Fama & French (2015): The Five-Factor Asset Pricing Model Explained

#The Paper at a Glance

Title: A five-factor asset pricing model

Authors: Eugene F. Fama and Kenneth R. French

Published: Journal of Financial Economics, 2015

DOI: 10.1016/j.jfineco.2014.10.010

Twenty-two years after their landmark three-factor model, Fama and French acknowledged that three factors weren't enough. Two additional characteristics—profitability and investment—were needed to explain the cross-section of returns.

#From Three Factors to Five

The Original Three (1993)

1. 1Market (MKT-RF): Excess return of the market over risk-free rate
2. 2Size (SMB): Small minus big—small caps outperform large caps
3. 3Value (HML): High minus low book-to-market—value beats growth

The Two New Factors (2015)

1. 1Profitability (RMW): Robust minus weak operating profitability

1. 1Investment (CMA): Conservative minus aggressive asset growth

#Why Profitability Matters

The RMW Factor

Profitable companies outperform unprofitable ones by nearly 5% per year. The economic logic is straightforward:

• Profitable firms generate cash that can be reinvested or returned to shareholders
• Unprofitable firms burn cash and often need to raise capital, diluting existing shareholders
• Profitability tends to persist—today's profitable companies are likely tomorrow's profitable companies

#Why Conservative Investment Matters

The CMA Factor

Companies that invest conservatively outperform aggressive investors by about 3% per year. Why?

The Empire-Building Problem

• Companies with excess cash often over-invest in marginal projects
• Aggressive acquisitions frequently destroy value (winner's curse)
• Management empire-building prioritizes growth over returns
• Capital discipline signals management quality

#The Surprise: Value Becomes Redundant

Perhaps the most controversial finding: the value factor (HML) adds nothing once you include profitability and investment.

When Fama and French added RMW and CMA to the model, the value factor's contribution to explaining returns dropped to near zero. The information in book-to-market ratios is already captured by the combination of profitability and investment.

This finding sparked intense debate. Does value still "work"? Or was it always just a proxy for profitability and investment patterns?

#Critical Perspectives

Not Everyone Agrees

• Hou, Xue & Zhang (2015) developed an alternative q-factor model that replaces value entirely with profitability and investment
• Robeco (2024) questioned whether the investment factor adds enough value beyond what profitability captures
• Practitioners note that value's recent underperformance may reflect structural changes (intangible economy)

The Emerging Consensus

Most researchers agree that: 1. Profitability is the strongest and most robust factor 2. Investment/asset growth has a reliable negative premium 3. Traditional value (book-to-market) needs updating for the modern economy 4. Size is the weakest factor and may not be a true premium

#What This Means for Multi-Factor Models

The five-factor model establishes a key principle: factors should be economically motivated and statistically independent.

Simply throwing more factors at the problem doesn't help. Each factor must: 1. Have a plausible economic rationale 2. Show statistical significance after controlling for other factors 3. Work across markets and time periods 4. Survive replication attempts

#How This Applies to Our Rankings

Our six-factor model includes direct descendants of all five Fama-French factors:

We diverge from Fama-French by dropping size (weakest evidence), adding momentum (strong but not in FF5), adding low volatility, and adding short interest. But the intellectual heritage is clear.

See how our factors rank stocks →

#Academic Source

Fama, E. F., & French, K. R. (2015). "A five-factor asset pricing model." Journal of Financial Economics, 116(1), 1-22.