Fama and French: The Five-Factor Model Revisited

Eugene F. Fama and Kenneth R. French introduced their three-factor model that augments the Capital Asset Pricing Model (CAPM) nearly three decades ago. They proposed two factors in addition to the CAPM to explain asset returns: small minus large (SMB), which represents the return differential between small-cap and large-cap stocks, and high minus low (HML), which measures the return differential between the high register. -market shares and book-to-market shares.

Since then, Fama and French’s initial framework has undergone many alterations and evolutions as other researchers added their own factors and put their own spin on the duo’s ideas. For their part, Fama and French updated their model with two more factors to further capture return on assets: robust minus weak (RMW), which compares the returns of firms with high or robust operating profitability and those with weak or low operating profitability. operating profitability; and Conservative Less Aggressive (CMA), which measures the difference between companies that invest aggressively and those that invest more conservatively.

So how has Fama and French’s five-factor model explained returns over the decades? According to our analysis, only one factor actually held true across all time periods.

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To evaluate the performance of a factor, we built a $1 portfolio and then tracked its growth as if we were an investor who was heavily involved in the factor in question. For example, the SMB portfolio represents $1 invested in 1926 in a portfolio that is long a basket of small-cap stocks and short large-cap stocks.

The SMB or size factor performed well until around 1982, generating returns of approximately 600% over the time period. Then, from 1982 to 2000, the pattern reversed and large-cap stocks outperformed small-caps. The factor recovered somewhat after that, but has largely stagnated over the past 10 to 15 years.

Cumulative returns SMB

Although causality in such cases is difficult, if not impossible, to establish, this falling and leveling performance deserves an explanation. And there is wide speculation about the causes, macro or otherwise. After all, global markets have seen many developments since the 1920s. But if we accept Occam’s razor that the simplest explanation is often the most likely, Clifford Asness’s theory may have more appeal: “No there is a size effect.”

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The plight of the HML factor is well documented. Value investing, buying companies priced high in the market and fending off their downmarket peers, had a historic run from 1926 to 2007. During that time period, a long HML portfolio and short generated returns in excess of 4000%.

But the tide has turned. Since 2007, the results have completely changed. After the Great Recession, that same long-short portfolio lost about half its value as growth stocks took off. Indeed, many have written the obituary of the value factor.

Cumulative returns HML

Chart showing cumulative HML returns

But Robert D. Arnott and his co-authors have offered a different narrative: “Reports of Value’s death may be greatly exaggerated.” They attribute the recent underperformance of the value factor to two phenomena: HML’s book-to-price definition, which they believe does not adequately account for intangible assets, and the decline in valuations of value versus growth stocks.

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The trajectory of the CMA factor somewhat mirrors that of HML. Backing companies that invest conservatively worked well for over 40 years. But since 2004, the power of this factor has dissipated. In particular, since 2013, stocks of companies that invest aggressively have only earned a 20% excess return.

Cumulative returns CMA

Chart showing CMA's cumulative returns

Which brings us to the quality factor, or RMW. RMW is the only factor that has consistently generated excess returns. During every economic cycle since 1963, going long high-quality stocks, or profitable companies, and shorting their low-quality, unprofitable counterparts has been a great investment strategy. And the power of the factor has not diminished.

As Jason Hsu, Vitali Kalesnik, and Engin Kose have written, the definition of quality has proven quite malleable, but “Profitability and investment-related characteristics tend to capture most of the quality performance premium “.

Cumulative returns RMW

Of course, when Fama and French proposed their three-factor model, the intuition was that the SMB and HML factors would consistently add value over time just as the RMW has. This didn’t come out. It remains to be seen if RMW continues to be the gem factor that always delivers excess returns going forward. But it’s worth remembering that sometimes this time really is different.

Still, the key lesson of Fama and French’s five-factor model and recent market history is simple, if not particularly telling: Investing in profitable companies has been a solid, time-tested strategy.

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images / artur carvalho

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Derek Horstmeyer

Derek Horstmeyer is a professor at the George Mason University School of Business, specializing in exchange-traded funds (ETFs) and mutual fund performance. He is currently director of the new Financial Planning and Wealth Management major at George Mason and founded the first student-managed mutual fund at GMU.

Ying Liu

Ying Liu is a senior at George Mason University and is completing his bachelor’s degree in business with a major in finance. He is interested in financial markets and information related to risk management. He is looking for opportunities in the financial analyst profession after finishing his university studies.

Amber Wilkins

Amber Wilkins holds a BA in Finance from George Mason University. She is currently a finance intern at PAE and will join the corporate financial planning and analysis team as a financial analyst after graduation.

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