The Fama and French Three-Factor Model (or the Fama French Model for short) is an asset pricing model developed in 1992 that expands on the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor in CAPM.
How do I conduct a Fama French 3 Factor model on a portfolio?
CAPM has been prevalently used by practitioners for calculating required rate of return despite having drawbacks. ... It means that Fama French model is better predicting variation in excess return over Rf than CAPM for all the five companies of the Cement industry over the period of ten years.
The Fama-French model aims to describe stock returns through three factors: (1) market risk, (2) the outperformance of small-cap companies. relative to large-cap companies, and (3) the outperformance of high book-to-market value companies versus low book-to-market value companies.
Although the Fama-French factors still show a strong long-term performance, they have now experienced two lost decades during which various other factors were able to deliver. Therefore, it seems that more factors are needed for an accurate and comprehensive description of the cross-section of stock returns.
What Are the Three Factors of the Model? The Fama and French model has three factors: size of firms, book-to-market values and excess return on the market. In other words, the three factors used are SMB (small minus big), HML (high minus low) and the portfolio's return less the risk free rate of return.
Small minus big (SMB) is a factor in the Fama/French stock pricing model that says smaller companies outperform larger ones over the long-term. High minus low (HML) is another factor in the model that says value stocks tend to outperform growth stocks.
SMB stands for "Small [market capitalization] Minus Big" and HML for "High [book-to-market ratio] Minus Low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks.
Alpha for Portfolio Managers
Professional portfolio managers calculate alpha as the rate of return that exceeds the model's prediction, or comes short of it. They use a capital asset pricing model (CAPM) to project the potential returns of an investment portfolio. That is generally a higher bar.
The five factors driving returns
Size: The market capitalization of a stock. Small-cap stocks have tended to outperform large-cap ones. Value: The measurement of a stock by its price-to-book ratio or other ratios. Profitability: The operating profitability of a stock's underlying company.
Formally stating alpha=Return of Asset minus Expected Return. Expected Return is from CAPM, Rf+B(Rm-Rf).
Measuring factor exposure
Once a factor has been defined, the factor exposure of an index can be measured as the sum of the factor scores of the index's constituents, multiplied by each constituent's weight in the index.
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