Key Takeaways
- Adds size and value factors to market risk.
- Explains stock returns better than CAPM.
- Size factor favors small-cap stocks.
- Value factor favors high book-to-market stocks.
What is Fama and French Three Factor Model?
The Fama and French Three Factor Model, developed by Eugene Fama and Kenneth French, enhances the traditional Capital Asset Pricing Model (CAPM) by adding two key factors—company size and value—to better capture variations in stock returns beyond market risk alone. This model improves the understanding of expected returns by incorporating factor investing principles.
By including the size factor (small vs. large companies) and the value factor (high vs. low book-to-market ratios), the model explains why certain stocks outperform the market consistently.
Key Characteristics
The model relies on three primary factors to explain asset returns more comprehensively than CAPM:
- Market Risk: Reflects the excess return of the overall market relative to the risk-free rate, similar to CAPM's beta.
- Size Factor (SMB): Small capitalization stocks tend to outperform large-cap stocks, capturing additional risk related to firm size.
- Value Factor (HML): Stocks with high book-to-market ratios (value stocks) generally yield higher returns than growth stocks with low book-to-market ratios.
- Alpha and Abnormal Returns: The model estimates abnormal return (alpha) to measure manager skill or inefficiencies beyond those factors.
How It Works
The model quantifies expected stock returns by regressing them against three factors: market excess returns, size premium, and value premium. Each stock or portfolio receives factor loadings (betas) indicating sensitivity to these risks.
For example, a small-cap value stock will usually have positive exposures to both the size and value factors, predicting higher expected returns than a large-cap growth stock with negative loadings. These factor sensitivities help isolate the systematic risks driving returns and differentiate them from idiosyncratic risk.
Examples and Use Cases
Understanding the Fama and French Three Factor Model helps in portfolio construction and risk assessment across different market segments:
- Large-Cap Growth Stocks: Investors exploring best growth stocks can evaluate how these stocks’ returns relate to size and value factors, often showing lower exposure to SMB and HML.
- Value Investing: Portfolios tilted toward best value stocks benefit from the model’s value factor, explaining why such stocks may outperform over time.
- Airlines: Companies like Delta often exhibit varying factor sensitivities based on their market capitalization and book-to-market ratios, affecting their expected returns under this model.
- Large Caps: For those focusing on best large-cap stocks, the model clarifies how size and value factors influence these typically lower-risk investments.
Important Considerations
While the Fama and French model improves return predictions, it does not capture all sources of risk, such as momentum or profitability, which later models address. Additionally, factor loadings can change over time, requiring continuous evaluation.
Investors should also recognize the model’s reliance on historical data, meaning unexpected market events or shifts in economic conditions may affect its accuracy. Using metrics like Jensen’s measure alongside the model can provide further insight into manager performance.
Final Words
The Fama-French Three Factor Model offers a more nuanced view of stock returns by incorporating size and value factors alongside market risk. To harness its insights, consider applying the model to your portfolio to identify exposure to these factors and adjust your strategy accordingly.
Frequently Asked Questions
The Fama and French Three Factor Model is an asset pricing model developed in 1992 that expands on the Capital Asset Pricing Model (CAPM) by including two additional factors—company size and value—to better explain stock returns beyond just market risk.
Unlike CAPM, which considers only market risk, the Fama-French model adds size and value factors to capture the higher returns associated with small-cap stocks and high book-to-market (value) stocks, improving explanatory power for stock returns.
The three factors are market risk (excess market return over the risk-free rate), the size factor (SMB, which measures small-cap stocks outperforming large-cap ones), and the value factor (HML, which captures the return difference between high book-to-market value stocks and low book-to-market growth stocks).
The size factor reflects the tendency for smaller companies to outperform larger ones on average, indicating that smaller firms carry higher risk that the model accounts for when explaining stock returns.
The value factor (HML) represents the outperformance of stocks with high book-to-market ratios (value stocks) compared to those with low book-to-market ratios (growth stocks), helping to explain differences in returns related to company valuation.
Investors use the model to estimate how much of a portfolio's return is due to exposure to market risk, company size, and value factors, allowing better prediction of expected returns and risk by examining factor sensitivities or betas.
Historical data for the size and value factors, as well as market returns, are publicly available on Kenneth French's website, which provides ranked stock portfolios and factor returns used to calculate the model's variables.
Empirical studies show that the Fama-French model explains around 90% of stock return variations, making it significantly more reliable than CAPM, which typically explains about 70% of the return variation.
