The Limitations of CAPM and Fama-French's Discovery
The CAPM (Capital Asset Pricing Model) attempts to explain the expected return of individual stocks using only market risk (beta). However, in the early 1990s, Eugene Fama and Kenneth French at the University of Chicago demonstrated that systematic return patterns exist that CAPM cannot explain. Specifically, they identified the "size effect," where small-cap companies deliver higher returns than large-cap stocks, and the "value effect," where companies with low price-to-book ratios (value stocks) deliver higher returns than high price-to-book companies (growth stocks).
The three-factor model published in 1993 explains equity returns using three factors. The first is the market factor (Rm - Rf), which is the overall market return minus the risk-free rate. The second is the size factor (SMB: Small Minus Big), which is the return of a small-cap portfolio minus the return of a large-cap portfolio. The third is the value factor (HML: High Minus Low), which is the return of high book-to-market (value) stocks minus the return of low book-to-market (growth) stocks. It has been empirically demonstrated that these three factors can explain approximately 90% of equity returns.
Why Do the Size Effect and Value Effect Exist?
There are broadly two interpretations for why the size and value effects exist. The risk-based interpretation holds that small-cap and value stocks carry higher bankruptcy and liquidity risks, so investors demand compensation (a risk premium) for bearing those risks, resulting in higher realized returns. Small-cap stocks have fragile business foundations and are more vulnerable to economic downturns, while value stocks often include financially distressed companies - the logic being that returns commensurate with these additional risks are provided.Books on risk premiums and equity returns also provide detailed analysis of both sides of this debate.
The other interpretation is based on behavioral finance, which holds that investors' cognitive biases create these effects. Investors tend to place excessive expectations on large, well-known companies and growth stocks, purchasing them at inflated prices. Meanwhile, unglamorous small-cap stocks and underperforming value stocks are excessively shunned and left undervalued. The excess returns for small-cap and value stocks arise as these price distortions are corrected. Which interpretation is correct remains academically unresolved, but from a practical standpoint, factor-aware investing is effective regardless of which explanation holds.
How Individual Investors Can Use the Three-Factor Model
The most practical way for individual investors to use the three-factor model is to consciously adjust their portfolio's factor exposures. A global equity index fund provides exposure to the market factor, but exposure to the size and value factors is limited. By adding small-cap index funds or value index funds, you can increase exposure to these factors.
However, factor returns fluctuate significantly in the short term and can be negative for periods of several years.Practical guides to factor investing point out that the 2010s was a period when growth stocks significantly outperformed value stocks, raising questions about the effectiveness of the value factor. Practicing factor investing requires the patience to endure short-term underperformance and the theoretical conviction that long-term factor premiums exist.
Next Actions for Getting Started with Factor Investing
To apply the insights of the three-factor model to your investments, the first step is to understand your current portfolio's factor exposures. Review the constituent holdings of your funds and assess whether they are large-cap-centric or include small caps, and whether they lean toward growth or value. If you hold only a global equity index fund, recognize that your exposure to the size and value factors is limited.
If you want to increase factor exposure, consider adding small-cap index funds or value index funds at around 10-20% of your portfolio. However, since factor premiums can disappear for periods of a decade or more, you need the commitment to take a long-term view of 20 years or more without expecting short-term results. Use our compound interest calculator to compare portfolios with and without factor tilts, and see how the difference in expected returns translates into asset differences over the long term.