**Risk Factor**

Certain characteristic of economy (Inflation/GDP) **or **stock market itself (S&P 500)

**Factor Model**

Factor model uses movements in risk factors **to explains** portfolio returns

**Questions which factor investing answers**

- Why different asset have systematically lower or higher average returns?
- How to manage the asset portfolio with the underlying risks in mind?
- How to benefit of our ability to bear specific types of risks to generate returns?

### Fama-French Model

Assumes linear relationship between empirical factors and stock returns:

- Market Factor (MER)
- Size Factor (SMB)
- Value Factor (HML)
- Profitability Factor (RMW)
- Investment Factor (CMA)

**Factors **are constructed daily from definitions, as illustrated previously

- They are global for the entire stock market

**Factor sensitivities** are calibrated using regression

- They represent “reward for taking a specific risk”, which is different for every stock
- Risk/Reward relationship is expected to hold over time
- Objective: maximize the model’s predictive power R2

### Market Excess Return (MER)

- Market excess return (over RF rate) alone explains around 80% of asset movements
- Daily returns are ~normally distributed
- Relationship between returns of the overall market and returns of selected portfolio

### Size (SMB) factor

- Small-cap companies typically bear additional risk premium - was it always the case?
- Python can help you to see that this factor has a different prevalence in different economic regimes

### Value (HML) factor

- Value companies trade at higher yields to compensate for lack of growth potential
- Python can help you to see that this factor has different explanatory power in different market situations and on different portfolios (very interesting)

### Profitability and investment factors

__Profitability factor__(RMW) to attribute superior returns of companies with robust operating profit margins and strong competitive position among peers__Investment factor__(CMA) to segment companies based on their capital expenditures**Analysts opinion**: High capex structurally associated with growth companies, which puts usefulness of this factor in question

### Evaluating 5-factor model

**Analyst opinion**: High correlations between risk factors puts usefulness of 5-factor model into question.- R2 10-20% for RMW, CMA
- 5 factor improvement only by 0.2%