What is the Three-Factor Model?
Economists rely on models-approximations of reality-to characterize and predict the relationship between risk and return. The Three-Factor Model identifies three independent dimensions of equity returns and allows us to measure their respective roles in returns:
1.The Market Factor: the extra risk of Equities vs. Fixed Income (First identified by Nobel Prize winner, William Sharpe)
2.The Size Factor: the extra risk of Small Cap stocks over Large Cap stocks
3.The Value Factor: the extra risk of high Book-to-Market (BtM) over low BtM stocks
What does it mean?
The Three-Factor Model clarifies decisions because portfolios are based on research and rational expectations rather than hunches. This model takes the relationship between risk and return even further. We know that performance vs. the market or another manager depends almost entirely on the three factors. The model enables a number of useful functions:
Calculate expected returns based on factor exposure
Analyze manager styles and successes
Analyze proposed portfolios and reallocations
Analyze contributions of additional asset classes
The model makes it possible to calculate the way portfolios take different types of risk and calculate their expected returns based on these risks. Asset classes can be created that offer higher expected returns than simple growth strategies. Questions and problems are answered using a consistent philosophy. This increases self-confidence and client confidence.