Common Risk Factors in the Returns on Stocks and Bonds
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What they found
This is the paper that built the three-factor model. Fama and French constructed tradable portfolios that capture the size effect (SMB, small minus big) and the value effect (HML, high minus low book-to-market), and showed that these two factors plus the market explain most of the variation in diversified stock portfolio returns. They also examined bond factors (term and default). The three-factor model became the standard tool for measuring whether a fund or strategy has 'alpha' beyond exposure to known factors.
What you can use
- When someone claims 'alpha', ask what it is measured against; the three-factor model is the minimum bar.
- Much of what looks like stock-picking skill is just tilting toward small or cheap stocks.
- The factor data is published free on Kenneth French's website, so you can benchmark your own returns.
Caveats
The model is descriptive, not a theory of why the factors are priced. Later evidence added momentum, profitability, and investment factors. U.S. data, 1963 onward.
Tags: factor, factor-model, value, size
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.