What are the five factors in the Fama-French five-factor model and what risk does each capture?

Question

AcadiFi · Accepted Answer

The Fama-French five-factor model extends the original three-factor model by adding profitability and investment factors to better explain the cross-section of equity returns.

**The Five Factors:**

| Factor | Name | Long Portfolio | Short Portfolio | Risk Captured |
|---|---|---|---|---|
| MKT | Market | Equity market | Risk-free rate | Systematic market risk |
| SMB | Small Minus Big | Small-cap stocks | Large-cap stocks | Size risk |
| HML | High Minus Low | High B/M (value) | Low B/M (growth) | Value premium |
| RMW | Robust Minus Weak | High profitability | Low profitability | Profitability premium |
| CMA | Conservative Minus Aggressive | Low investment | High investment | Investment premium |

**Factor Construction (RMW Example):**

1. Sort all stocks by operating profitability (revenue minus COGS, SGA, and interest, divided by book equity)
2. Form portfolios: top 30% = Robust, bottom 30% = Weak
3. RMW = Average return of Robust portfolios minus average return of Weak portfolios

**Worked Example -- Explaining Returns for Duravolt Energy (fictional)**

Duravolt is a mid-cap, high-profitability, low-investment utility company.

| Factor | Beta (Loading) | Factor Return (Annual) | Contribution |
|---|---|---|---|
| MKT | 0.85 | 8.0% | +6.80% |
| SMB | 0.30 | 2.5% | +0.75% |
| HML | 0.45 | 3.0% | +1.35% |
| RMW | 0.60 | 3.5% | +2.10% |
| CMA | 0.50 | 2.0% | +1.00% |
| Alpha | | | +0.50% |
| **Expected excess return** | | | **12.50%** |

**Why Five Factors?**

The three-factor model left significant unexplained return variation. Novy-Marx (2013) showed that profitability predicts returns as strongly as book-to-market. Firms that invest conservatively (low asset growth) also outperform aggressive investors, consistent with the q-theory of investment where low investment signals high expected returns.

Adding RMW and CMA substantially reduces the HML factor's explanatory power, suggesting that part of the "value premium" was actually a profitability and investment premium in disguise.

What are the five factors in the Fama-French five-factor model and what risk does each capture?

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