Fama-French Three-Factor Model

Overview

Fama and French (1993) extended CAPM by adding two factors — size (SMB) and value (HML) — to explain cross-sectional variation in stock returns that CAPM alone cannot capture. The model shows that small-cap and high book-to-market stocks earn systematic premiums.

When to Use

• Explaining why CAPM alpha is nonzero for certain portfolios
• Evaluating fund manager skill after controlling for factor exposures
• Constructing factor-tilted portfolios
• Academic research on asset pricing anomalies

When NOT to Use

• For fixed income or derivatives pricing (equity-focused factors)
• When factor data is unavailable for the market in question
• As a complete model — profitability and investment factors may also matter (five-factor)

Assumptions

IRON LAW: Single-factor models (CAPM) underestimate expected returns
for small-cap and value stocks. Size and value represent systematic
risk factors that command their own premia.

Key assumptions:

1. SMB and HML capture systematic risk, not mispricing
2. Factor premia are persistent across time periods and markets
3. Factors are constructed from observable, rebalanced portfolios

Methodology

Step 1 — Obtain Factor Data

• Rm-Rf: market excess return
• SMB (Small Minus Big): return of small-cap portfolio minus large-cap portfolio
• HML (High Minus Low): return of high B/M portfolio minus low B/M portfolio

Step 2 — Run Time-Series Regression

Ri - Rf = ai + bi(Rm-Rf) + si(SMB) + hi(HML) + ei. See references/ for construction details.

Step 3 — Interpret Factor Loadings

• bi: market sensitivity (same as CAPM beta)
• si: size exposure (positive = small-cap tilt)
• hi: value exposure (positive = value tilt, negative = growth tilt)

Step 4 — Evaluate Alpha

If alpha (ai) is statistically insignificant, returns are explained by factor exposures — no manager skill.

Output Format

## Fama-French Analysis: [Fund / Portfolio]

### Regression Results
| Factor | Loading | t-stat | Interpretation |
|--------|---------|--------|----------------|
| Market (Rm-Rf) | x.xx | x.xx | [market exposure] |
| SMB | x.xx | x.xx | [size tilt] |
| HML | x.xx | x.xx | [value tilt] |
| Alpha | x.xx% | x.xx | [skill or luck] |

### R-squared
- Three-factor R2: x% vs CAPM R2: x%

### Conclusions
- [Factor attribution summary]
- [Manager skill assessment]

Gotchas

• Factor premia vary across countries and time periods — not guaranteed to persist
• HML has weakened post-publication; some attribute this to arbitrage
• Five-factor model (2015) adds profitability (RMW) and investment (CMA) — three-factor may be insufficient
• Factor construction methodology matters; different breakpoints yield different results
• High R-squared does not mean the model is "correct" — it means factors explain variance
• Debate persists whether factors represent risk or mispricing

References

• Fama, E. & French, K. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3-56.
• Fama, E. & French, K. (2015). A five-factor asset pricing model. Journal of Financial Economics, 116(1), 1-22.
• Fama, E. & French, K. (1992). The cross-section of expected stock returns. Journal of Finance, 47(2), 427-465.