Swedroe: Improving On Fama-French

March 21, 2014

Fama and French did note that, “While the five-factor model doesn’t improve the description of average returns of the four-factor model that drops HML, the five-factor model may be a better choice in applications. For example, though captured by exposures to other factors, there is a large value premium in average returns that is often targeted by money managers.”

Thus, “in evaluating how investment performance relates to known premiums, we probably want to know the tilts of the portfolios toward each of the factors.”

They added that “for explaining average returns, nothing is lost in using a redundant factor.”

Importantly, they also found that the five-factor model does perform well.

“Unexplained average returns for individual portfolios are almost all close to zero,” Fama and French noted.

Among their other interesting findings were that “controlling for investment, value stocks behave like stocks with robust profitability, even though unconditionally value stocks tend to be less profitable.”

Additionally, Fama and French found that the value, profitability and investment factors are negatively correlated with both the market and the size factor, providing important information regarding potential benefits from portfolios that diversify exposures across factors.

What’s more, they found that “the lethal combination for microcaps is low profitability and high investment; low profitability alone doesn’t appear to be a problem.”

However, they found that this problem doesn’t hold for large stocks with low profitability and high investment.

Another interesting finding is that with this new model, just as the well-known value factor isn’t needed to explain the variation in returns of diversified portfolios, momentum isn’t needed either.

The authors of “Digesting Anomalies” found that their profitability factor has a high correlation (0.50) with the momentum factor, meaning that it plays a similar role to the momentum factor in analyzing performance.

Returning to the question—knowing what we know today, which model would they choose?— Fama and French concluded that since HML seems to be a redundant factor in the sense that its high-average return is fully captured by its exposure to other factors, the four-factor model may well be adequate in some cases, though not all.

“In applications where the sole interest is abnormal returns, our tests suggest that a four-factor model that drops HML performs as well as (no better and no worse than) the five-factor model. But if one is also interested in measuring portfolio tilts toward value, profitability and investment, the five-factor model is the choice.”

Only time will tell if the new model replaces the Fama-French one. But with their endorsement, it does seem like a good possibility.


Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

 

 

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