Fama-French-Carhart Model: Understanding the Four Factor Portfolios

The Fama-French-Carhart factor model is a really interesting tool used in finance to better understand what drives stock returns. Think of it like trying to understand why some cars are faster than others. Just saying “horsepower” isn’t the whole story. Factors like aerodynamics, weight, and tire grip also play a role. Similarly, in the stock market, the Fama-French-Carhart model suggests that just looking at the overall market movement isn’t enough to explain why some stocks perform better or worse than others. It proposes that we need to consider additional factors, and to do this, it uses specific portfolios designed to isolate these factors.

Let’s start with the most fundamental, the market factor portfolio. This is represented as Mkt-RF, which stands for Market minus Risk-Free. This portfolio is essentially designed to capture the excess return of the overall stock market compared to a risk-free investment, like a government treasury bill. Imagine you’re investing in a broad basket of stocks, something like the S&P 500. This market factor portfolio represents the performance of that basket over and above what you could get from simply putting your money in a very safe, low-return investment. It’s the baseline risk that comes with investing in the stock market as a whole.

The next portfolio is designed to capture the size factor, often called SMB, which stands for Small Minus Big. This portfolio is constructed by going long in small-cap stocks and short in large-cap stocks. Now, what does that mean? Think of it like this: imagine you create two groups of companies, one group of smaller companies and another group of larger, more established companies. The SMB portfolio is like betting that smaller companies, on average, will outperform larger companies. This is based on the idea that smaller companies might be riskier, but also have more growth potential, and historically, they have tended to provide higher returns over the long run. So, the SMB portfolio is designed to isolate and measure the return premium associated with investing in smaller companies relative to larger ones.

Then we have the value factor portfolio, known as HML, or High Minus Low. This one is about value versus growth stocks. Value stocks are companies that might look undervalued based on metrics like their book value compared to their market price. They might be seen as ‘bargains’. Growth stocks, on the other hand, are often companies expected to grow rapidly in the future, even if they look expensive today. The HML portfolio is constructed by going long in value stocks, those with high book-to-market ratios, and short in growth stocks, those with low book-to-market ratios. Think of it like comparing a solid, reliable, perhaps slightly older business to a flashy, new, high-tech startup. The HML portfolio is designed to capture the return difference between investing in these ‘value’ oriented companies versus ‘growth’ oriented companies, isolating the value premium. Historically, value stocks have often outperformed growth stocks over long periods, and this portfolio aims to measure that effect.

Finally, we have the momentum factor portfolio, UMD, which stands for Up Minus Down. This factor was added later by Carhart to the original Fama-French three-factor model. Momentum in the stock market refers to the tendency for stocks that have performed well recently to continue to perform well in the short term, and stocks that have performed poorly to continue to perform poorly. The UMD portfolio is constructed by going long in stocks that have been past ‘winners’ – those with high prior returns – and short in stocks that have been past ‘losers’ – those with low prior returns. Imagine it like surfing a wave. If a stock is on an upward trend, the momentum factor suggests it’s more likely to keep going up for a while. This portfolio tries to capture that continuation effect. It isolates the return premium that can be gained by investing in stocks with positive momentum compared to those with negative momentum.

So, in summary, the Fama-French-Carhart model utilizes four specific portfolios: the market factor portfolio (Mkt-RF), the size factor portfolio (SMB), the value factor portfolio (HML), and the momentum factor portfolio (UMD). Each of these portfolios is carefully constructed to isolate and measure a specific risk factor beyond just the overall market risk. By considering these factors, the model provides a more nuanced and potentially more accurate explanation of stock returns than models that only focus on the market as a whole. These portfolios are not meant to be investment strategies in themselves for most individuals, but rather they are tools used by financial analysts and academics to better understand and predict how different types of stocks behave in the market. They help us break down the complex world of stock returns into more manageable and understandable components, much like understanding the different factors that contribute to a car’s speed helps us understand how cars work.