Fama And French Three Factor Model

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What is the 'Fama And French Three Factor Model'

The Fama and French Three Factor Model is an asset pricing model that expands on the capital asset pricing model (CAPM) by adding size and value factors to the market risk factor in CAPM. This model considers the fact that value and small-cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for the outperformance tendency, which is thought to make it a better tool for evaluating manager performance.

BREAKING DOWN 'Fama And French Three Factor Model'

Eugene Fama and Kenneth French, both professors at the University of Chicago Booth School of Business, attempted to better measure market returns and, through research, found that value stocks outperform growth stocks. Similarly, small-cap stocks tend to 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 adjusts downward for small-cap and value outperformance.

Debating the Three Factor Model

There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency. On the efficiency side of the debate, the outperformance is generally explained by the excess risk that value and small-cap stocks face as a result of their higher cost of capital and greater business risk. On the inefficiency side, the outperformance is explained by market participants mispricing the value of these companies, which provides the excess return in the long run as the value adjusts. Investors who subscribe to the body of evidence provided by the Efficient Markets Hypothesis (EMH), are more likely to side with the efficiency side.

What It Means for Investors

Fama and French were quick to point out that, while value beats growth and small beats large, over the long term, investors must be able to ride out the extra short-term volatility and periodic underperformance that could occur in a given short-term time frame. Investors with a long-term time horizon of 15 years or more will be rewarded for any pain they might suffer in the short term. Fama-French conducted studies to test their model, using thousands of random stock portfolios, and found that when size and value factors are combined with the beta factor, they could then explain as much as 95% of the return in a diversified stock portfolio.

Given the ability to explain 95% of a portfolio’s return versus the market as a whole, investors can construct a portfolio in which they receive an average expected return according to the relative risks they assume in their portfolios. The main factors driving expected returns are sensitivity to the market; sensitivity to size, as in small-cap stocks; and sensitivity to value stocks, as measured by the book-to-market ratio. Any additional average expected return may be attributed to unpriced or unsystematic risk.

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