The Multi-factor Model

Eugene Fama, winner of the Nobel Prize in Economics, and his colleague, Kenneth French, are both highly respected academics, who developed the multi-factor model, to explain how securities are priced in the market.

Fama and French divided the market into categories by the size of companies and how much their stocks’ prices were above or below their accounting book values. They took half of the companies, those with the largest market value, and placed them into the large-cap category, and placed the other half in the small-cap category. Next, if the company’s stock price was relatively high compared to its book value, it was placed in the growth category, and if the stock price was relatively low compared to its book value, it was put into the value category. They made no attempt to evaluate good or bad companies, good or bad management, or other factors.

A portfolio tilted toward small and value securities has a higher expected return than a typical market index.

The results can be seen in Graphic 7. The average annual return of the large-cap growth companies is 9.52% and of large-cap value companies it is 10.6%. The difference between those two annual rates of return is 1.08%. The annual return for small-cap growth companies is 9.18% and 13.86% for small-cap value: a whopping difference of 4.68%.

These averages were calculated over 87 years, meaning that in any given year you will not get these exact results. For some years, growth companies did better and value companies worse. This reaffirms what we learned earlier: few active managers beat an index or a market average in any single year or multiple years, let alone 87 years.

Fama and French applied the same techniques to analyze non-U.S. companies in the developed world and the emerging market countries, finding the same relationships held true.

Fama and French’s model states that security prices are explained using three factors:

  • Equity or fixed income — Equity securities have a higher return because they are associated with higher risks.
  • Market capitalization — Riskier, smaller companies provide higher expected returns (on average) than larger, established companies.
  • Value or growth — Value stocks tend to have a higher expected return than growth stocks.

Following this model an investor can achieve the benefits of indexing and a higher expected return without reconstitution cost and style drift.

Small-cap and value Companies outperformance is pervasive in all stock markets.

Graphic 7: Small-cap and value appear to outperform

chart7

Source: Index data provided by Fama/French in U.S. dollars and is compiled from securities data from the Center for Research in Security Prices, Bloomberg and MSCI, except the data for the S&P 500, International Small, MSCI EAFE and MSCI Emerging Markets. International Small data compiled by Dimensional from Bloomberg, Style Research, London Business School, and Nomura securities data. MSCI EAFE and MSCI Emerging Markets data provided by MSCI; copyright 2013, all rights reserved. MSCI Emerging Markets Index is shown gross before foreign withholdings taxes on dividends; all other data is shown on a net basis.
Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Values change frequently and past performance may not be repeated. Small company risk: Securities of small firms are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Emerging markets risk: Numerous emerging countries have experienced serious, and potentially continuing, economic and political problems. Stock markets in many emerging countries are relatively small, expensive, and risky. Foreigners are often limited in their ability to invest in, and withdraw assets from, these markets. Additional restrictions may be imposed under other conditions. Foreign securities and currencies risk: Foreign securities prices may decline or fluctuate because of: (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets. Investors holding these securities are also exposed to foreign currency risk (the possibility that foreign currency will fluctuate in value against the U.S. dollar).