The Fama-French Five-Factor Model: Factors, Tests, and Limitations

Summary

The article outlines the development of the Fama-French five-factor asset-pricing model from CAPM and the three-factor model. Alongside market, size, and value effects, the five-factor version adds profitability and investment. The article frames these additions through the dividend discount model and describes empirical tests that use portfolios formed to create spreads in size, book-to-market, profitability, and investment. Time-series regressions estimate how the five factor returns relate to portfolio returns and whether they account for average returns.

Citing reported research, the article says the model explains 71% to 94% of cross-sectional return variance in the targeted portfolios and leaves fewer anomaly returns unexplained than the three-factor model. It also reports that value can become redundant for explaining average returns once profitability and investment are included. The model’s stated weakness is its failure to capture low returns among some small firms with high investment and low profitability. These findings concern particular empirical tests; the article does not establish that the factors guarantee future performance, and its conclusion is cautious about the model’s adoption.

Key ideas

• The five-factor model extends the market, size, and value factors with profitability and investment factors.
• Empirical tests use portfolios formed around the characteristics the model is intended to explain.
• The cited results report stronger explanatory coverage than the three-factor model for targeted portfolios.
• Value may add little explanatory power when profitability and investment are included.
• The model can still miss returns among small firms with high investment and low profitability.

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