What Is the Fama-French 3-Factor Model?
The mutual fund rating company Morningstar is the biggest resource for classification. Funds are separated horizontally into three groups through a B/M ranking (value ranking) and vertically based on a ranking of market capitalization (size ranking). Ying Liu is a senior at George Mason University and is completing his bachelor of business as a finance major. fama french 3 factor model He is interested in financial markets and information related to risk management. He is pursuing opportunities in the financial analyst profession after finishing his university studies. Fama and French insist that investors must be ready to handle extra periodic underperformance and short-term volatility that can happen in a short period of time.
- In September 2020, we removed the adjustment to book equity related to FASB Statement No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, which was issued in 1990.
- Let’s learn how the Fama-French 3-factor model can be used to build portfolios, evaluate mutual funds and alpha, the value added by a fund manager.
- Next, we merge the portfolios to the return data for the rest of the year.
- The mutual fund rating company Morningstar is the biggest resource for classification.
- Value is more persistent than size but both are worthy of the investor’s attention.
There is a third theory which states that the broad market index weighs stocks in accordance to the market capitalization. This third factor shows that in the long run, growth companies have lower returns than value companies. Again, the logic behind the Fama-French model is that higher returns come from small-cap companies, rather than large-cap companies. So, with a few adjustments and with updated risk factors, the model also became useful for Asia, Europe and other regions. This excess risk is the result of a higher cost of capital and greater business risk. Nowadays, it is very popular as a measurement for portfolio performance and for predicting future stock returns.
DIFFERENT FAMA-FRENCH MODELS
It takes into consideration three factors which best describe the stock return value. With this model, you as an investor can construct a portfolio where you can see the average expected return, all according to the relative risks you’ve assumed. When you combine size and value factors with their beta factors, they explain about 90% of the return in your diversified stock portfolio.
SMB stands for “Small [market capitalization] Minus Big” and HML for “High [book-to-market ratio] Minus Low”; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks. If the model fully explains stock returns, the estimated alpha should be statistically indistinguishable from zero. The Fama-French Three Factor model is a formula to describe the rate of return on a stock investment. Jumping off those observations the two economists developed their three-factor model as an expansion of the Capital Asset Pricing model (CAPM).
Introduction to International CAPM
Value investing — buying high book-to-market firms and shorting their low book-to-market peers — had an historic run from 1926 to 2007. Over this time frame, a long-short HML portfolio generated over 4000% returns. The SMB or size factor performed extremely well up to about 1982, generating returns of about 600% over the time period. Then from 1982 to 2000, the pattern reversed and large-cap stocks outdid small caps. The factor rebounded a bit thereafter but has largely stagnated over the last 10 or 15 years.
Though some researchers and economists have urged over the fact that applying the Fama French Factor boards the book-to-market ratio explanation, performing the equity ratio is not considerable. The vertical axis (Y-axis) is the “Size” factor, represented as SMB. The upper side (more positive) is termed “Small Cap,” the lower side (more negative) is “Large Cap.”
Let’s learn how the Fama-French 3-factor model can be used to build portfolios, evaluate mutual funds and alpha, the value added by a fund manager. Under the CAPM model, the return on your investment is estimated based entirely on overall market risk. The Fama-French Three Factor model estimates an investment’s return based on market risk, market size and investment value. The HML factor reveals that, in the long-term, value stocks (high book-to-market ratio) enjoy higher returns than growth stocks (low book-to-market ratio). From the investor’s eye, the Model provides a pre-explanation of risk factors and how one can gauge the returns.
If any additional average expected return occurs, it is attributed to unsystematic or unpriced risk. This explains why the portfolios returns are accredited only to the value premium. The original excess of the manager will decrease because the model is able to explain more of the portfolio’s return. HML is used to show the spread in returns between companies which have high and companies which have a low book to market ratios (value companies and growth companies).
But, it didn’t do a very good job of explaining the observed market returns, especially if a portfolio strayed very far from the center of the market. Small company and value companies had persistently higher returns than CAP-M could explain. It represents the spread in returns between companies with a high book-to-market value ratio (value companies) and companies with a low book-to-market value ratio. Like the SMB factor, once the HML factor is determined, its beta coefficient can be found by linear regression. In asset pricing, Fama and French introduced the Three-Factor Model, which aimed to provide a more comprehensive understanding of stock market returns. Later, in 2015, they expanded this model into the Five-Factor Model by adding two more factors, Investment and Profitability.
This was proven when Fama and French ran their studies with thousands of random stock portfolio to test their model. Well, we’ve established that when we look long-term, small companies have a tendency to outperform large companies. It’s not officially stated by the creators, Fama and French, why book-to-price ratios measure risk. If this was the case, an investor or a manager could estimate the stock return value precisely, and then there would be no need for CAPM at all. The other parts of the equation are there to address all additional risks the investor is facing. Basically, CAPM explains portfolio performance primarily using the performance of the market as a whole.
Fama and French: The Five-Factor Model Revisited
Investment advisors understand that they can get fired for looking too different from everybody else. The Wall Street default strategy is “Don’t stand out, don’t get fired.” Unfortunately, that strategy stands little chance of systematically achieving returns above market. The further you tilt the portfolio, the less it will look like the more commonly reported indexes. So, an investor that can’t stand having different performance than his neighbor’s ought not to tilt his portfolio very far, even if doing so might increase his total performance over the long haul.
A lot of studies in emerging markets were conducted to see how the model would handle in that territory. This leads to thinking that the added two factors in this model are just a couple of tweaks, which address these problems. If a stock has a high book-to-price ratio, it could mean that the stock is “distressed”. The main goal of the CAPM formula is to determine if the stock is valued as it should be.
In short, this model describes stock returns, which is one of the most important factors investors take into consideration when choosing which project, product or company is worth their time and money. When a portfolio is measured using this model, the vast majority of returns are explained. Alpha just about completely disappears when a portfolio measurement accounts for the average size and value weights of the holdings. No longer can portfolio managers claim credit for unexplained excess results that occur simply because they held a portfolio tilted toward small or value.
Rather than just gauge market risk as the CAPM does, the Fama-French Three Factor model adds value risk and size risk to the calculation. Fama and French highlighted that investors must be able to ride out the extra short-term volatility and periodic underperformance that could occur in a short time. These increased expected returns do not rely on any magic performance by an active manager. They can be economically achieved by building a portfolio of index funds that rely solely on exposure to risk factors that over time have demonstrated persistent strong positive premiums. This process takes a long step forward in turning investment management from voodoo science into a real discipline.
Calculating SMB and HML
Frank Armstrong is the founder and principal of Investor Solutions, a Miami-based NAPFA fee-only registered investment adviser with more than $550 million of assets under management. He has more than 38 years’ experience in https://1investing.in/ the securities and financial services industry and has published four books and hundreds of articles on investments and retirement planning. These anomalies presented problems that made a generation of economists buggy.
