What Is the Fama and French Three-Factor Model?
Let me explain the Fama and French Three-Factor Model directly: introduced in 1992 by Eugene Fama and Kenneth French, this model builds on the traditional Capital Asset Pricing Model (CAPM) by adding size and value risk factors to the market risk. You need to know that it recognizes how small-cap and value stocks tend to outperform the overall market consistently. By including these factors, the model gives you a more precise tool for evaluating portfolio performance, adjusting for the expected higher returns from these stock types.
How It Works
Here's how it breaks down: Eugene Fama and Kenneth French observed that value stocks often beat growth stocks, and small-cap stocks outperform large-cap ones. If your portfolio is loaded with small-cap or value stocks, it might underperform what CAPM predicts, but the Three-Factor Model corrects for that by factoring in their typical outperformance.
The model uses three factors: firm size, book-to-market values, and excess market return. Specifically, these are small minus big (SMB) for small market cap companies that yield higher returns, high minus low (HML) for value stocks with high book-to-market ratios that perform better than the market, and the portfolio's return minus the risk-free rate.
There's ongoing debate on why this outperformance happens—whether it's due to market efficiency (extra risk means higher returns) or inefficiency (mispricing by the market). If you follow the Efficient Markets Hypothesis, you'll lean toward the efficiency explanation.
The Formula
You can see the model's structure in this formula: Rit - Rft = αit + β1 (RMt - Rft) + β2 SMBt + β3 HMLt + ϵit, where Rit is the total return of a stock or portfolio i at time t, Rft is the risk-free rate at time t, RMt is the market portfolio return at time t, SMBt is the size premium (small minus big), HMLt is the value premium (high minus low), and β1,2,3 are the factor coefficients.
Fama and French tested this and found it explains up to 95% of returns in diversified portfolios when you include size and value. That means you, as an investor, can build portfolios with expected returns based on the risks you're taking—sensitivity to the market, size, and value as measured by book-to-market ratio. Any extra return beyond that is likely unpriced or unsystematic risk.
Remember, you have to tolerate the added volatility and short-term underperformance; if your horizon is 15 years or more, you'll get rewarded for sticking it out.
Fama and French's Five-Factor Model
Building on the original, Fama and French expanded to a Five-Factor Model in 2014. It keeps the three factors and adds profitability—companies with higher future earnings tend to have higher stock returns—and investment, where firms pouring money into growth projects might see stock losses.
Researchers have also explored other factors like momentum, quality, and low volatility, but the five-factor version provides an even more comprehensive view of asset pricing.
Key Takeaways
- The Fama and French Three-Factor Model enhances CAPM with size and value risks to better explain portfolio returns.
- It highlights small-cap and value stocks' tendency to outperform, adjusting expectations accordingly.
- The model uses SMB, HML, and market excess return to assess performance.
- Expanded to five factors in 2014, adding profitability and investment for greater accuracy.
Frequently Asked Questions
What does this mean for you as an investor? You need to endure short-term volatility for long-term gains, and the model helps tailor portfolios to expected returns based on risks like market sensitivity, size, and value.
The three factors are firm size (SMB), book-to-market (HML), and excess market return.
The Five-Factor Model adds profitability (higher earnings lead to better returns) and investment (heavy growth investments may cause losses).
Other articles for you
A press conference is an event for distributing information and answering media questions, often used by companies, politicians, and officials to address news or issues.
This text is a comprehensive glossary of financial and economic terms starting with the letter 'U' from Investopedia.
This text explains the concept of taxation, its history in the US, purposes, and various types.
Tape reading is an outdated stock analysis method using ticker tapes, now evolved into modern electronic techniques.
A Chief Operating Officer (COO) is a senior executive who manages a company's daily operations and reports to the CEO.
GMROI is a ratio that measures how effectively a company turns its inventory into profit by comparing gross margin to average inventory cost.
Marxism is a philosophy by Karl Marx critiquing capitalism and predicting a worker-led revolution to achieve a classless society.
A term loan offers businesses a lump sum of cash upfront with a structured repayment plan over a set period, often used for purchasing assets.
Variable costs are business expenses that change directly with the level of production or sales.
Predatory pricing is an illegal tactic where companies set unrealistically low prices to drive out competitors and establish a monopoly.