How does the French FAMA model workvalid until: 29 Oct 2021date published: 29 Oct 2020
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.
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What is the FAMA Model and the French Three Factors?
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