The Fama-French Model: Foundations of Modern Factor Investing

Factor investing relies on rigorous models developed by academic research, notably the work of Eugene Fama and Kenneth French. Their initial three-factor model (1993) revolutionized the understanding of stock returns by introducing, in addition to the market factor, two systematic premiums: size (small minus big, SMB) and value (high minus low, HML).

The 3-factor model is formalized as follows:

Ri - Rf = α + β (RM - Rf) + s SMB + h HML + ε

with:

  • Ri: return of asset i
  • Rf: risk-free rate
  • RM - Rf: market premium
  • SMB: size premium (small caps over large caps)
  • HML: value premium (stocks with low price/book ratio over growth stocks)

In 2015, Fama and French expanded this framework to five factors by adding profitability and investment:

  • RMW (robust minus weak): premium related to high profitability (ROE, operating margin)
  • CMA (conservative minus aggressive): premium related to a conservative investment policy (low asset growth)

This 5-factor model better explains returns than the 3-factor model, notably by eliminating certain anomalies related to low-profitability value stocks or excessive growth.

Sources: Fama & French (1993, 2015)

The Value Premium: A Historically Contested Outperformance

The value premium is the most famous of the factor premiums. For 90 years, according to data compiled by Fama-French, "value" stocks (low price/book ratio) have outperformed l