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WEDNESDAY, JUNE 24


FACTOR INVESTING AND FAMA-FRENCH MODEL


This notebook illustrates factor investing and five-factor Fama-French model.





RISK FACTOR

Certain characteristic of economy (Inflation/GDP) or stock market itself (S&P
500)

FACTOR MODEL

Factor model uses movements in risk factors to explains portfolio returns






QUESTIONS WHICH FACTOR INVESTING ANSWERS







 * Why different asset have systematically lower or higher average returns?
 * How to manage the asset portfolio with the underlying risks in mind?
 * How to benefit of our ability to bear specific types of risks to generate
   returns?






FAMA-FRENCH MODEL




Assumes linear relationship between empirical factors and stock returns:



 * Market Factor (MER)
 * Size Factor (SMB)
 * Value Factor (HML)
 * Profitability Factor (RMW)
 * Investment Factor (CMA)





Factors are constructed daily from definitions, as illustrated previously



 * They are global for the entire stock market



Factor sensitivities are calibrated using regression



 * They represent “reward for taking a specific risk”, which is different for
   every stock
 * Risk/Reward relationship is expected to hold over time
 * Objective: maximize the model’s predictive power R2




MARKET EXCESS RETURN (MER)

 * Market excess return (over RF rate) alone explains around 80% of asset
   movements
 * Daily returns are ~normally distributed
 * Relationship between returns of the overall market and returns of selected
   portfolio




SIZE (SMB) FACTOR

 * Small-cap companies typically bear additional risk premium - was it always
   the case?
 * Python can help you to see that this factor has a different prevalence in
   different economic regimes




VALUE (HML) FACTOR

 * Value companies trade at higher yields to compensate for lack of growth
   potential
 * Python can help you to see that this factor has different explanatory power
   in different market situations and on different portfolios (very interesting)




PROFITABILITY AND INVESTMENT FACTORS

 * Profitability factor (RMW) to attribute superior returns of companies with
   robust operating profit margins and strong competitive position among peers
   
   
 * Investment factor (CMA) to segment companies based on their capital
   expenditures
   
   
 * Analysts opinion: High capex structurally associated with growth companies,
   which puts usefulness of this factor in question







EVALUATING 5-FACTOR MODEL

 * Analyst opinion: High correlations between risk factors puts usefulness of
   5-factor model into question.
 * R2 10-20% for RMW, CMA
 * 5 factor improvement only by 0.2%






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