The Fama-French Three-Factor Model
The Fama-French Three-Factor Model is a method for explaining the risk and return of stocks. It was designed by Nobel Laureate Eugene Fama and renowned researcher Kenneth French when both were professors at the University of Chicago.
What makes the Fama-French Three-Factor Model so extraordinary is that it not only reveals the primary factors that drive stock return but also provides a strategy for using those factors in your portfolio for a potentially higher expected long-term return. In portfolios designed at Portfolio Solutions®, we incorporate the three-factor model into asset allocations.
In more detail, the Fama-French Three-Factor Model separates stock returns into three distinct risk factors:
Beta – a measure of volatility of a stock in comparison to the market as a whole; the risk of owning stocks in general; or an investment’s sensitivity to the market. A beta of 1 means that the security will move with the market. If the beta of any investment is higher than the market, then the expected volatility is also higher and vice versa.
Size – the extra risk in small company stocks. Small company stocks (small cap) tend to act very differently than large company stocks (large cap). In the long run, small-cap stocks have generated higher returns than large-cap stocks; however, the extra return is not free since they have higher risk.
Value – the value in owning out-of-favor stocks that have attractive valuations. Value stocks are companies that tend to have lower earnings growth rates, higher dividends and lower prices compared to their book value. In the long run, value stocks have generated higher returns than growth stocks, which have higher stock prices and earnings, albeit because value stocks have higher risk.
The Fama-French Three-Factor Model is an advancement of the Capital Asset Pricing Model (CAPM). Beta is the brainchild of CAPM, which is designed to determine a theoretically appropriate required rate of return of any investment and compare the riskiness of an investment to the risk of the market.
Fama and French found that on average, a portfolio’s beta is the reason for 70% of its actual stock returns. Unsatisfied, they thought, rightly, that there was an even better explanation. They discovered that figure jumps to 95% with the combination of beta, size and value.
Their research showed the premium provided by small-cap and value stocks as well as the small, if any, influence active trading has on stock returns.
Therefore, we capture the benefits of the three-factor model by starting with a beta position in the total markets (U.S. and foreign) and then adding U.S. and foreign small-cap value stock index funds to “tilt” the portfolio toward size and value factors.