Revisiting The Five-Factor Model

Revisiting The Five-Factor Model

Nearly 30 years ago, Eugene Fama and Kenneth French introduced their three-factor model, augmenting the capital asset pricing model (CAPM) with small minus big (SMB) and high minus low (HML). That model has undergone many changes over the years, and Fama & French updated the model themselves with two additional factors: robust minus weak (RMW) and conservative minus aggressive (CMA). But according to an article in CFA Institute that analyzed the model, only one of those factors has held up over time.

Using a fictional $1 portfolio, CFA Institute tracked each individual factor. For SMB, that factor generated good returns of about 600% from 1926-1982. Then, large-cap stocks outperformed small caps for the next 18 years. Since then, the factor has mostly flatlined.

Meanwhile, HML had an incredible run from 1926-2007; a long-short HML portfolio produced over 4000% returns. But following the 2008 recession, that same portfolio lost nearly half its value as growth stocks have soared. But while some have written off the factor completely others, such as Rob Arnott, say that the factor’s underperformance is due to the plunge in valuations of value stocks, as well as the HML book-value-to-price definition not correctly accounting for intangible assets.

The trajectory of the CMA factor echoes the HML. Initially, buying companies that invested conservatively was successful for over 40 years. But that success dissolved in 2004, and the stocks of firms that invest aggressively has brought in 20% excess returns since 2013.

Last is RMW, which is the one factor that has delivered excess returns in every cycle since 1963. Going long on high quality stocks while shorting their unprofitable counterparts has been a truly winning strategy, even as the definition of “quality” has shifted over time.

In conclusion, CFA Institute writes, while the SMB and HML factors didn’t pan out as expected, RMW has proven that investing in profitable companies continues to be a strong and smart time-tested strategy.