Celebrating Groundbreaking Research with Giants of Finance: Fama and French
It has been 30 years since Fama and French published their paper proposing a three-factor model for stocks. Their research paved the way for...
By Savina Rizova, PhD, Global Head of Research, Dimensional Fund Advisors
KEY TAKEAWAYS
- This year marks the anniversaries of research that laid the foundation for a new way to invest.
- Merton’s Intertemporal Capital Asset Pricing Model (ICAPM) (1973), the Fama/French three-factor model (1993), and Novy-Marx’s profitability research (2013) underpin Dimensional strategies.
- In the second of three conversations, we hear from Eugene Fama and Kenneth R. French about their three-factor model, now ubiquitous in financial theory and practice.
In 1993, two academics out of the University of Chicago, future Nobel laureate Eugene Fama and his longtime collaborator Kenneth R. French, published “Common Risk Factors in the Returns on Stocks and Bonds.” The paper proposed a three-factor model for stocks that included, in addition to the market factor, a size factor and a value factor. The three-factor model appeared to explain differences in average stock returns and enabled investors to attribute over- and underperformance to factor exposure. This provided the industry with a way to transform the concept of multifactor asset pricing into practical investment solutions.
The year 2023 marks the anniversaries of that and two other breakthroughs in financial science that underpinned a new way of investing—factor investing—which combined the low cost, transparency, and diversification of index investing with a systematic pursuit of higher expected returns:
- Fifty years since the publication of Robert C. Merton’s Intertemporal Capital Asset Pricing Model (ICAPM), which provided the theoretical framework for multifactor investing.
- Thirty years since the development of the three-factor model of Fama and French, which paved the way for the implementation of multifactor systematic investing.
- Ten years since the publication of the profitability research of Robert Novy-Marx, which added the profitability premium to the ranks of size and value as an important long-term driver of expected stock returns.
In honor of these 50-, 30-, and 10-year anniversaries, I had the great fortune to interview the pioneers themselves on their findings. In this series of three articles, I asked Bob, Ken, Gene, and Robert about the impact and continuing relevance of their groundbreaking work. Here, in part two, Professors Gene Fama and Ken French talk with me about their three-factor model, which has become ubiquitous in financial theory and practice.
30 Years of the Three-Factor Model
The significance of the three-factor model cannot be overstated. It is on almost all finance and economics syllabuses, and every credible asset manager in the world has a view on how its strategy fits within the framework of the three (now five) factors. There were, of course, value investors and people with an affinity for smaller companies before 1993. But the Fama/French model provided a framework for why certain stocks and fund managers tended to outperform others. And at a time when most investors faced the binary choice between stock picking and index tracking, the research implied a third option that systematically targets premiums.
Question: Why has the three-factor model you developed become so popular both in academia and the industry?
Answer: When we developed the three-factor model, it was the best model available for estimating expected stock returns, and it organized expected returns in an intuitive way. Small and value stocks tend to have higher expected returns than big and growth stocks. We know the model is not literally true, but it has held up well relative to competitors.
Q: This year marks the 50th anniversary of the publication of Professor Merton’s Intertemporal Capital Asset Pricing Model (ICAPM), which provided a theoretical framework for multifactor investing. Can we link the three-factor model to the ICAPM?
A: When we developed the three-factor model, we were thinking within the framework of the ICAPM: Differences in expected return are linked to risk. Over the last 30 years, we and other researchers have not found a smoking gun that links specific differences in expected return to specific ICAPM risks. Both of us think multifactor risk in the sense of Merton’s (1973) ICAPM is important.
Q: What led you to expand the three-factor model to a five-factor model in 2015?
A: For many years, we have interpreted the ratio of book equity and market equity as a catchall for differences in expected returns (Ball, 1978). If book equity is a good proxy for expected cash flows to shareholders, high book value relative to market value implies a high long-run discount rate, or equivalently, a high long-run expected stock return. But book is a noisy measure of expected cash flows.
Valuation theory says expected stock returns are related to three variables—B/M [book to market], expected profitability, and expected investment. Controlling for B/M and expected profitability, higher expected investment implies lower expected cash flows to investors and lower expected returns. Controlling for B/M and expected investment, higher expected profitability implies higher expected cash flows to investors and higher expected returns. Controlling for expected profitability and expected investment, we are back to our simple prediction that a high B/M predicts a high long-run expected return.
We confirm these predictions in FF (2006), but the relations are weaker than we expected. The research challenge is to improve the proxies for expected profitability and expected investment. Novy-Marx (2013) identifies a proxy for expected profitability that is strongly related to average return. Aharoni, Grundy, and Zeng (2013) identify a weaker but still reliable relation between investment and average return. In the spirit of HML [high minus low] in our three-factor model, we use their measures to construct the profitability and investment factors in the five-factor model (FF, 2015). Adding these improves the three-factor model. Five-factor models for the United States and regions outside the US explain important patterns in average returns that three-factor models cannot (FF, 2016 and 2017).
Q: Where do you see financial science and investing evolving?
A: The excitement of research is not knowing the answer to this question. We will continue along the trail, wherever it may lead.
Savina Rizova is an employee of Dimensional Investment LLC, a subsidiary of Dimensional Fund Advisors LP.
Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. Robert Merton provides consulting services to Dimensional Fund Advisors LP. Robert Novy-Marx provides consulting services to Dimensional Fund Advisors LP.
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