What are the advantages and disadvantages of using macroeconomic factors for APT?

1 Advantages of using macroeconomic factors

One of the main advantages of using macroeconomic factors for APT is that they can capture the systematic risk and diversification benefits of different securities and portfolios. Macroeconomic factors reflect the common sources of uncertainty and volatility that affect the economy and the financial markets, such as inflation, interest rates, exchange rates, growth, and consumption. By using these factors, the APT can account for the sensitivity and exposure of different securities to these macroeconomic variables, and how they affect their expected returns. For example, a security that has a positive factor loading on inflation will have a higher expected return when inflation is high, and vice versa. Similarly, a portfolio that has low or negative correlations with the macroeconomic factors will have lower risk and higher diversification benefits than a portfolio that has high or positive correlations.

Another advantage of using macroeconomic factors for APT is that they can be tailored to specific markets and sectors. Unlike the CAPM, which assumes a single market portfolio that represents the entire market, the APT allows for the possibility of multiple market portfolios that reflect the characteristics and dynamics of different segments of the market. For example, a market portfolio for the US may differ from a market portfolio for Europe or Asia, and a market portfolio for the technology sector may differ from a market portfolio for the energy sector. By using macroeconomic factors that are relevant and representative for each market and sector, the APT can provide more accurate and realistic estimates of the expected returns and risks of different securities and portfolios.

2 Disadvantages of using macroeconomic factors

One of the main disadvantages of using macroeconomic factors for APT is that they can be difficult to measure and identify. Unlike the CAPM, which uses a single and observable factor (the market risk premium), the APT requires multiple and unobservable factors that need to be estimated and tested. The choice and number of macroeconomic factors can vary depending on the data availability, the time period, the methodology, and the researcher's preferences. There is no consensus or standard on how to select and construct the macroeconomic factors, and different factors may have different effects on different securities and portfolios. Moreover, the macroeconomic factors may not be stable or consistent over time, and may change due to structural shifts or shocks in the economy and the financial markets.

Another disadvantage of using macroeconomic factors for APT is that they can be incomplete and insufficient. Even if the macroeconomic factors can capture some of the systematic risk and diversification benefits of different securities and portfolios, they may not capture all of them. There may be other sources of risk and return that are not explained by the macroeconomic factors, such as industry-specific, firm-specific, or idiosyncratic factors. These factors may have significant impacts on the performance and valuation of different securities and portfolios, and may require additional factors or adjustments to account for them. For example, a security that has a high factor loading on growth may still have a low expected return if it has poor earnings, management, or governance. Similarly, a portfolio that has low correlations with the macroeconomic factors may still have high risk if it has high correlations with other factors that are not included in the APT.