Factor Analysis of Mutual Funds is a quantitative technique used to understand and evaluate the underlying factors that drive the performance of mutual funds. It involves decomposing the returns of a mutual fund into various components, or "factors," which could be macroeconomic variables, market indices, or other financial metrics that influence fund returns.
The Fama-French Three-Factor Model is an asset pricing model developed by Eugene Fama and Kenneth French in 1992. It expands on the traditional Capital Asset Pricing Model (CAPM) by adding two additional factors to better explain the returns of a portfolio or a stock. These factors are intended to capture the impact of size and value on stock returns.
The model posits that the returns of a portfolio or stock can be explained by three factors:
Market Excess Return (Mkt-RF): This is the excess return of the market over the risk-free rate. It is the same as the CAPM’s market factor.
SMB (Small Minus Big): This factor captures the size premium, which is the historical tendency for smaller companies to outperform larger companies.
HML (High Minus Low): This factor captures the value premium, which is the historical tendency for value stocks (those with high book-to-market ratios) to outperform growth stocks (those with low book-to-market ratios).
Use in Portfolio Management The Fama-French Three-Factor Model is widely used in finance to evaluate the performance of mutual funds, hedge funds, and other investment portfolios. By understanding how much of a portfolio's returns can be attributed to these three factors, investors can better understand the sources of risk and return in their investments.
Market Factor (Mkt-RF): Captures the overall market risk. A portfolio or stock with a higher beta will be more sensitive to market movements.
Size Factor (SMB): A positive loading indicates a tilt towards smaller-cap stocks, which have historically provided higher returns than large-cap stocks.
Value Factor (HML): A positive loading indicates a tilt towards value stocks, which have historically outperformed growth stocks.