Asset Pricing And Portfolio Management Models

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There are many different asset pricing and portfolio management models available to assist us in the estimation and evaluation of a stock’s return. The Fama-French Model (“FFM”) is one of those models. Kenneth French and Eugene Fama who were professors at the University of Chicago Booth School of Business designed the FFM. Kenneth French and Eugene Fama observed that historically, the Capital Asset Pricing Model (“CAPM”), which was predominantly used, was inaccurate as it often resulted in high alpha values which meant that a huge portion of excess returns were left unexplained. They also observed that companies with smaller market caps would outperform companies with higher market caps and companies with higher book-to-market (“B/E”) …show more content…

This would form the excess returns that small firms have over larger firms and the firm specific beta will be assigned to it to formulate the value of SMB, accounting for the size risk factor. This is based on the assumption that smaller firms tend to experience higher excess returns. Accordingly, if β_SMB is larger than 0, it means that the portfolio would have higher expected returns signifying that it consist mostly of small companies and vice versa. This assumption is in line with the fact that smaller companies are riskier than larger companies. As the general rule that the higher the risk the higher the returns, it is only fitting that companies with smaller market caps thus higher risk would bring in higher returns. This occurs because the smaller firms are usually not very popular hence; there are not many investors that are interested in the stock consequently, the share price would be relatively low, giving it room to perform better. On the other hand, firms with larger market cap are traded often due to investor’s interest, causing their share price to be high. Evidence of this can be found in a report issued by a research company Duff and Phelps (2013). It shows that in a 30 year period, small companies has out performed large companies 92% of the time, further proving that size factor plays a huge part in evaluating the returns of a

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