Definition
Developed by Eugene Fama and Kenneth French, the three-factor model adds size (SMB: small minus big) and value (HML: high book-to-market minus low) factors to CAPM's market factor. The five-factor model further adds profitability (RMW) and investment (CMA). These models explain a much larger proportion of return variation than CAPM alone and are the standard for academic performance evaluation.
functions Formula
R = Rf + β₁(Rm-Rf) + β₂(SMB) + β₃(HML)
lightbulb Example
A fund returns 15%. Three-factor decomposition: market exposure explains 8%, size tilt (small-cap) explains 3%, value tilt explains 2%. True alpha = 15% - 8% - 3% - 2% = 2%—much less than the naive 5% CAPM alpha.
verified_user Key Points
- Extends CAPM with size and value factors
- Five-factor model adds profitability and investment
- Standard for academic performance attribution
- Most apparent "alpha" is explained by factor exposure