CAPM says a stock's Expected Return — definition">expected return depends on exactly one thing: how much it moves with the overall market. [3]
$$E(r_i) = R_f + \beta_i \bigl(E[R_M] - R_f\bigr)$$
Two stocks with the same market beta should earn the same return. Full stop.
The problem: empirically, that isn't true. Small-cap stocks, cheap stocks, and recent winners all earn returns that CAPM can't explain — even after controlling for market beta. These patterns are not noise; they persist across time and markets. [3]
Arbitrage Pricing Theory (Ross, 1976) generalises this. It says a stock's return is driven by several systematic risk factors, not just one: [1]
$$R_{i,t} = E[R_i] + \beta_{i,1}f_{1,t} + \beta_{i,2}f_{2,t} + \ldots + \beta_{i,K}f_{K,t} + \epsilon_{i,t}$$
Each $\beta_{i,k}$ is the stock's sensitivity to factor $k$. Each factor carries its own risk premium $\lambda_k$ — the extra return investors demand for bearing that systematic risk. [1]
CAPM is simply APT with $K = 1$ (the market factor only). [1]
| CAPM | APT | |
|---|---|---|
| Risk factors | 1 (market beta) | Multiple |
| Theoretical basis | All investors hold market portfolio | No-arbitrage condition |
| Empirical fit | Poor | Much better |
The no-arbitrage logic is key: if any risk-free return opportunity existed, investors would pile in and bid it away. So every systematic risk must be compensated. Only idiosyncratic (firm-specific) risk earns nothing — because you can diversify it away. [1]
In Indian markets, the documented priced factors include value, momentum, quality, size, and low Volatility — definition">volatility. [6] When a fund "beats the Nifty 50," ask: is that skill, or is it just exposure to one of these factors — factor beta, not alpha? [2]
Paying a 1.5% active fee for momentum exposure you could get for 0.20% via an ETF is expensive once you understand APT. [2]
Apply this → Use the Fund Screener to check IR) — definition">Information Ratio — a fund with high IR is generating return beyond what its factor exposures explain. That's where active fees may be justified. [9]