Fama and French three factor model

Fama and French three factor model is an asset pricing model developed in 1992. It elaborates size risk and capital risk factors to the market risk factors in CAPM. This way of prediction takes into consideration that small cap companies outperform the market every working day.

If we add these two factors, it can help us make a better tool for evaluating manager performance.

Keypoints from the blog

  1. Major keypoints from the blog
  2. Understanding Fama and french three factor model
  3. Five factor model

1. Major keypoints from the blog

It is a capital asset pricing model which adds on size risk and value risk factors to the market risk factors to better evaluate the risk attached.

This model is developed by Nobel laureates Eugene Fama and his colleague Kenneth French in th 1990s.

It is a result of econometric regression of historical stock prices.

2. Understanding Fama and French three factor model

When Sir Nobel and researcher Kenneth researched market, they found value stocks outperform growth stocks. Similarly small cap stocks tends to outperform large cap stocks.

As an evaluation tool, performance of portfolios with large number of small cap companies would be lower than the CAPM result as the three factor module adjusts downward for observed small cap and value stock out performance.

Module is having three factors :

  • Size of the firm
  • Book to market values
  • Excess return on the market

Three factors which are used is Small minus big ( SMB ), High minus low ( HML ) and the portfolio return less the risk free rate of return.

SMB is a factor which indicates the small cap companies giving higher market returns and HML is a factor which contains value stock with high book to market ratio who outperform market with higher returns.

This unexpected outperformance is somehow supported by the market inefficiency. The amount of risk small cap and value stocks face as a result of high cost of capital and business risk is higher.

Fama and french three factor model indicates that people should ride out the risk associated, volatility and underperformance of short term. Investors with more than 15 years of time horizon of holding equity will be rewarded for each short term risk and losses they will be taking everyday.

When this model was tested in thousands of different diversified portfolio, it was found that when size and value factor is combined with the beta factor, it can easily explain all the returns.

3. Five factor model

In later stages along with the three major factors, F&F model have that is :

  • Momentum
  • Quality
  • Low volatility

They stated two more factors which are majorly involved. Fourth one is ” Profitability ” that means companies which are reporting higher future earnings have higher return in stock market. Fifth one is ” Investment ” that depicts companies which are investing their internal profit into major growth projects may face short term loss in market.

So overall this model helps you think none about high volatility and short term underperformance of the companies in short term. As per the survery of more than thousands of diversified portfolios says that 95% of the portfolio gets the reward in a span of 15 years of all the risk and short term loss they face.

Hope you got to learn everything from Fama and French three factor model, Stay tuned for more upcoming infomational blogs.


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