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Fama-French Three Factor Model

CAP-M uses a single factor (proportional market risk) to explain pricing and asset returns. It's an elegant theory, and a remarkable breakthrough in finance that won its creator, William Sharpe, the Nobel Prize in Economics in 1990. But, it didn't do a very good job of explaining the observed market returns, especially if a portfolio strayed very far from the center of the market. Small company and value companies had persistently higher returns than CAP-M could explain.

These anomalies presented problems that made a generation of economists buggy. Prices and performance just didn't fit the model very well. A related problem for investment professionals was that investment managers with small and/or value exposure could claim lots of Alpha that they didn't deserve. After all, you don't create added value by holding a portfolio that could be indexed. Additionally, CAP-M simply wasn't much use in portfolio construction.

A Better Mouse Trap: The Fama-French Three Factor Model

The Three Factor Model takes a different approach to explain market pricing. Fama-French found that investors are concerned about three separate risk factors rather than just one. Actually, they found that in the real world, investors care about lots of different risks. But, the risks that have systematic prices attached to them and that in combination do the best job of explaining performance and pricing are market, size and value.

Investor returns are the mirror image of a firm's cost of capital. Even in the secondary market, the cost of a firm's capital is best estimated by the price of their securities. Small firms must pay more for capital when borrowing or issuing securities in the capital markets. Distressed firms (value), those that have poor prospects, bad financial performance, irregular earnings and/or poor management must also pay more for capital. Small firms and distressed firms have lower stock prices to compensate investors for these risks. Fama-French found that most appropriate measurement ý the one with the most explanatory power ý was the ratio of the stock's adjusted Book value to its Market price (BTM). Stocks with high BTM are value stocks.

So, everybody that buys any traded stock (or portfolio of stocks) takes market risk. If your portfolio holds all traded stocks in the weighted proportion of the total market, that's the end of the story. But, if your portfolio differs in it's makeup in average size or on the growth-value spectrum of the market, then you will have a different result. There are additional premiums for accepting a portfolio either larger or smaller than the market, and/or with a tilt toward growth or value different than the market. (These risks are sometimes called a priced risk, because we can identify additional return for accepting them.)

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