Expanding the 3-factor model

1. Expanding the 3-factor model

Now that you've seen both the CAPM and the Fama-French 3-factor models in action, you might be tempted to believe that you can explain every market movement given enough time and information. While that may be theoretically true, it is also practically impossible, and yet many people have built massive fortunes on Wall Street by simply trying to get closer.

2. Fama French 1993

There have been many attempts to improve the Fama-French 3 factor model throughout the years, and many arguments made against it in general.

3. Cliff Assness on Momentum

Cliff Asness from the quantitative hedge fund AQR, for example, argued that momentum should be included as a factor, but Eugene Fama and Kenneth French disagreed. Now they all have their own funds pursuing better versions of these models, and generating billions of dollars in returns for their investors.

4. The Fama-French 5 factor model

In the latest iteration of the Fama-French model, two new factors have been added: RMW, or profitability, and CMA, or investment. There have been many studies of these additional factors. Some argue that the model fails to explain returns in the UK, for example, but this the fun part. Results are open to interpretation, and there's no reason you couldn't come up with better factors to use. So now it's up to you to evaluate the performance of this model, and to maybe think up new factors.

5. The Fama-French 5 factor model

So here's what it looks like when you add the CMA and RMW factors into your analysis. These factors are freely available on Kenneth French's website along with other factors, and you can see how everything is computed there. Factors are pretty simple to calculate, but there is a ton of research that goes into building them and proving their efficacy across time.

6. The Fama-French 5 factor model in Python

As you can see, it really is as simple as adding another column into the regression formula. The hard part is finding new factors, testing them, and explaining why they make economic sense. This is the fundamental basis of many quantitative investment firms, each managing billions of dollars at a time. If you're interested in learning more about factor analysis, read some of Eugene Fama or Kenneth French's research papers, and some of Cliff Assness's as well.

7. Let's practice!

You think you can do better? Then show us - because now it's your turn to run the models.

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