Portfolio Management-Three Factor Model
Before going further into the articles, let me give you a brief idea about Portfolio Management. Portfolio management is more than running multiple projects. Each portfolio needs to be assessed in terms of its’business value and adherence to strategy. Basically, a portfolio is designed to achieve a defined business objective or benefit.
The three-factor model, also known as the Fama and French three-factor model, and was developed in 1993 by Eugene Fama and Kenneth French. This three-factor model is widely analyzed by fund managers and investors to analyze and return associated market/instruments to make the highest return for the risk taken.
CAPM (Capability Asset Pricing Model) model is the original model of the three-factor model. Hence, for a greater understanding of the three-factor model, it is essential to ananlyze this model as well. The formula of CAPM is: R= Rf+ beta * (Rm -Rf), where R is the return, Rf is the return rate of risk-free investments, beta is the risk associated with a security market, and Rm is the return rate expected from the market. CAPM model successfully explains around 80% of returns.
The formula of three-factor model is: R= Rf + beta* (Rm-Rf) + Bs*SMB+ Bv* HML.SMB is called as the Small Minus Gap, and HML is known as “High Minus Low”. Bs and Bv are beta related to small cap and large cap portfolios having values of either 0 or 1.
The idea behind this model is that, value and small cap stocks often outperform large- cap stocks. The potential reasons for this could be a higher reward for covering higher risk taken and early mispricing of equities. Fundamentally small-cap companies often show better growth and this is reflected on their stock prices.
This model has gained lot of popularity amongst fund managers and investors because it has outperformed most others.So, if you want to have better understanding of market and its’ gimmicks, follow the three-factor model.
