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%