Three Factor Model for Portfolio Management

Three factor model, popularly known as Fama and French three-factor model, is one of the most followed portfolio management models. The model was developed in 1993by Eugene Fama and Kenneth French; by modifying other very popular investing model Capital Asset Pricing Model (CAPM). Three-factor model is widely followed by investors and fund managers to analyze risk and return associated with instruments/markets and to make highest return for risk taken.

For good understanding of three-factor model, understanding of CAPM, the original model, is necessary. CAPM consider only one factor, the market risk or beta, to determine the risk and return. The formula of CAPM is as follows

R = Rf + beta x (Rm - Rf)

Where R is the return, Rf is the return rate of risk-free investments, beta is the risk associated with a security/market, and Rm is the return expected from market. The model says that it is better to invest in instruments/markets whose expected return exceeds required return. CAPM successfully explains around 80% of returns.

Three factor model is more evolved than CAPM. In addition to market risk or beta, it considers two more market factors, size or market capitalization and value or book/market ratio of an instrument. The formula of three factor model is as follows,

R = Rf + beta x (Rm - Rf) + Bs x SMB + Bv x HML

Where SMB is ‘Small cap Minus Big’ (historic excess returns of small cap instruments), HML is ‘High value Minus Low’ (historic excess returns of value stocks), and Bs and Bv are beta corresponding to small cap and large cap portfolio having values either 0 to 1. For a portfolio having all small cap stocks Bs will be 1 and Bv will be 0 and for a portfolio having all large cap stocks Bs will be 0 and Bv will be 1.

The idea behind the three factor portfolio management model is that, value and small cap stocks often outperform large-cap stocks. Most possible reason for this out performance include 1) higher reward for compensating higher risk taken, 2) early mispricing of equities resulting in later corrections, and 3) small-cap companies often shows higher growth and this is reflected on their stock prices.

The widespread adoption of three factor model by investors is a result of the fact that mutual funds and portfolio managers following three factor model of investment outperformed most others. Investors can also add custom factors to the model to make it more precise and to enhance reward. But investing only in small cap or value stocks can cause problems for investors, especially in periods of high volatility. Investors should diversify their portfolio investments and should be aware of other risk minimizing strategies.

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