Understanding, Formula, and Influence of the Fama-French Three-Factor Model
The Fama and French Five-Factor Model, introduced by Nobel Laureate Eugene Fama and researcher Kenneth French in 2015, is an extension of their earlier Three-Factor Model. This new model aims to provide a more nuanced and complete framework for asset pricing, offering a better explanation for the cross-section of stock returns.
The Fama and French Five-Factor Model
The Five-Factor Model builds upon the Three-Factor Model by incorporating two additional factors: profitability and investment. These factors are designed to capture the dimensions of risk and expected return in equity markets beyond size and value.
The five factors in the Fama and French Five-Factor Model are:
- Market risk (overall market return minus risk-free rate)
- Size (Small Minus Big, SMB, capturing the size effect)
- Value (High Minus Low book-to-market ratio, HML, capturing the value effect)
- Profitability (Robust Minus Weak, RMW, differentiating firms by profitability)
- Investment (Conservative Minus Aggressive, CMA, reflecting differences in capital investment)
Key Differences Between the Three-Factor and Five-Factor Models
| Aspect | Three Factor Model | Five Factor Model | |-----------------------|------------------------------------|------------------------------------------------------| | Factors included | Market, SMB (Size), HML (Value) | Market, SMB, HML, Profitability (RMW), Investment (CMA) | | Purpose | Explains returns based on market risk, size, and value factors | Adds profitability and investment patterns to better explain cross-sectional returns | | Year proposed | 1993 | 2015 | | Empirical improvement | Improved over CAPM but left some variation unexplained | Offers better explanation for variations in returns by including profitability and investment |
The Advantage of the Five-Factor Model
The main rationale for the five-factor model is that companies with higher profitability and conservative investment tend to have higher average returns, so adding these factors captures additional systematic variation.
With this model, investors can construct portfolios to receive expected returns based on their assumed risks. Given that the Fama and French Five-Factor Model could explain as much as 95% of the return in a diversified stock portfolio, investors can tailor their portfolios to receive an average expected return according to the relative risks they assume.
The Profitability Factor
The profitability factor suggests that companies reporting higher future earnings have higher returns in the stock market. This factor aims to capture the premium associated with firms that are profitable over time.
The Investment Factor
The investment factor proposes that companies investing heavily in growth projects may face stock market losses. This factor is designed to capture the risk associated with a company's investment strategy.
The Original Three-Factor Model
Before the introduction of the Five-Factor Model, the Three-Factor Model was already a significant improvement over the Capital Asset Pricing Model (CAPM). The Three-Factor Model uses three key factors: size, value, and market excess return. Combining size and value factors with the beta factor in the Three-Factor Model explains up to 95% of returns in diversified portfolios.
Investors must be able to ride out the extra volatility and periodic underperformance that could occur in the short term to benefit from both the Three-Factor and Five-Factor Models. However, those with a long-term time horizon of 15 years or more will be rewarded for losses suffered in the short term.
In conclusion, the Fama and French Five-Factor Model offers a more comprehensive approach to asset pricing, providing a better explanation for the cross-section of stock returns. By incorporating profitability and investment factors, it supplements the Three-Factor Model, offering a more nuanced understanding of the equity market.
[1] Fama, Eugene F., and Kenneth R. French. "A five-factor asset pricing model." Journal of financial economics 116, no. 1 (2015): 1-22. [2] Fama, Eugene F., and Kenneth R. French. "The cross-section of stock returns." Journal of financial economics 33, no. 1 (1993): 3-56. [5] Fama, Eugene F., and Kenneth R. French. "Three common factors in the returns on stocks and bonds." Journal of financial economics 43, no. 3 (2001): 383-410.
- In the context of finance and investing, the Fama and French Five-Factor Model, introduced in 2015, integrates profitability and investment factors to offer a more comprehensive explanation for the cross-section of returns in the equity market, beyond size and value, as opposed to the Three-Factor Model proposed in 1993.
- By focusing on companies with higher profitability and conservative investment strategies, investors can construct portfolios in the crypto market capital aimed at receiving expected returns based on their assumed risks, as the Fama and French Five-Factor Model could explain as much as 95% of the return in a diversified stock portfolio.
