Fama-French Three-Factor Model

Overview

Fama and French (1993) extended CAPM by adding two factors — size (SMB) and value (HML) — to explain cross-sectional variation in stock returns that CAPM alone cannot capture. The model shows that small-cap and high book-to-market stocks earn systematic premiums.

When to Use

• Explaining why CAPM alpha is nonzero for certain portfolios
• Evaluating fund manager skill after controlling for factor exposures
• Constructing factor-tilted portfolios
• Academic research on asset pricing anomalies

When NOT to Use

• For fixed income or derivatives pricing (equity-focused factors)
• When factor data is unavailable for the market in question
• As a complete model — profitability and investment factors may also matter (five-factor)