How does the French FAMA model work
Eugene Fama, a Nobel Prize winner and researcher Kenneth French, two former professors at the University of Chicago's Booth School of Business, tried to better gauge market returns and found, through research, that equity values outperformed growth stocks. Likewise, stocks with small capitalization tend to outperform large-cap stocks. As a rating tool, portfolios with a large number of small or valued stocks will underperform the CAPM score, as the three-factor model adapts to the performance of small stocks and outflows.
The FAMA model and the French model contain three factors: size of firms, book values for the market, and excess return on the market. In other words, the three factors used are SMB (small minus large), HML (high minus low) and the portfolio yield is the lowest risk-free rate of return. SMB accounts for publicly traded companies with small market caps generate higher returns, while HML acquires higher value stocks with higher book-to-market ratios that yield higher returns compared to the market.
There is a lot of debate about whether the trend of superior performance is due to market efficiency or market inefficiency. In support of market efficiency, the overall superior performance is explained by the increased risk faced by small stocks as a result of higher cost of capital and increased business risk. To support market inefficiency, market participants interpret superior performance through incorrect pricing of these firms' value, providing long-term excess return while adjusting for value. Investors who share the body of evidence provided by the Effective Markets Hypothesis (EMH) are more likely to agree with the efficiency aspect.
What does the French FAMA model mean for investors?
Fama and French emphasized that investors must be able to overcome additional short-term fluctuations and poor cyclical performance that may occur in a short time. Investors with a long time horizon of 15 years or more will be rewarded for the losses they incurred in the short term. Using thousands of random stock portfolios, Fama and French conducted studies to test their model and found that when combining volume and value factors with the beta factor, they could then explain up to 95% of the return in a diversified stock portfolio.
Given the ability to explain 95% of a portfolio's return against the market as a whole, investors can create a portfolio in which they obtain the average expected return according to the relative risk they assume in their portfolios. The main factors driving expected returns are market sensitivity, volume sensitivity, and equity sensitivity, as measured by the book's ratio to the market. Any additional expected average return may be attributed to unpriced or erratic risk.
French Fama and Five Factor model
Researchers have expanded the three factors model in recent years to include other factors. These include "momentum", "quality" and "low volatility" among others. In 2014, Fama and French adapted their model to include five factors. Besides the original three factors, the new model adds the concept that firms reporting higher future profits have higher returns in the stock market, a factor referred to as profitability. The fifth factor, referred to as investing, relates to the concept of inward investment and returns, indicating that companies that direct their profits toward major growth projects are more likely to incur losses in the stock market.
What is the FAMA Model and the French Three Factors?
The FAMA and French Three-Factor Model (or the French FAMA Model for short) is an asset pricing model developed in 1992 that extends the capital asset pricing model (CAPM) by adding volume risk and value risk factors to the market risk factor of CAPM. This model takes into account the fact that value stocks and smaller stocks regularly outperform the markets. By including these two additional factors, the model adapts to this superior trend, which is believed to make it a better tool for evaluating a manager's performance.