Fama & French (2015) - A Five-Factor Asset Pricing Model

Overview

Fama and French (2015) extend their three-factor model with profitability (RMW) and investment (CMA) factors, providing a more complete description of the cross-section of average stock returns. The five-factor model is not an empirical grab bag — it is derived from valuation theory.

The Dividend Discount Motivation

The authors start from the dividend discount model: the value of a stock is the present value of expected future dividends, so market-to-book embeds expected profitability and expected investment. If two firms have the same market-to-book, the one with higher expected profitability must be cheaper for a reason, and the one investing more aggressively must grow into its price. The model therefore predicts that profitability and investment capture return variation that value alone misses.

The Factors

RMW (robust minus weak) sorts stocks on operating profitability; CMA (conservative minus aggressive) sorts on asset growth. Constructed with the same 2x3 portfolio methodology as SMB and HML, the factors are added to the market, size, and value factors to form the five-factor model. The paper tests the model on US data from 1963 to 2013.

What Works and What Does Not

The five-factor model absorbs the value premium's unexplained parts and eliminates many of the three-factor model's pricing errors. The famous failure is equally instructive: the model cannot price stocks that behave like firms with low profitability that nonetheless invest aggressively — the "glamour with no profitability" corner that the model's own logic says should not exist. HML also becomes largely redundant once RMW and CMA enter the regression.

Why It Matters

The five-factor model is the current industry workhorse for performance attribution, smart-beta construction, and risk decomposition. Understanding its derivation tells practitioners which corners of the factor space the model was designed to explain — and which anomalies it was never going to capture.

Key Takeaways

• RMW and CMA come from valuation theory, not pure empiricism — expected profitability and investment discipline price stocks.
• HML's role shrinks dramatically once profitability and investment are included.
• Know the model's blind spot: high-investment, low-profitability firms still puzzle the five-factor framework.