Factor Theory: The Fama-French Three Factor Model

Beside the earnings/price ratio, the CAPM had to survive more critique. Banz (1981) and again Basu (1983) discovered that firms with low market capitalization have higher average returns than firms that have large market capitalization. If small firms give a higher return then the CAPM would be suffer another blow. Supporters of the CAPM quickly pointed out that the beta of small firms is usually higher than the beta of large firms. However, this difference in beta is not significant enough to fully explain the different return between small and large caps. A third problem with the CAPM was published by Rosenberg, Reid and Lanstein (1985). They created another piece of evidence against the CAPM by showing that stocks with high ratio‟s of book value

A firm with a higher amount of debt should have a higher beta, but Bhandari shows that even after the beta is adjusted, firms still can get a higher return.
In 1992, Fama and French published their most important paper. This paper was especially important, because it took all the research that had been done in the last 30 years and combined it into one formula, now known as the Fama-French Three Factor Model. What Fama and French did was using the old CAPM and then adding much of the critique explained in the above text. This gave some very interesting results. One of the first things they discovered was that the relation between the beta and the return was not quite true. Because of the (negative) correlation between company size and beta, beta and return only seemed to have a relation but when Fama and French adjusted for this correlation, the relation between beta and return pretty much vanishes. Because of this result, Fama and French decided to look for other variables that might explain the average returns. After some calculation, they tested whether size, E/P, leverage, Book to Market and beta, again following the findings that researchers had done