CFA Institute: Revisiting the Fama French 5 Factor Model

Eugene F. Fama and Kenneth R. French introduced their three-factor model augmenting the capital asset pricing model (CAPM) nearly three decades ago. They proposed two factors in addition to CAPM to explain asset returns: small minus big (SMB), which represents the return spread between small- and large-cap stocks, and high minus low (HML), which measures the return spread between high book-to-market and low book-to-market stocks.

Fama and French’s initial framework has since undergone many alterations and evolutions as other researchers added their own factors and put their own spin on the duo’s insights. For their part, Fama and French updated their model with two more factors to further capture asset returns: robust minus weak (RMW), which compares the returns of firms with high, or robust, operating profitability, and those with weak, or low, operating profitability; and conservative minus aggressive (CMA), which gauges the difference between companies that invest aggressively and those that do so more conservatively.

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

To gauge a factor’s performance, we constructed a $1 portfolio and then tracked its growth as if we were an investor going long on 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 one of large-cap stocks.

The SMB or size factor performed extremely well up to about 1982, generating returns of about 600% over the time period. Then from 1982 to 2000, the pattern reversed and large-cap stocks outdid small caps. The factor rebounded a bit thereafter but has largely stagnated over the last 10 or 15 years.

Read the rest at:

https://blogs.cfainstitute.org/investor/2022/01/10/fama-and-french-the-five-factor-model-revisited/