Fama & French 5-Factor Model

Fama & French 5 Factor Indices Comparison

A chart comparing the percentage growth of the five Fama & French factor indices, all rebased to the same starting level: Market Risk Premium, Small Minus Big, High Minus Low, Robust Minus Weak, and Conservative Minus Aggressive.

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Interpretation

The chart above shows the cumulative performance of the US Fama-French five-factor portfolios, each constructed as a long-short index that compounds monthly factor returns.

Fama and French designed these factor portfolios to explain why some diversified groups of stocks earn higher or lower average returns than others, a pattern researchers call the cross-section of stock returns. The original three-factor model uses market risk (Mkt-RF), size (SMB: Small Minus Big), and value (HML: High Minus Low) to explain average returns across portfolios sorted by size and value, as documented in their 1993 paper "Common risk factors in the returns on stocks and bonds". Market risk is the excess return of a broad market portfolio over the risk-free rate, SMB captures the size effect by going long small-cap stocks and short large-cap stocks, and HML captures the value effect by going long high book-to-market ("value") stocks and short low book-to-market ("growth") stocks.

The later five-factor model extends this framework by adding two more factors based on profitability and investment (RMW and CMA) as described in Fama and French’s 2015 article "A Five-Factor Asset Pricing Model". RMW (Robust Minus Weak) goes long firms with strong operating profitability and short firms with weak profitability, while CMA (Conservative Minus Aggressive) goes long firms that invest conservatively and short firms that invest aggressively. All five factors are formed as long-minus-short portfolios using firm characteristics from Kenneth French’s data library and are meant to represent systematic patterns in expected returns rather than individual securities.

Taken together, the five factors generally do a better job in Fama and French's U.S. sample than the original three-factor model of explaining differences in average returns across diversified stock portfolios. In simple terms, small, cheap ("value"), highly profitable and conservatively investing companies have historically earned higher average returns than large, expensive, low-profit or aggressively investing companies, even after accounting for basic market exposure.

The five-factor work also suggests that much of the historical "value premium" captured by HML can be understood as a combination of profitability (RMW) and investment (CMA) effects; in Fama and French's five-factor tests, HML becomes statistically redundant once RMW and CMA are included, so the five-factor model places less emphasis on value as a separate driver of returns, at least in their U.S. sample for 1963-2013.

For interpretation of these charts, it is helpful to keep in mind the distinction that Aswath Damodaran draws between factor models and the CAPM. In his view, Fama-French is part of a broader family of empirical "proxy" models that let market data reveal which firm characteristics the market has historically rewarded. This data-driven approach has contributed to what Harvey, Liu, and Zhu describe as a "factor zoo" of proposed anomalies and raises questions about the economic rationale and future stability of any given set of factors. Consequently, while Fama-French models are powerful for explaining and attributing realized performance, their reliance on historically observed patterns makes them less directly applicable for forward-looking tasks like estimating a company's cost of equity, where Damodaran often favors the simpler, though also flawed, CAPM in corporate valuation practice.

Data Sources

• Kenneth R. French - Data Library: F-F_Research_Data_5_Factors_2x3 (US equity research factors, monthly returns)

Further Information

• Eugene F. Fama & Kenneth R. French (2015): "A Five-Factor Asset Pricing Model", Journal of Financial Economics.
• Eugene F. Fama & Kenneth R. French (1993): "Common risk factors in the returns on stocks and bonds", Journal of Financial Economics.
• Aswath Damodaran: Riskfree Rates and Equity Risk Premiums (Session 6, lecture).
• Aswath Damodaran (2012): "Equity Risk Premiums (ERP): Determinants, Estimation, and Implications - The 2012 Edition".
• Campbell R. Harvey, Yan Liu, and Heqing Zhu (2016): "... and the Cross-Section of Expected Returns".
• Investopedia: Fama and French Three Factor Model
• Breaking Down Finance: Fama French 5 Factor Model
• LongtermTrends: Factor Investing
• LongtermTrends: Market-Cap Weight vs Equal-Weight
• LongtermTrends: Growth Stocks vs Value Stocks
• LongtermTrends: Large-Cap vs Small-Cap

Interpretation

This chart gives a different view of the same factor data as the first chart by plotting the raw monthly returns for the market factor (Mkt-RF), size factor (SMB), value factor (HML), profitability factor (RMW), and investment factor (CMA) from Kenneth French’s data library, showing how far each factor has moved up or down in percent terms over the selected period rather than the compounded index values.