Wednesday, June 24

Factor Investing and Fama-French model

This notebook illustrates factor investing and five-factor Fama-French model.

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%