Interpreting Fama–French Factor Returns and CAPM Comparisons

Summary

The document clarifies how to interpret the Fama–French five-factor data when comparing factor portfolios with a CAPM Security Market Line. The SML portfolio in the data is a small-minus-large return spread, so its average is an excess return rather than the total return of a standalone asset. For a CAPM plot that uses total returns on the vertical axis, the average risk-free rate must be added to a portfolio’s average excess return; the beta is estimated by regressing the portfolio’s excess returns on the market excess return.

The explanation is brief and does not provide calculations, a worked example, or a broader discussion of the factor definitions and construction. The adjustment also depends on using consistent return conventions and periods: a comparison based on excess returns should keep the risk-free rate subtracted throughout, while a total-return plot must restore it. The document addresses interpretation, not whether a particular factor portfolio or CAPM test establishes model weakness.

Key ideas

• The SML factor represents the return difference between small and large stocks, so its reported average is an excess return.
• For total-return comparisons, add the risk-free rate to an average excess return.
• Estimate a portfolio’s CAPM beta by regressing its excess return on the market excess return.
• Keep the return convention consistent when comparing portfolios with a Security Market Line.

Tags

# Understanding Fama/Frenchs' Five Factors - Returns or Excess Returns?


# Understanding Fama/Frenchs' Five Factors - Returns or Excess Returns?












two short questions:

- If I download the five factor data from Kenneth French's website (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and for example calculate the average of the SML-portfolio, I get an excess return and not only a return, right?

- If I want to prove, that the CAPM is a weak model, I just put the factor portfolios in a figure, where I also put the CAPM-predicted Security Market Line. The Security Market Line goes from the risk free rate on the y-axis through the average market return at beta=1. For the factor portfolios I calculate their CAPM-Betas by doing a regression. But wat is their return? Is their return equal to their excess return oder do I have to add the risk free rate on top of the calculated average excess returns?

## Answer by python_enthusiast (score 3)

https://quant.stackexchange.com/a/36743

For the first question: you get the excess return of small minus large (SML).

For the second question: if you want to find the average return, you have to add the risk-free rate to the average excess return.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.