The Dimensions of Investment Returns

Sharpe’s CAPM was widely held as the explanation of equity returns until 1992 when Nobel Laureate Eugene Fama and Kenneth French introduced their Fama/French Three-Factor Model, identifying market, size and value as the three factors that explain as much as 96% of the returns of diversified stock portfolios. Fama and French analyzed the CRSP database back to 1962 to determine that equity returns can be explained by a portfolio’s exposure to the market as a whole, as well as the exposure to small and value companies. Their data show that small and value companies carried higher risk and that risk was rewarded. These small and value excess returns had shown to carry long-term persistence, but are not consistent in short periods of time. More than 86 years of risk and return data confirm their results.

Fama and French later expanded their model to include fixed income, identifying term and default as two additional risk factors that explain returns for fixed income. Thus, a Five-Factor Model was created, as shown in Figure 8-6.

Figure 8-6

The relationship that exists between these five risk factors and a portfolio’s expected return serves as a framework for designing investment portfolios. The five risk factors are portrayed on the following pages.

Step 8CAPMEugene FamaKenneth FrenchThree Factor ModelCRSPFive Factor Model