11.3 Fama-French Three-Factor Model and Extensions
4 min read•july 30, 2024
The builds on the CAPM by adding size and value factors to explain stock returns. It suggests that small-cap and value stocks tend to outperform the market over time, offering investors a more nuanced approach to understanding risk and return.
This model has significant implications for portfolio management and performance evaluation. By considering size and value characteristics alongside market risk, investors can potentially construct more effective portfolios and better assess fund manager performance.
Fama-French Three-Factor Model
Model Overview
Top images from around the web for Model Overview
The Cross-Section of Stock Returns: An Application of Fama-French Approach to Nepal View original
Is this image relevant?
Reading: Influences on Consumer Decisions | Principles of Marketing View original
Is this image relevant?
Whether profitability and investment factors have additional explanatory power comparing with ... View original
Is this image relevant?
The Cross-Section of Stock Returns: An Application of Fama-French Approach to Nepal View original
Is this image relevant?
Reading: Influences on Consumer Decisions | Principles of Marketing View original
Is this image relevant?
1 of 3
Top images from around the web for Model Overview
The Cross-Section of Stock Returns: An Application of Fama-French Approach to Nepal View original
Is this image relevant?
Reading: Influences on Consumer Decisions | Principles of Marketing View original
Is this image relevant?
Whether profitability and investment factors have additional explanatory power comparing with ... View original
Is this image relevant?
The Cross-Section of Stock Returns: An Application of Fama-French Approach to Nepal View original
Is this image relevant?
Reading: Influences on Consumer Decisions | Principles of Marketing View original
Is this image relevant?
1 of 3
- Extends the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor
- The three factors used are:
- The excess return on the market (market factor)
- The difference between the return on a portfolio of small stocks and the return on a portfolio of large stocks ()
- The difference between the return on a portfolio of high book-to-market stocks and the return on a portfolio of low book-to-market stocks ()
- States that the expected return on a portfolio in excess of the risk-free rate is explained by the sensitivity of its return to the three factors
Model Extensions
- Extensions to the model have been proposed, such as the which includes a momentum factor
- The Fama-French adds profitability and investment factors to the original three factors
- The five-factor model includes the market factor, size factor, value factor, profitability factor (measured by operating profitability), and investment factor (measured by change in total assets)
Size and Value Factors
Size Factor (SMB)
- Represents the additional return investors have historically received by investing in stocks of companies with relatively small market capitalization (referred to as the "size premium")
- Positive SMB in the model indicates that small-cap stocks outperformed large-cap stocks in a given period
- Negative SMB indicates that large-cap stocks outperformed small-cap stocks
- The coefficient (factor loading) for SMB in the regression indicates the portfolio's exposure to the size factor
- A positive coefficient indicates a portfolio is exposed to small-cap stocks
- A negative coefficient indicates the portfolio is exposed to large-cap stocks
Value Factor (HML)
- Represents the additional return provided to investors for investing in companies with high book-to-market values (value stocks), often referred to as the "value premium"
- Positive HML in the model indicates that value stocks outperformed growth stocks in a given period
- Negative HML indicates that growth stocks outperformed value stocks
- The coefficient (factor loading) for HML in the regression indicates the portfolio's exposure to the value factor
- A positive coefficient indicates a portfolio is exposed to value stocks
- A negative coefficient indicates the portfolio is exposed to growth stocks
- The model predicts that portfolios consisting of small-cap and value stocks tend to outperform the market over the long term
Fama-French vs CAPM
Superior Explanatory Power
- The Fama-French model has been shown to explain a greater proportion of the cross-sectional variation in average stock returns compared to the CAPM
- The CAPM only takes into account the market factor (beta), while the Fama-French model incorporates additional factors (size and value) that have been shown to historically affect stock returns
- Empirical studies have shown that the Fama-French model provides a better fit to actual stock returns data compared to the CAPM, as evidenced by higher R-squared values in regressions
Criticisms and Limitations
- The Fama-French model has been criticized for its empirical nature and lack of strong theoretical foundation
- Some argue that the size and value factors are simply proxies for other, more fundamental risk factors
- Despite its limitations, the Fama-French model is widely used in practice for portfolio management and performance evaluation due to its superior explanatory power compared to the CAPM
Implications for Portfolio Management
Factor-Tilted Portfolios
- The Fama-French model suggests that investors should consider a stock's size and value characteristics in addition to its beta (market risk) when constructing portfolios
- Investors may be able to achieve higher risk-adjusted returns by tilting their portfolios towards small-cap and value stocks, which have historically outperformed the market according to the model
- Multifactor models like the Fama-French model can be used to construct factor-tilted portfolios or "smart beta" strategies that systematically exploit the size and value premiums
Performance Evaluation
- The model can be used to evaluate the performance of portfolio managers by comparing their returns to what would be expected given the portfolio's exposures to the size and value factors
- The Fama-French model also has implications for the debate between active and passive investing
- Some argue that the model's success in explaining stock returns suggests that markets are not perfectly efficient
- Skilled active managers may be able to exploit mispricing related to size and value factors
Risk Considerations
- Investors should be aware that the size and value premiums are not guaranteed to persist in the future
- Factor-tilted portfolios may underperform the market for extended periods of time
Key Terms to Review (18)
Arbitrage Pricing Theory: Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model that explains the relationship between the return of an asset and various macroeconomic factors. Unlike the Capital Asset Pricing Model (CAPM), which focuses solely on market risk, APT allows for multiple sources of risk, acknowledging that asset returns can be influenced by different economic variables. This makes APT a flexible framework for understanding how various factors can impact investment returns.
Carhart Four-Factor Model: The Carhart Four-Factor Model is an asset pricing model that expands upon the Fama-French Three-Factor Model by adding a fourth factor, which is the momentum factor. This model provides a more comprehensive framework for understanding stock returns by including not just market risk, size, and value, but also the tendency of stocks that have performed well in the past to continue performing well in the future. This extension makes it a valuable tool for investors looking to analyze and predict stock performance.
Efficient Market Hypothesis: The Efficient Market Hypothesis (EMH) suggests that financial markets are 'informationally efficient,' meaning that asset prices reflect all available information at any given time. This concept has major implications for how investors approach trading strategies, risk assessment, and portfolio management.
Eugene Fama: Eugene Fama is a renowned economist often referred to as the 'father of modern finance' for his groundbreaking work on the Efficient Market Hypothesis (EMH). His theories suggest that asset prices fully reflect all available information, which challenges traditional views on market inefficiencies. Fama's insights also paved the way for further developments, including the exploration of market anomalies and the creation of models like the Fama-French Three-Factor Model that extend beyond basic market efficiency.
Factor Investing: Factor investing is an investment strategy that involves targeting specific drivers of return within a portfolio, based on the belief that certain characteristics can explain the risk and return of securities. This approach identifies factors like value, size, momentum, and quality that have been shown to deliver higher returns over time. Understanding these factors allows investors to construct portfolios that can achieve better performance than the overall market.
Fama-French Three-Factor Model: The Fama-French Three-Factor Model is an asset pricing model that expands on the Capital Asset Pricing Model (CAPM) by incorporating three factors to explain stock returns: the market risk factor, the size effect, and the value effect. This model was developed to address certain market anomalies and limitations in traditional finance theories by recognizing that smaller companies and undervalued stocks tend to outperform larger companies and overvalued stocks over time.
Five-factor model: The five-factor model is an extension of the Fama-French Three-Factor Model that includes two additional factors, namely profitability and investment, to explain stock returns. This model enhances our understanding of asset pricing by acknowledging that not only market risk, size, and value but also a firm's profitability and its investment behavior play significant roles in explaining differences in expected returns among stocks.
Idiosyncratic risk: Idiosyncratic risk refers to the risk associated with a specific asset or company that is not correlated with the overall market. This type of risk can arise from factors unique to the individual company, such as management decisions, operational challenges, or competitive positioning. In the context of asset pricing models, like the Fama-French Three-Factor Model, understanding idiosyncratic risk is crucial as it differentiates between the risk that can be diversified away and the systematic risk that affects all investments.
Kenneth French: Kenneth French is an influential American economist known for his work in finance, particularly his contributions to asset pricing and portfolio management. He is most recognized for co-developing the Fama-French Three-Factor Model, which expands on the Capital Asset Pricing Model (CAPM) by including size and value factors, providing a more comprehensive understanding of stock returns and market behavior.
Long-short equity strategy: A long-short equity strategy is an investment approach that involves buying stocks that are expected to increase in value (long positions) and selling stocks that are expected to decrease in value (short positions). This strategy aims to capitalize on the relative performance of selected stocks while hedging against market risk, making it a popular technique among hedge funds and active investors.
Market risk premium: Market risk premium is the additional return that investors require for taking on the higher risk of investing in the stock market compared to risk-free assets, such as government bonds. It reflects the compensation investors expect for the uncertainty associated with equity investments and is a crucial component in asset pricing models, which help assess the expected returns on investments relative to their risk.
Portfolio theory: Portfolio theory is a framework for understanding how to assemble a collection of investments that can maximize returns while minimizing risk. It emphasizes the importance of diversification, suggesting that a well-constructed portfolio can lead to better risk-adjusted returns compared to individual investments. This concept is foundational for evaluating investment strategies, particularly in relation to various models and extensions that enhance our understanding of risk and return.
Regression Analysis: Regression analysis is a statistical technique used to understand the relationship between a dependent variable and one or more independent variables. It helps quantify how changes in the independent variables can impact the dependent variable, making it a vital tool for analyzing risk and return, as well as asset pricing models. By identifying relationships, it allows investors and analysts to make more informed decisions based on data-driven insights.
Risk-adjusted return: Risk-adjusted return is a measure that evaluates the return of an investment relative to the amount of risk taken to achieve that return. It provides a more comprehensive view of investment performance by incorporating the risk factor, allowing investors to compare the returns of different investments on a level playing field. This concept is vital for understanding how well an investment compensates for its inherent risks, connecting deeply with various analytical methods and performance evaluation frameworks.
Sharpe Ratio: The Sharpe Ratio is a measure used to evaluate the risk-adjusted return of an investment by comparing its excess return to its standard deviation. This ratio helps investors understand how much additional return they are receiving for the extra volatility they endure compared to a risk-free asset. It is crucial in assessing portfolio performance, allowing for better decision-making in investment strategy and asset allocation.
Size factor: The size factor is a financial metric that refers to the tendency for smaller companies to outperform larger companies in terms of investment returns. This phenomenon, often referred to as the 'small-firm effect,' suggests that smaller firms may offer greater potential for growth compared to their larger counterparts, which is a key component in asset pricing models like the Fama-French Three-Factor Model.
Systematic Risk: Systematic risk refers to the inherent risk that affects the entire market or a large segment of the market, often due to economic factors, geopolitical events, or changes in interest rates. This type of risk cannot be eliminated through diversification, as it impacts all investments in the market simultaneously, making it crucial to understand when evaluating the overall risk and return of a portfolio.
Value factor: The value factor refers to the tendency of undervalued stocks to outperform overvalued stocks in the long run. It is a key component of investment strategies that focus on identifying securities that are trading for less than their intrinsic value, based on fundamental analysis, and is integral to understanding risk and return dynamics within asset pricing models.