High Minus Low (HML), also known as the value premium, is one of three central factors in the Fama-French three-factor model. This renowned model, devised by economists Eugene Fama and Kenneth French, helps in evaluating stock returns. HML captures the differences in returns between value stocks—companies with high book-to-market ratios—and growth stocks, those with lower book-to-market values.
Key Insights
- Essential Factor: High Minus Low (HML) is integral to the Fama-French model.
- Model Genesis: The model was developed to systematize stock return evaluation.
- Value vs. Growth: It asserts that value stocks typically outperform growth stocks.
- Portfolio Performance: HML, alongside Small Minus Big (SMB), helps in estimating portfolio managers’ excess returns.
- Performance Trends: Historically, small and value stocks have outperformed large and growth-oriented stocks.
Understanding the Essence of HML
To grasp HML fully, it’s imperative to understand the Fama-French three-factor model, which was established in 1992. The model employs three distinct factors, one of which is HML, to explain the excess returns in a manager’s portfolio.
The cornerstone of this model is the insight that certain returns are driven by factors outside of managers’ control. For example, value stocks have a history of outperforming growth stocks, and smaller companies tend to do better than larger ones.
The first factor, HML, relates to the outperformance of value stocks, while the second, Small Minus Big (SMB), explains the superior performance of smaller firms. Evaluating how much of a manager’s performance is due to these factors allows for a better estimate of their skill.
In terms of HML, the model can display whether a manager is banking on the value premium by investing in stocks with elevated book-to-market ratios to gain an abnormal return. A significant correlation to the HML factor flags that a portfolio’s returns are owed mainly to the value premium, thus tightening the explanation gap of original excess returns.
Evolution: Fama and French’s Five-Factor Model
In 2014, Fama and French expanded their three-factor model to a five-factor model, adding two more dimensions. The updated model proposes that companies with higher future earnings tend to see higher returns (profitability factor). The fifth factor, investment, suggests that firms that make aggressive growth investments might underperform over time.
HML in Financial FAQs
Why Is the Fama-French Model Superior to CAPM?
The Fama-French three-factor model extends beyond the limitations of the Capital Asset Pricing Model (CAPM). Studies, including a 2012 publication, illustrate that the Fama-French model more effectively explains expected returns when compared to CAPM. Testing data from the New York Stock Exchange (NYSE) portfolios supports this superior explanatory power, though results can fluctuate based on portfolio configurations.
What Does the HML Beta Represent?
High Minus Low (HML) serves as a value premium, highlighting the return spread between high and low book-to-market value companies. The HML beta coefficient, derived through linear regression, can be either positive or negative. A positive beta signifies a portfolio’s alignment with value stocks, indicating a link to the value premium. Conversely, a negative beta denotes characteristics akin to a growth stock portfolio.
Related Terms: Value Premium, Fama-French three-factor model, Small Minus Big (SMB), Book-to-Market Ratio.
References
- International Journal of Business and Management. “CAPM Vs Fama-French Three-Factor Model: An Evaluation of Effectiveness in Explaining Excess Return in Dhaka Stock Exchange”.
- Public and Municipal Finance. “The use of CAPM and Fama and French Three Factor Model: portfolios selection”.
