A very well known multi-factor model is the Fama French three-factor model. This was developed in the 1990s by two professors Eugene Fama and Kenneth French at the University of Chicago. They wrote one of the most quoted and influential papers on the topic in it. They began with a simple premise if our objective in risk and return models is to come up with the expected return on investments. Should we not judge the quality of these models by looking at how well they explained actual returns over very long periods. They began by looking at the cap band in it. All return differences across Investments should be explained by differences in beta looking at the actual stock returns from 1962 to 1990 famine French found that betas cannot explain a very large portion of the differences in returns across stocks. So they created a new model to try to explain those differences the Arbitrage pricing theory states that systematic risk is of multi-dimensional character and is therefore dependent.
Different economic factors major differences are that the initial apt is silent on the issue of appropriate risk factors for use some see this is a major weakness fam in French specified the factors and added non-macrofactors to the mix by adding firm specific factors.
According to their initial research there have been two groups of stocks that tend to have higher returns than those predicted solely by their sensitivity to the market return famine friendship observed that companies with different market capitalization show differing returns. Then you would expect from just broad Market sensitivity moreover. The return also appeared to be dependent on the book to market value of the firm. This argument was validated through their historical analysis.
The basic rational is that stocks of small firms historically earn higher returns and carry higher risk. Similarly. Third Factor shows that in the long run growth companies have lower returns than value companies who have higher book to Market ratios while over the very long term. This may be true in recent years. There is evidence that the relationship is changing blackrocks European value manager, Brian Hall recently published a white paper reviewing the relationship between book to Market ratios and returns. He concluded that while all value metrics succeeded in outperforming the market in the previous decade traditional value strategies. Notably priced the book have performed poorly since the financial crisis.
hencefama, French developed the three-factor model that explained the US Stock returns based on the market return the return on a size portfolio and the return on a value in the portfolio The Firm size Factor premium also known as the SMB small minus big is equal to the difference in returns between portfolios of small and big firms the book to market value Factor premium also known as HML High minus low is equal to the difference in returns between portfolios of high in Low Book to Market firms RH minus RL their research in 1992 shows the three Factor model explains over 90% of a diversified portfolios returns unlike that of cap bam, which averaged about 70% in 1997 Mark Carhart included a fourth factor to the three Factor model momentum momentum is the tendency for the stock to continue Rising if the price is going up, And to continue falling if the price is going down from a French responded to a five-factor model in 2015 the fourth variable profitability predicated that companies reporting High future earnings have high returns in the stock market while the fifth variable is an investment which relates the concept of internal investment in returns suggesting that companies while directing profit towards growth projects are likely to experience losses in the market while the SNB and HML have been present over long periods. It should be noted that they have been negative in recent years.
