small company index funds. Investing in these funds is the most efficient and effective way to maximize exposure to the three risk factors that generate 95% of the market returns. For example, DFA offers investors value index funds that are structured to (1) maximize exposure to the size and price risk factors and (2) diversify that exposure as much as possible. This building block approach to building portfolios is a cleaner and more consistent way of managing money.

How a portfolio is structured for optimal exposure to the three risk factors determines how well the portfolio performs relative to other portfolios. Portfolio structure refers to the indexes the portfolio holds and in what proportions. The Fama and French findings offer guidelines to investors for effectively allocating indexes within a portfolio. The allocation decision is crucial, since the degree of exposure to the three risk factors for equities and two additional factors (term and default) for fixed income accounts for nearly all the returns earned by diversified portfolios of stocks and bonds. That’s why investors should focus on properly structuring their portfolios rather than trying to pick winning stocks or managers.

Measuring the Performance of Active Managers

Indexes such as the S&P 500 or Wilshire 5000 are often used to evaluate the performances of active money managers. Given the Fama and French findings, the use of such benchmarks is often misleading. Because these indexes are weighted heavily towards large company stocks and high priced stocks, the performances of managers investing more heavily in small company stocks or low priced stocks won’t be accurately measured by them. Instead, customized benchmarks are needed to provide accurate measurements of the contributions to performances made by active money managers.

The Fama and French Three-Factor Model is a superior way to evaluate the performances of active money managers. It shows whether a manager achieves returns in excess of index returns. After all, an active manager shouldn’t be rewarded just for buying value stocks—that’s something that can be done inexpensively with an indexing strategy.

The place where a portfolio is positioned or structured on the crosshair map in Figure 8-18 determines the vast majority of its return. The crosshair map doesn’t plot the market risk factor since all stock portfolios take similar market risk and are plotted relative to the stock market. So, there’s no need for a separate axis; instead, the stock market sits right at the crosshairs of the map. The crosshair map has two dimensions. The size dimension is plotted along the vertical axis, and the value (BtM) dimension is plotted along the horizontal axis. The axes represent exposure to these two risk factors. Portfolios that take on a lot of size risk appear higher along the size axis, and portfolios that take on a lot of value risk appear further along to the right on the growth/value axis.

Changing the Definition of “Alpha”

The Fama and French Three-Factor (Five Factors with bonds) Model changes the definition of alpha, as seen in Figure 8-19. According to the one-factor CAPM, alpha is the amount by which an active money manager outperforms a broad market index. The Fama and French Three-Factor Model defines alpha for equities more precisely as the return an active manager achieves above the sum of the portfolio’s expected return due to all three equity risk factors. Alpha measures a manager’s skill in earning a return that couldn’t have been achieved by indexing the same exact risk exposure as the portfolio run by the manager. In short, did the money manager earn anything above the indexed return?

Figure 8-19 Reference: Common risk factors in the returns on stock and bonds, Eugene F. Fama and Kenneth R. French, Journal of Financial Economics 33 (1993)

A portfolio can be plotted anywhere on the crosshair map, and it’s easy to calculate its expected return. For example, a small-cap manager may overweight value stocks relative to a benchmark, such as the Russell 2000 Small-Cap Index. As a result, the manager outperforms it. But if the extra return was simply compensation for taking additional non-diversifiable market risk, why should the manager get credit? The job of an active manager is to consistently outsmart the millions of other traders who get the same news at the same second, and through this process provide additional returns that can’t be achieved through indexing. This is exactly what t