Finance Concept Explained: The Value Premium in High Minus Low (HML) Strategy
The Fama-French Five-Factor Model, an expansion of the original three-factor model, offers a broader perspective on stock returns. Developed by Nobel laureate Eugene Fama and Kenneth French, the model aims to provide a more comprehensive explanation of portfolio returns.
To grasp the concept of the High Minus Low (HML) factor, a key component of the model, it's essential to first understand the Fama-French three-factor model. This model was designed to better explain portfolio returns by accounting for the value effect, alongside size and market factors.
The first factor in the original model, and the basis for the HML factor, is the outperformance of value stocks. The HML factor represents the return spread between value stocks with high book-to-market ratios and growth stocks with low ratios. A positive HML beta implies a portfolio is aligned with value stocks, while a negative HML beta means it behaves more like a growth stock portfolio.
The HML factor reveals if a manager relies on the value premium by investing in high book-to-market stocks for abnormal returns. This factor helps investors see how value versus growth influences portfolio performance. The HML beta coefficient can take positive or negative values. A positive beta means that a portfolio has a positive relationship with the value premium.
The Fama-French Five-Factor Model, updated in 2014, includes the concepts of profitability and investment alongside the original three factors. The profitability factor refers to the higher returns in the stock market for companies reporting higher future earnings. The investment factor suggests that companies that invest aggressively in growth projects are likely to underperform in the future.
The Fama-French Five-Factor Model helps investors analyze stock returns by comparing value stocks with growth stocks, similar to the original three-factor model. By including profitability and investment as new dimensions, the model aims to improve the explanatory power of asset returns, addressing limitations of the original three-factor model.
Small and value stocks tend to outperform larger or growth-focused ones, explaining much of a portfolio's performance. A study published in 2012 found that the Fama-French Three-Factor Model is better than the Capital Asset Pricing Model (CAPM) at explaining expected returns, further emphasising the importance of this model in financial analysis.
The Fama-French Five-Factor Model is often favored over the CAPM for its broader perspective on returns. By providing a more comprehensive understanding of stock returns, the model makes it easier to interpret performance and make better financial decisions.
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