Loading the player...

What is '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 risk and value risk 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 this outperforming tendency, which is thought to make it a better tool for evaluating manager performance.

BREAKING DOWN 'Fama and French Three Factor Model'

Nobel Laureate Eugene Fama and researcher Kenneth French, former 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. In support of market efficiency, 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. In support of market inefficiency, the outperformance is explained by market participants incorrectly pricing 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 agree with the efficiency side.

What It Means for Investors

Fama and French highlighted that investors must be able to ride out the extra short-term volatility and periodic underperformance that could occur in a short time. Investors with a long-term time horizon of 15 years or more will be rewarded for losses suffered in the short term. Using thousands of random stock portfolios, Fama and French conducted studies to test their model 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, 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.

RELATED TERMS
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model (CAPM) is a model that describes ...
  2. International Capital Asset Pricing ...

    The international capital asset pricing model (CAPM) is a financial ...
  3. Factor Investing

    Factor investing is strategy in which securities are chosen by ...
  4. Inefficient Portfolio

    An inefficient portfolio is one that delivers an expected return ...
  5. Market Risk

    Market risk is the possibility of an investor experiencing losses ...
  6. Cost Of Equity

    The cost of equity is the rate of return required on an investment ...
Related Articles
  1. Investing

    Why Index Investors Should Give Factor Investing a Try

    If you believe in index investing, you should believe in factor based investing. Here's why.
  2. Investing

    Is Apple's Stock Over Valued Or Undervalued?

    Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ...
  3. Investing

    Valuing Small-Cap Stocks

    When done right, small-cap investing can improve the performance of your portfolio without adding a great degree of risk.
  4. Investing

    Small-Cap And Value: A Reliable Smart Beta Combination

    Consider combining small-cap and value for stellar long-term performance.
  5. Investing

    Introduction to International CAPM

    ICAPM is one of several models used to determine the required return on an asset.
  6. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  7. Investing

    Size Matters With Smart Beta

    A multi-factor approach to small-caps can boost returns while reducing volatility.
  8. Investing

    Smart Beta Strategies for Retail Investors

    Retail investors must understand the processes underlying the various “smart-beta” investment strategies, and build portfolios that are low-cost, diversified, and aligned with their goals.
RELATED FAQS
  1. How do I use the CAPM (capital asset pricing model) to determine cost of equity?

    Learn about the elements of the capital asset pricing model, and discover how to calculate a business' cost of equity financing ... Read Answer >>
  2. How does market risk affect the cost of capital?

    Find out how market risk directly affects the total cost of capital, including how to use the capital asset pricing model ... Read Answer >>
  3. How is the Capital Asset Pricing Model (CAPM) represented in the Security Market ...

    Learn about the capital asset pricing model and the security market line and how the model is used in the calculation and ... Read Answer >>
  4. What are some examples of ways that sensitivity analysis can be used?

    Understand the concept of sensitivity analysis and learn about the wide variety of disciplines to which it can be applied. Read Answer >>
  5. What is the difference between cost of equity and cost of capital?

    Read about some of the differences between a company's cost of equity and its cost of capital, two measures of its required ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center