![]() Published in 1997, the Carhart Four Factor Model builds on the Fama-French Three Factor Model. The magnitudes of the factor premiums differ from country to country, but they exist and are fairly accurate at explaining returns. Size (SMB) - The return of the 50% smallest stocks by market cap minus the return of the 50% largest stocks by market cap.Īlthough the original study focused on the US stock market, subsequent research has shown the model is equally effective in explaining the returns of the stock markets of other countries.Value (HML) - The return of the 30% cheapest stocks by P/B minus the return of the 30% most expensive stocks by P/B.Almost overnight, two-thirds of the alpha in the money management universe turned out to be compensation for risk clients didn't even know they were taking rather than manager skill. It was a major leap forward over the CAPM because it explained roughly 90% of a diversified portfolio's return compared to just 70% for the CAPM. Fama-French Three Factor ModelĮugene Fama and Kenneth French published a landmark paper in 1992 introducing the world to the Size and Value factors. Until the advent of the Fama-French three factor model, most of this chunk of return was attributed to alpha, or manager skill. The remaining 30% is attributable to other factors and investor skill. The CAPM explains about 70% of the returns of a diversified stock portfolio, which implies 70% of your portfolio's return is determined by how much stock you hold. Portfolios on the curve live on the Efficient Frontier ![]() The advent of broad market index investing follows directly from the CAPM as the primary tool used to move up and down the efficient frontier. You can increase return by increasing risk, or reduce risk by decreasing return, but they remain intrinsically linked no matter which direction you go. There's a theoretical curve on which it is impossible to earn more return without taking on more risk. The CAPM is the origin of the concept of the Efficient Frontier, which is a method of optimizing risk and return. In the CAPM, beta represents an asset's sensitivity to non-diversifiable market risk, meaning it can't be reduced any further simply by adding more stocks to a portfolio. Introduced in the mid 1960s by the luminaries of modern finance like Markowitz, Sharpe, and Traynor, the CAPM forms the backbone of modern portfolio theory and contains only a single factor, Beta. It isn't used by academics to explain returns anymore due to the development of far more complete factor models, but I'm including it here because it was so influential on everything that came after. The CAPM is the granddaddy of all performance attribution models. How to Calculate Your Portfolio's Factor Loadings (Exposure).Fundamentals of Factor Portfolio Construction.How Do We Know Factor Premiums Will Persist?.How to Tell Good Factors From Bad: Taming the Factor Zoo.Popular Multi-Factor Models (3, 4, and 5 factor models).They are the Capital Asset Pricing Model (CAPM), the Fama-French Three Factor Model, the Carhart Four Factor Model, and the Fama-French Five Factor Model. Recent growth in the factor zoo has led to similar growth in the number of factor models seeking to explain returns, but there are really only four factor models worth paying attention to. ![]() In other words, a model with 4 factors is preferable to a model with 18 factors even if they have the same explanatory power. The most successful and popular of these models do so consistently and with as few parameters as possible. Many academics have tried to construct factor models with broad explanatory power of asset returns. ![]()
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