (7.79) [22] 0.78 (5.52) [10] 0.70 (3.96) [16] 0.76 (3.12)
[11]

2.57 (2.06) [53] 2.61 (1.87) [51] -2.79 (-1.16) [82] 3.07 (2.92) [42] 2.44 (0.99) [58] -0.56 (-0.25) [79] 2.76 (3.06) [48] 3.54 (2.47) [38] 3.89 (2.16) [32] 6.62 (2.67)
[7]

0.68 (7.08) [76] 0.62 (5.69) [80] 1.22 (6.55) [28] 0.65 (7.94) [79] 1.03 (5.44) [58] 0.73 (4.28) [75] 0.79 (11.38) [72] 1.36 (12.29) [19] 1.07 (7.67) [53] 1.60 (8.31)
[7]

0.37 0.26 0.27 0.51 0.24 0.16 0.62 0.61 0.40 0.40 0.44 0.34 0.58 0.61

-1.14 (-1.83) [62] -1.45 Machine Tools (-2.39) [49] -2.07 Machine (-5.00) Tools, Hand [21] -1.76 Machinery, Construction& (-5.27) Material [35] Handling -1.09 Machinery, (-1.99) Agricultural [65] -1.35 Machinery, Industrial (-4.63) [53] -2.24 Machinery, (-5.38) Specialty [13] -1.56 Metals, Aluminum (-2.93) [42] -0.14 Metals, (-2.44) Copper [81] -1.76 Metals, Steel (-2.84) Products [34] -0.81 Metals & Mining, Misc. (-1.37) [71]

LeisureTime Products

0.45 (2.16) [65] 0.30 (1.51) [80] 0.73 (5.26) [14] 0.53 (4.78) [51] 0.64 (3.52) [29] 0.44 (4.51) [67] 0.56 (4.02) [46] 0.24 (1.36) [82] 0.41 (2.50) [69] 0.36 (1.75) [77] 0.64 (3.27) [32]

3.99 (1.89) [31] 4.08 (1.98) [29] 3.02 (2.15) [43] 3.75 (3.31) [35] 2.07 (1.10) [65] 3.82 (3.85) [34] 1.01 (0.71) [77] 2.30 (1.32) [59] 2.59 (1.76) [52] 3.30 (1.57) [41] 2.23 (1.11) [63]

1.60 (9.78) [5] 1.23 (7.73) [26] 1.27 (11.68) [25] 1.09 (12.43) [50] 1.00 (6.96) [60] 1.14 (14.80) [44] 1.29 (11.79) [24] 1.17 (8.49) [38] 1.50 (8.51) [13] 1.14 (7.00) [43] 1.18 (7.62) [35]

0.33 0.67 0.57 0.38 0.46 0.30 0.34

1.75 1.70 1.71 2.08 2.13 2.00 1.65

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 37

Table II-

Continued Type-i Risk (default) Risk Type-2 (term structure) Risk Type-3 or (inflation deflation) Risk Type-5 Risk Type-4 (unexpected (residual in market change growthrate risk) of profits)
-0.93 1.93

Industry Name

R2 (adjusted R-squared)

DW (DurbinWatson statistic)
2.12

Mobile

-3.38

1.05

8.60

0.54

Home Builders Motion

Pictures

(-5.29) [1] -1.71

(-1.31) [37]

(4.34) [1] 0.59

(3.42) [40]

(3.49) [4] 2.73

(1.55) [49]

(-1.06) [39] -0.56

(-0.89) [65]

(10.12) [1] 1.44

(10.66) [16]

0.50 0.35 0.75 0.43 0.46 0.42 0.53 0.62 0.49 0.49 0.56 0.54 0.52 0.54 0.41 0.44 0.56 0.41
0.47

1.70 1.87 1.85 1.77 1.59 1.55 2.01 1.79 1.75 1.90 1.66 2.03 1.83 2.08 2.08 2.02 1.81 2.04
2.01

NaturalGas Transmission Office & Business Equipment Oil & Gas Drilling Oil, Crude Producers Oil, Integrated Domestic Oil, Integrated Int'l Paper Photographic Pollution Control Publishing Publishing, Newspapers Radio-TV Broadcasters Railroad Equipment RetailDept. Stores Retail, Discount Stores Retail Drug Stores Retail Food Chains
Retail, Misc.

-1.48 (-1.80) [47] -1.94 (-0.95) [25] -0.70 (-0.95) [75] -0.49 (-0.96) [77] -0.66 (-1.46) [76] -0.73 (-2.20) [74] -1.85 (-5.36) [30] -2.58 (-5.19) [5] -1.70 (-2.83) [38] -1.37 (-3.64) [52] -1.44 (-3.52) [50] -1.39 (-3.14) [51] -1.90 (-4.73) [27] -1.67 (-3.62) [39] -2.32 (-5.24) [11] -2.12 (-4.79) [18] -2.05 (-5.30) [22]
-2.79 (-4.17) [3]

0.71 (2.59) [15] 0.59 (3.37) [41] 0.83 (3.37) [6] 0.64 (3.79) [30] 0.53 (3.38) [52] 0.40 (3.69) [74] 0.63 (5.51) [35] 0.80 (4.83) [9] 0.62 (3.11) [37] 0.56 (4.48) [44] 0.48 (3.52) [58] 0.47 (3.19) [61] 0.49 (3.68) [57] 0.63 (4.10) [36] 0.75 (5.07) [13] 0.81 (5.46) [8] 0.64 (4.96) [34]
0.59 (2.66) [39]

9.73 (3.48) [1] 4.08 (0.77) [30] 1.94 (0.77) [69] 1.55 (0.90) [73] -0.74 (-0.46) [80] 2.80 (2.50) [47] 1.97 (1.67) [68] 1.93 (1.14) [70] 8.04 (3.94) [5] 4.97 (3.88) [19] 5.30 (3.81) [14] 4.42 (2.94) [22] 1.89 (1.39) [71] 5.19 (3.31) [15] 3.43 (2.27) [40] 6.17 (4.10) [9] 2.29 (1.74) [62]
9.68 (4.25) [2]

-1.11 (-1.11) [30] -1.67 (-2.40) [7] -1.84 (-2.04) [6] -0.94 (-1.52) [38] -0.81 (-1.41) [48] -0.71 (-1.75) [52] -1.52 (-3.60) [11] -1.60 (-2.63) [9] -1.56 (-2.13) [10] -0.79 (-1.72) [49] -0.65 (-1.30) [58] -0.63 (-1.16) [82] -0.61 (-1.24) [61] -0.69 (-1.23) [54] -0.33 (-0.61) [73] -0.66 (-1.21) [57] -0.31 (-0.65) [1]
-1.51 (-1.85) [13]

1.56 (7.23) [11] 1.53 (9.51) [12] 1.85 (9.51) [2] 1.34 (10.01) [21] 1.17 (9.44) [39] 0.99 (11.44) [63] 1.16 (12.82) [40] 1.20 (9.18) [32] 1.57 (9.99) [9] 1.10 (11.10) [48] 1.18 (10.97) [36] 1.23 (10.59) [27] 1.19 (11.30) [33] 0.92 (7.59) [67] 0.85 (7.27) [71] 1.21 (10.41) [30] 0.68 (6.66) [77]
1.57 (8.95) [8]

Service Shoes

-2.00

0.69

9.01

-0.84
(-1.52)

1.45

0.62 0.22

1.93 2.08

(-4.43)

(4.59)

(5.87)

(12.21)

[23] -2.39
(-3.37)

[21] 0.65
(2.77)

[3] 2.35
(0.98)

[36] -0.70
(-0.81)

[15] 0.91
(4.89)

[10]

[27]

[60]

[53]

[69]

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 38

Table II-

Continued Type-i Risk (default) Risk Type-2 (term structure) Risk Type-3 or (inflation deflation) Risk Type-5 Risk Type-4 (unexpected (residual in market change growthrate risk) of profits)
-0.88 (-2.51) [43] 0.36 (1.11) [81] 0.78 (10.36) [73] 0.35 (5.07) [81]

Industry Name

R2 (adjusted R-squared)

DW (DurbinWatson statistic)
1.89

Soaps

Telephone

Textile ApparelMfg. Textile

Products

-1.29 (-4.49) [56] -0.78 (-2.95) [72]

-1.74 (-3.66) [36] -1.14

(-2.78) [63]

0.70 (7.30) [18] 0.38 (4.37) [76]

0.45 (2.82) [66] 0.46

(3.39) [62]

5.80 (3.60) [10] 5.03

(3.61) [17]

4.93 (5.05) [20] 1.28 (1.42) [74]

0.60

0.30

2.06

-0.68 (-1.17) [56] -0.65

(-1.29) [59]

1.22 (9.77) [29] 1.00

0.48 0.46 0.49 0.51

0.33

1.94 2.08 1.79 2.10

2.11

(9.30) [61]

Tire & RubberGoods Tobacco

Toys

-1.85 (-4.44)
[31]

0.46 (3.32)
[63]

2.47 (1.74)
[56]

-0.92 (-1.80)
[40]

1.11 (10.16)
[47]

-1.16
(-4.25) [61] -2.42 (-2.58) [8] [19]

0.53
(5.83) [53] 0.91 (2.91) [4] [31]

2.03
(2.20) [67] 5.65 (1.77) [11] [23]

-0.30
(-0.91) [74] -1.65 (-1.45, [8] [76]

0.67
(9.35) [78] 1.80 (7.32) [3] [14]

Wholesalers

-2.09 (-3.06)

0.64 (2.81)

4.24 (1.82)

-0.12 (-0.15)

1.48 (8.20)

0.39

2.01

a. Numbersin parenthesesare t-statistics. b. The numbersin squarebracketsreportthe rank orderingof (the absolute value of) the correspondingtype of risk exposure. Thus, for example, the aerospaceindustry ranked73rdout of 82 industrieswith respect to its exposureto type-1 and type-2 risks. At press time, three of the original82 industrieswere dropped because the data were found to be problematic; this does not affectthe reportedrank orderings.

Table I. The analysis of risk exposure by industry, however, provides further insight into the reasons behind the factor sensitivities we observe. For instance, the mobile home building industry is unique in that it ranks first in sensitivity to default risk (type-1), first in sensitivity to term-structurerisk (type-2), fourth in sensitivity to unexpected inflation risk (type-3), and first in sensitivity to residual market risk (type5). The reasons this industry performed so poorly during the time period under consideration, when unexpected inflation and other unfavorableshocks often predominated, are evident. The industries that are most sensitive to unexpected inflation risk include retailers, services, eating places, hotels and motels, drug stores, toys, and textile apparel manufacturers.For the most part, their products tend to be "luxuries," and the demand for "luxuries"plummets when consumer real incomes fall. These industries are thus not well insulated from unexpected drops in real income due to unexpected inflation. In contrast, the industries least sensitive to unex-

pected inflation tend to sell "necessities," the demands for which are relatively insensitive to declines in real income. These industries include foods, cosmetics, tire and rubber goods, shoes, tobacco and breweries. Several industries appear to exhibit no significant sensitivity to unexpected inflation risk. For instance, both corn and soybean refiners and sugar refiners have negative but insignificant sensitivity to unexpected deflation (f3). This is important, because the active and passive portfolio management techniques we discuss below depend upon selection of assets with low or opposite sensitivities to the risk factors the portfolio manager wishes to control. In sum, exposure to different types of risk varies considerably both across economic sectors and across industries.17 Are there some simple strategies for effectively managing these different types of risk?

A Risk-Sterilization Strategy
For simplicity, assume that a portfolio manager has determined that he or she wishes to have

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 39

exposure to only one type of risk-say, residual market risk. This objective can be attained by forming a portfolio of short and long positions such that the overall portfolio has zero quantities of risk exposure to the first four risk factors. If short sales are precluded or limited in practice, this objective may not be attainable. A strategy that is always feasible, however, is to form a portfoliothat has exposures to the first four different types of risk that are exactly proportionalto the correspondingexposures for any particularmarket index the manager may select (say, the S&P 500) while selecting a desired exposure to residual market risk. (If this exposure to residual market risk is 1.0, the strategy is equivalent to holding a portfolio that mimics the S&P500; otherwise it is not.) We call such a strategy risksterilization.18 Briefly, if we multiply bi5 times Equation (3) and subtract the result from Equation (1), we find, after rearrangingterms, that:
ri- Eri= ai + cil x fl + ci2 x f2 + cD X f3 + c4 x f4+ bi5 x (rm- TB) + ei, (5)

ple. Further generalizations will suggest themselves to the reader. For example, a manager may design portfolio strategiesto obtainvarious exposures to one particular type of risk or to particular combinations of different types of risk. Similarly, a pension fund manager can sterilize a portfolio so that its exposure to unexpected inflation or deflation risk is exactly the same as the exposure of the S&P500 to this risk, while at the same time selecting desired profiles of exposures to the remaining risks.

An Active APT Strategy

An active APT investment strategy entails being able to forecast the factor realizations accurately,at least on average. Suppose a manager believes that he or she can forecast (or can purchase a forecast of) unexpected inflation for the next month. Remember that the manager must accuratelyforecastunexpected inflation, not actual inflation. Thus, for example, a portfolio manager might forecast that the market as a whole expects inflation to be 4 per cent annually, while it will actually be 6 per cent annually. In this case, the managermust forecasta realization for unexpected inflation of 2 per cent. In fact, the portfolio manager "only" has to forecast correctlythe signs of the factor realizations. To illustratethis point, let's presume that a manager can accurately forecast the sign of unexpected inflation (which is the opposite sign of the realization for f3). Using the methods described above, he or she first selects a subset of stocks for which the exposures to the remaining types of risks (type-1, type-2 and type-4) are exactly proportional to the exposures of, say, 0 Then, to the S&P500 (so that ci1= cC = cC4 O). bet on unexpected deflation in the next month-a positive realization of the factor f3the manager chooses from the above subset of stocks a portfolio that has (1) the largest quantities of type-3 risk (the largest bi3s) and (2) an overall portfolio exposure to market risk near 1.0. To bet on unexpected inflation next month-a negative realizationof the factor f3the manager follows exactly the same procedure, but selects stocks with the smallest quantities of type-3 risk (the smallest bi3s). If the forecasts are correct on average, this portfolio will outperform the S&P 500. With accurate forecasts of unexpected inflation or deflation, the manager can outperform any index selected. The extent of the superior

where
Ci
=

bil

bi5 X bml,

c2 = bi - bi5 x b2, and so on, and where ai is a constant. If

Cil=

= C3 = Ci4 =

0,

then Equation (5) simplifies to:

ri - Eri =ai + bi5 x (rm - TB) + ei.

That is, when all the ciis, as defined above, are zero, any discrepancy between the actual and expected rate of return for the ith asset is explained by only the excess return on the market, a constant and an asset-specific error term. For a large portfolio, this asset-specific erroris diversified away. Consider, then, a large diversified portfolio consisting only of stocks for which ci1= ci2 = CD = ci4 = 0. Such a portfolio has a risk profile for the first four factors that is exactly proportional to the risk profile for the S&P 500. The same result can be obtained for any market index or any well-diversified portfolio the manager may select. Furthermore, by selecting appropriate weights for the stocks in this portfolio, the manager can achieve any desired exposure to the remaining type of risk-residual market risk, as measured by the S&P 500 in this exam-

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 40

performancewill be proportional to the size of the factor realization whose sign the manager forecast correctly, but which the market as a whole predicted to be zero. Implications The use of APT as an investment management tool is in its infancy. But a reliable database for asset returns and risk factor realizations, plus the availability of computer power that was unthinkable even 10 years ago, means that practicalAPT-based strategies can now be implemented at low cost. We have described two simple portfolio management strategies-a passive strategy that sterilizes portfolios from excessive exposure to selected types of risk and an Footnotes
1. APT originatedwith the theoreticalwork of S.A. Ross, "The Arbitrage Theory of Capital Asset Theory,December Pricing," Journalof Economic 1976. Less difficult expositions can be found in Portfolio Theory E.J.Eltonand M.JGruber,Modern andInvestment Analysis,2nd ed. (New York:John Wiley & Sons, 1984); T.E. Copeland and J.F. and Corporate Policy,2nd Weston, Financial Theory ed. (Reading, MA: Addison-Wesley Publishing Company, 1984); B.G. Malkiel, A RandomWalk Down Wall Street, 4th ed. (New York: W.W. Norton & Company, 1985);and R. Roll and S.A. Ross, "TheArbitragePricingTheoryApproachto Strategic Portfolio Planning," FinancialAnalysts Journal, MaylJune1984. 2. The technical results reviewed in this article are contained in the following papers: E. Burmeister and K.D. Wall, "The Arbitrage Pricing Theory and Macroeconomic FactorMeasures,"TheFinancial Review,February1986;Burmeister,Wall and J.D. Hamilton, "Estimation of Unobserved Expected Monthly Inflation Using Kalman FilterStatistics, ing," Journalof Businessand Economic April 1986; and M. McElroyand E. Burmeister, "Arbitrage PricingTheoryas a RestrictedNonlinear Multiple Regression Model: ITNLSUREstiand Economic Statistics, mates," Journal of Business January1988. Questions, including requests for copies of these papers, should be directed to Edwin Burmeister, Department of Economics, 114 Rouss Hall, University of Virginia, Charlottesville, VA 22901;telephone 804/924-3177. 3. The first papers to identify APT risk factorswith plausible economic variables were Burmeister and Wall, "The Arbitrage Pricing Theory and MacroeconomicFactor Measures," op. cit; N.-F. Chen, Roll and Ross, "EconomicForces and the Stock Market,"Journal of Business, July 1986;and

active one in which a portfolio manager makes bets based on forecasts of risk factor realizations. Other strategies, too numerous to discuss, suggest themselves; for example, the APT methodology described here is also applicable to the risk management of fixed-income securities.19 Moreover, once a set of relevant APT factors is known, portfolio managers need not invoke the full APT machinery to pursue these risk management strategies. APT provides effective means for managing the differenttypes of risk to which investors are exposed. Its use in the investment communityis certain to increase as managers become more familiarwith the new strategic investment opportunities it offers.20U

4.

5. 6. 7.

K.C. Chan, Chen and D.A. Hsieh, "An Exploratory Investigationof the FirmSize Effect,"journal of Financial Economics, September 1985. The price associated with an APT factor may be negative if investors want, perhaps for hedging purposes, to hold stocks whose returns increase when there is an unanticipated positive realization of that factor (and whose returns decrease when there is an unanticipatednegative realization). This negative price reflectsan attributethat investors find desirable.Similarly,the "quantity" of a particulartype of risk inherent in an asset is negative if the return on that asset decreases (increases) when there is a positive (negative) realizationof the correspondingrisk factor.These technical issues are discussed in Burmeisterand McElroy,"JointEstimationof FactorSensitivities and Risk Premia for the ArbitragePricing Theory" (Paper prepared for the American Finance Association Meeting, Chicago, December 1987 and forthcoming in the Journalof Finance)and Burmeisterand McElroy, "APT and Multifactor Asset Pricing Models with Measured and Unobserved Factors:Theoreticaland EconometricIssues" (Paper prepared for the Southern Finance AssociationMeeting, Washington,D.C., November 1987). See McElroyand Burmeister,"ArbitragePricing Theory as a Restricted Nonlinear Multiple Regression Model," op. cit. Ibid. For more discussion of this, see McElroy and Burmeister, "ArbitragePricing Theory as a Restricted Nonlinear Multiple Regression Model," op. cit. and especially Burmeisterand McElroy, "JointEstimationof FactorSensitivities and Risk Premia,"op. cit. We use the term "equivalent"to mean that the empirical results obtained using

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1988 D 41

8.

9.

10.

11.

12.

13.

14.

one set of factors can be derived exactly from an equivalent set of factors. Thus equivalent sets contain exactly the same information. See Burmeisterand Wall, "The ArbitragePricing Theory and MacroeconomicFactor Measures," op. cit. and McElroyand Burmeister,"Arbitrage PricingTheoryas a RestrictedNonlinearMultiple Regression Model," op. cit. We use one month as the time period in this study. One month is the shortest time period for which it is possible to measure some of our factors. In addition, monthly data are free from many troubling anomalies present in daily or weekly data (such as "holiday effects," autocorrelated returns, etc.). See McElroyand Burmeister,"ArbitragePricing Theory as a Restricted Nonlinear Multiple Regression Model," op. cit. and Burmeister and McElroy,"JointEstimationof FactorSensitivities and Risk Premia,"op. cit. Data were obtained from the series constructed by IbbotsonAssociates, Inc. For details, see R.G. Ibbotson and R.A. Sinquefield, Stocks, Bonds, ThePast and the Future(CharBills, and Inflation: lottesville, VA: Financial Analysts Research Foundation, 1982). The Ibbotson T-bill series serves this purpose well, because it is the one-month holding period return for a one-bill portfolio that is the shortest bill not less than 30 days in maturity. The constant C was 0.5 per cent at a compound annual rate. It is crucialto rememberthat GBand CB measure total monthly returns, not yields to maturity. The expected inflationseries was estimated using the Kalmanfilteringmethods of Burmeister,Wall and Hamilton ("Estimationof Unobserved Ex-

pected Monthly Inflation Using Kalman Filtering," op. cit.). 15. Some of these tests are reported in Burmeister, Wall and Hamilton, "Estimationof Unobserved ExpectedMonthly InflationUsing KalmanFiltering," op. cit. 16. The other standard ordinary-least-squares summary statistics: R2 = 0.24; DW = 2.13 (rho = -0.064); and F = 10.1 with a probabilityvalue of
0.0001.

17. An analysis of mutual funds similarto the analysis of sectors and industries discussed here is presented in M.A. Berry, Burmeisterand McElroy, "A Practical Perspective of Mutual Fund Risks:1974-1982," Investment Management Review, March-April1988. 18. The key to implementing risk sterilization is containedin McElroyand Burmeister,"Arbitrage PricingTheoryas a RestrictedNonlinearMultiple RegressionModel," op. cit. This strategycan also be used to construct portfolios that track any diversified index; it could therefore be used in connection with index futures contracts. 19. An excellent non-technical introduction to the use of APT-based risk-managementtechniques for bond portfoliosis containedin Ross, "Modifying Risk and Return in Managing Bond Portfolios," in TheRevolution in Techniques for Managing BondPortfolios (Charlottesville,VA: The Institute of CharteredFinancialAnalysts, 1983). 20. Personal computer software currentlyunder development and testing will enable portfoliomanagers to achieve alternativeinvestment objectives by implementing the strategies suggested here, as well as a variety of more sophisticated APTbased risk exposure optimization techniques.

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