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What is the Fama-French Three-Factor Investing Model?

The Fama-French Three-Factor Model Illustration
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What is the Fama-French Three-Factor Investing Model?

Investing is a tough field with innumerable strategies and approaches. One approach that has gained popularity over the years would definitely be factor investing. Even we are using it for our products. Factor investing is an investment strategy that involves targeting specific drivers of return across asset classes.

The Fama-French Three-Factor Model

One of the well-known factor investing models is the Fama-French three-factor model, which will be our main topic today. Built by economists Eugene Fama and Kenneth French, this model utilizes three factors: the size of firms, book-to-market values, and excess return on the market. In the model’s terminology, 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.

Size of Firms (SMB)

Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock. The size factor, also known as SMB (Small Minus Big), is based on this observation. This phenomenon is often attributed to the higher risk associated with smaller companies, which gives them a higher expected return (high risk and high return are correlated). Hence, investors should be aware of the higher volatility and potential significant losses.

Book-to-Market Values (HML)

The value factor, or HML (High Minus Low), aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow. This phenomenon is based on the observation that stocks with low prices relative to their book value (known as “value stocks”) tend to outperform those with high prices relative to their book value (known as “growth stocks”) over the long term.

Excess Return on the Market

This factor just represents the excess return of the portfolio over the risk-free rate. It is based on the idea that an investment should outperform a risk-free investment (such as US10YRs) over the long term.

Stocks that have a good track record tend to exhibit the same behavior in the future. A momentum strategy is usually based on relative returns from three months to one year. Thus, by embracing this momentum strategy and analyzing historical data, one might increase their return on investment.

Benefits of Factor Investing

Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns (creating higher alpha), and manage risk. Since traditional portfolio allocations, like 60/40, are relatively easy to implement, factor investing can seem overwhelming given the number of factors to choose from.

There are tools like ours to make that way easier; however, even understanding these factors from this article alone might help you to choose the stocks that suit your individual investment plan.

Practical Application

The Fama-French three-factor model can basically be used to analyze a portfolio’s performance and to construct a portfolio with specific risk and return characteristics.

It should be kept in mind that although the three-factor model can be advantageous in comprehending portfolio performance and building portfolios, it does not ensure future performance. The factors that have driven returns in the past may not do so in the future, and the model does not account for all possible sources of risk and return.

We access how the factors work on both the long time series 1990-2023 and the short time series 2020-2023 in our series of articles in the AP on the Street. The results often go against the theory presented here! We have been also developing the Factor Investing app to monitor and use the right factors.

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Conclusion

Factor investing is a useful tool for investors seeking to improve portfolio results, decrease volatility, and increase diversification. By understanding the many elements that impact returns, investors may make more educated decisions and perhaps achieve better results. Whether you are an experienced investor or just getting started, factor investing provides a solid framework for navigating the complicated world of investment.

Sources:
Investopedia, Factor Investing Definition.
Analytical Platform, In Factor Investing Even the Best Can Lose – Data-Driven Insights into Factor-Based Analysis.