Fama and French Three Factor Model

What Is the Fama and French Three Factor Model?

The Fama and French Three-Factor Model (or the Fama French Model for short) is an asset pricing model developed in 1992 that develops the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor in CAPM. This model considers the way that value and small-cap stocks outperform markets consistently. By including these two extra factors, the model adapts to this outperforming inclination, which is remembered to make it a better tool for assessing manager performance.

Understanding the Fama and French Three Factor Model

Nobel Laureate Eugene Fama and researcher Kenneth French, former teachers at the University of Chicago Booth School of Business, endeavored to better measure market returns and, through research, found that value stocks outperform growth stocks. Essentially, small-cap stocks will generally outperform large-cap stocks. As an evaluation tool, the performance of portfolios with a large number of small-cap or value stocks would be lower than the CAPM result, as the Three-Factor Model changes descending for noticed small-cap and value stock outperformance.

The Fama and French model has three factors: the size of firms, book-to-market values, and excess return on the market. At the end of the day, the three factors utilized are small minus big (SMB), high minus low (HML), and the portfolio's return less the risk-free rate of return. SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.

There is a ton of discussion about whether the outperformance propensity is due to market proficiency or market shortcoming. In support of market proficiency, the outperformance is generally made sense of by the excess risk that value and small-cap stocks face because of their higher cost of capital and greater business risk. In support of market failure, the outperformance is made sense of by market participants mistakenly pricing the value of these companies, which gives the excess return over the long haul as the value changes. Investors who buy into the collection of evidence given by the Efficient Markets Hypothesis (EMH) are bound to concur with the productivity side.

The formula is:
$\begin &R_ - R_ = \alpha_ + \beta_1 ( R_ - R_ ) + \beta_2SMB_t + \beta_3HML_t + \epsilon_ \ &\textbf \ &R_ = \text i \text t \ &R_ = \text t \ &R_ = \text t \ &R_ - R_ = \text \ &R_ - R_ = \text{excess return on the market portfolio (index)} \ &SMB_t = \text{size premium (small minus big)} \ &HML_t = \text{value premium (high minus low)} \ &\beta_{1,2,3} = \text \ \end$
Fama and French highlighted that investors must have the option to brave the extra volatility and periodic underperformance that could happen in a short time. Investors with a long-term time horizon of 15 years or more will be compensated for losses experienced in the short term. Utilizing great many random stock portfolios, Fama and French directed studies to test their model and found that when size and value factors are combined with the beta factor, they could then make sense of as much as 95% of the return in a diversified stock portfolio.

Given the ability to make sense of 95% of a portfolio's return versus the market as a whole, investors can develop a portfolio where they receive an average expected return as per the relative risks they expect in their portfolios. The principal factors driving expected returns are sensitivity to the market, sensitivity to estimate, and sensitivity to value stocks, as measured by the book-to-market ratio. Any extra average expected return might be ascribed to unpriced or unsystematic risk.

Fama and French's Five Factor Model

Researchers have expanded the Three-Factor model in recent years to incorporate different factors. These incorporate "force," "quality," and "low volatility," among others. In 2014, Fama and French adjusted their model to incorporate five factors. Along with the original three factors, the new model adds the concept that companies reporting higher future earnings have higher returns in the stock market, a factor alluded to as profitability.

The fifth factor, alluded to as "investment", relates the concept of internal investment and returns, recommending that companies coordinating profit towards major growth projects are probably going to experience losses in the stock market.

Highlights

• The model was developed by Nobel laureates Eugene Fama and his partner Kenneth French during the 1990s.
• The Fama French 3-factor model is an asset pricing model that develops the capital asset pricing model by adding size risk and value risk factors to the market risk factors.
• The model is basically the aftereffect of an econometric regression of historical stock prices.

FAQ

What Are the Three Factors of the Model?

The Fama and French model has three factors: the size of firms, book-to-market values, and excess return on the market. At the end of the day, the three factors utilized are SMB (small minus big), HML (high minus low), and the portfolio's return less the risk-free rate of return. SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.

How might Fama and French Three Factor Model Affect Investors?

The Fama and French Three Factor model highlighted that investors must have the option to brave the extra volatility and periodic underperformance that could happen in the short term. Investors with a long-term time horizon of 15 years or more will be compensated for losses experienced in the short term. Given that the model could make sense of as much as 95% of the return in a diversified stock portfolio, investors can tailor their portfolios to receive an average expected return as per the relative risks they assume.The primary factors driving expected returns are sensitivity to the market, sensitivity to estimate, and sensitivity to value stocks, as measured by the book-to-market ratio. Any extra average expected return might be credited to unpriced or unsystematic risk.

What Is the Fama and French Five Factor Model?

In 2014, Fama and French adjusted their model to incorporate five factors. Along with the original three factors, the new model adds the concept that companies reporting higher future earnings have higher returns in the stock market, a factor alluded to as profitability. The fifth factor, alluded to as "investment", relates the concept of internal investment and returns, proposing that companies coordinating profit towards major growth projects are probably going to experience losses in the stock market.