There are very few academic papers in the world of finance that can be genuinely called game-changing, and they only tend to be published about once every 20 years.

Portfolio Selection by Harry Markowitz, published in 1952, transformed the way people thought about portfolio construction. In 1970, Efficient Capital Markets: A Review of Theory and Empirical Work by Eugene Fama undermined the conventional wisdom that investors could consistently beat the market through stock selection or timing. Then, in 1973, Fischer Black, Myron Scholes and Robert Merton published papers which eventually earned them all a place, alongside Fama and Markowitz, as recipients of the Nobel Prize in Economics.

But we had to wait for almost another 20 years before the next revolutionary development in academic finance. It came with the publication in June 1992 of Common Risk Factors in the Returns on Stocks and Bonds by Eugene Fama and Kenneth French.

Until that point, it had generally been assumed that a stock's returns could be explained solely by its exposure to market risk — in other words, how much it moves with the overall market. But Fama and French showed that two additional factors could explain much of the variation in stock returns beyond just market risk.

These two factors were company size and value. Over long periods of time, they found, small companies tend to outperform big ones, while value, or cheap, stocks — those with high book-to-market ratios — tend to outperform expensive ones.

Market, size, and value explain almost everything

Fama and French determined that exposure to market, size and value risk factors explained as much as 96 percent of historical returns in diversified stock portfolios. So the optimal strategy, they argued, was to diversify your equity exposure across those three factors.

But why was the so-called three-factor model so influential? Well, for the first time, it showed there were systematic ways to understand and, to an extent, predict returns. The paper laid the foundation for what became known as factor-based investing.

To quote Mark Hebner in Step 8 of his award-winning book, Index Funds: The 12-Step Recovery Program for Active Investors: "The research of Eugene Fama and Kenneth French serves as a guiding protocol for both individual and institutional investing. Their multi-factor model has revolutionized how portfolios are constructed and analyzed and was one of the primary reasons for Eugene Fama being awarded the 2013 Nobel Prize in Economics."

Three factors became five in 2015

So what was the next pivotal research to be published after that paper in 1992? In fact it was an update on the same paper, again produced by Fama and French, called A Five-Factor Asset Pricing Model.

Published in the Journal of Financial Economics in April 2015, the paper added two more factors to the original three — profitability and investment. In short, Fama and French found that companies with higher profitability tend to deliver higher returns, and, perhaps counter-intuitively, companies that invest conservatively tend to outperform those that invest aggressively.

Interestingly, when profitability and investment were included, the value factor became less significant, suggesting that some of the value premium could be explained by these new factors.

Two key takeaways

What, then, are the implications for investors of the multi-factor models developed by Fama and French?

First, the three- and five-factor models further weaken the case for using traditional active fund managers. The evidence repeatedly shows us that, on a properly cost- and risk-adjusted basis, the vast majority of active funds will underperform their benchmarks over the long run. Because, at any one time, there are so many funds to choose from, there will always be managers with strong performance in the recent past. But close analysis of those funds' returns often show that they had simply overweighted the types of stocks that Fama and French demonstrated have higher expected returns.

In other words, there is no point in paying active managers to try to exploit, say, the size or value premiums when you can capture them yourself, far more cheaply and efficiently, by using funds that are specifically designed to target those factors.

Secondly, although traditional index funds are a good investment option, they aren't the best solution available. Traditional index funds are designed to track the performance of a market as represented by well-known indexes from firms like S&P Dow Jones, NASDAQ, FTSE Russell, Bloomberg, MSCI, and CRSP. These funds closely replicate the composition of the index, holding the same securities.

What traditional index funds don't give you, however, is specific exposure to the drivers of higher expected returns identified by Fama and French. For that you need to use what the U.S. financial regulator, the Securities and Exchange Commission, calls non-traditional index funds, which are designed to capture, systematically, the returns of the market, size, value, profitability, and investment factors.

Here at IFA, we use funds from Dimensional Fund Advisors, which purposefully isolate the Fama-French factors, unlike traditional index funds, have a flexible trading strategy which means they can benefit from specific market developments. As a firm, Dimensional is held in the highest regard, and Fama and French are key members of its board of directors, providing strategic advice and expertise to a more than 300-strong research team around the world.

To be clear, the Fama-French factors are not guaranteed to outperform in the future. Indeed there are bound to be long periods when they underperform. But, as you can see from the chart below, the long-term historical evidence shows that all five factors have amply rewarded patient and disciplined investors.

In the United States, for example, on an annualized basis, up to the end of 2023, stocks outperformed bonds by 6.56 percent since 1928. Over the same period, small-cap stocks beat large-caps by 2.10 percent, and value stocks outperformed growth stocks by 3.00 percent. From 1964 through 2023, high profitability stocks beat low profitability stocks by 3.75 percent, and, over the same period, low investment small-cap stocks outperformed high investment small-cap stocks by 5.39 percent.

It's also encouraging for investors to see that the Fama-French factors don't just apply in the U.S. All five factors have delivered premiums across both international stock markets and emerging markets.

Huge debt of gratitude

In conclusion, as Dimensional's Wes Crill explained in one of our recent videos, investors today owe Eugene Fama and Kenneth French a huge debt of gratitude.

For decades our parents and grandparents paid huge fees to brokers and active managers to try, but usually fail, to beat the market. But, thanks largely to Fama and French, we can now readily invest in practical products designed to benefit from the most important findings of academic finance. We are very fortunate to have that opportunity.

 

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ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

*Quotes and pictures are utilized for illustrative purposes only and should not be construed as an endorsement, recommendation, or guarantee of any particular financial product, service, or advisor.