Question

What criticisms could be made of the Fama and French three factor model.

Answer 1

The Fama and French Three-Factor Model (or the Fama French Model for short) is an asset pricing model that expands on the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor in CAPM. This model considers the fact that value and small-cap stocks outperform markets on a regular basis. By including these two additional factors, the model adjusts for this outperforming tendency, which is thought to make it a better tool for evaluating manager performance.

The Fama and French model has three factors: size of firms, book-to-market values and excess return on the market. In other words, the three factors used are SMB (small minus big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.

There is a lot of debate about whether the outperformance tendency is due to market efficiency or market inefficiency. In support of market efficiency, the outperformance is generally explained by the excess risk that value and small-cap stocks face as a result of their higher cost of capital and greater business risk. In support of market inefficiency, the outperformance is explained by market participants incorrectly pricing the value of these companies, which provides the excess return in the long run as the value adjusts. Investors who subscribe to the body of evidence provided by the Efficient Markets Hypothesis (EMH) are more likely to agree with the efficiency side.