Key Takeaways
- HML measures value stock excess returns over growth stocks.
- Constructed from high minus low book-to-market portfolios.
- Captures value premium beyond market risk in Fama-French model.
- Value stocks earn higher returns due to higher risk exposure.
What is High Minus Low (HML)?
High Minus Low (HML) is a key factor in the Fama-French three-factor model that measures the value premium by calculating the excess returns of high book-to-market (value) stocks over low book-to-market (growth) stocks. This premium helps explain why value stocks historically outperform growth stocks after adjusting for market risk.
HML captures differences in expected returns related to a stock’s valuation characteristics rather than just market movements, making it a fundamental concept in factor investing.
Key Characteristics
HML highlights the value premium through several defining traits:
- Value vs. Growth: Compares portfolios of stocks with high book-to-market ratios (value stocks) to those with low ratios (growth stocks).
- Constructed from Portfolios: Formed by taking differences in returns between high and low book-to-market portfolios, often adjusted for size effects.
- Risk Premium: Reflects compensation investors demand for holding potentially riskier value stocks, linked to idiosyncratic risk.
- Historical Outperformance: Value stocks have shown a positive average HML premium over time, though it varies with economic cycles.
How It Works
HML is calculated by sorting stocks into groups based on their book-to-market ratios, then measuring the return difference between high B/M (value) and low B/M (growth) portfolios. This factor is incorporated into asset pricing models alongside market risk and size factors.
Investors use HML loadings to identify how sensitive a stock or portfolio is to the value premium, adjusting expected returns accordingly. For instance, a portfolio with a high HML beta will benefit more during periods when value stocks outperform.
Examples and Use Cases
Understanding HML can improve portfolio construction and risk assessment by emphasizing value exposure.
- Airlines: Companies like Delta often have different valuations compared to growth-oriented firms, illustrating HML’s application in sector analysis.
- Value Stock Selection: Investors seeking higher expected returns might explore best value stocks identified by their high book-to-market ratios.
- ETF Strategies: Many ETFs incorporate HML factors to provide targeted value exposure, as outlined in guides to the best ETFs.
Important Considerations
While HML is a powerful tool for capturing the value premium, it is important to recognize that it may underperform during certain market environments, especially when growth stocks dominate. You should also consider the limitations of relying solely on HML without accounting for other risks and factors, such as momentum or size.
Monitoring abnormal returns relative to HML exposures can help differentiate skill from factor-driven performance in your portfolio management decisions.
Final Words
HML highlights the historical value premium, showing value stocks often outperform growth stocks after adjusting for market risk. To leverage this insight, evaluate your portfolio’s exposure to value factors and consider whether adding value stocks aligns with your investment goals and risk tolerance.
Frequently Asked Questions
HML stands for High Minus Low and measures the value premium by comparing returns of high book-to-market (value) stocks against low book-to-market (growth) stocks. It captures why value stocks tend to outperform growth stocks after accounting for market risk.
HML is created by sorting stocks based on their book-to-market ratios into value (high B/M) and growth (low B/M) portfolios. The HML return is the difference between average returns of value stocks and growth stocks, often adjusted for size to improve robustness.
HML adds a value factor to the traditional market risk model, helping explain returns that CAPM misses. It shows how exposure to value stocks can increase expected returns, quantifying the value premium alongside size and market factors.
Value stocks often have higher returns because they carry more risk, such as financial distress or economic downturn sensitivity. Behavioral factors also play a role, where investors overvalue growth stocks and undervalue value stocks, creating a premium.
Portfolio managers use HML betas from regression analysis to determine if a portfolio's excess returns come from exposure to value stocks versus market timing. This helps them understand the sources of returns and manage risk accordingly.
Yes, while HML has historically yielded positive premiums, the value premium fluctuates with economic cycles and market conditions. During some periods, growth stocks may outperform, reducing the HML factor's returns.
Value stocks have high book-to-market ratios, meaning their market price is low compared to their book value, often indicating undervaluation or distress. Growth stocks have low book-to-market ratios, reflecting high market valuations driven by expected future growth.
