- Length: 8 pages
- Sources: 8
- Subject: Economics
- Type: Essay
- Paper: #1288566

Difference between FF and Markowitz Portfolio Theory

Fama-French Three Factor Model

Eugene Fama and Kenneth French designed Fama-French three factor model to describe stock returns. Fama -- French model uses three variables. They added two factors to CAPM:

r = RF + ?3 (Km -- Rf) = bs . SMB + bv . HML + ?

r = portfolio's rate of return,

RF = risk-free return rate,

and KM = return of the whole stock market.

Over 90% of the diversified portfolios returns are explained by the Fama-French Three Factor model. It further measures investment returns with academic and mathematic approach. Consequently, the "small cap" stocks and stocks with a high book-to-market ratio provide a more return than the general market. For Fama and French, high returns are a reward for high risk, which means if returns increase with price, stocks with a high price ratio should be more risky (Fama EF., 2005).

Market index weights stocks on the basis of market capitalization, which makes it valuation blind and size-biased. Another factor, momentum is explained due the aforementioned reason. Momentum shows the putting of money. To take advantage of market efficiency, one may tweak index with momentum after starting it.

To explain the performance of portfolios via linear regression, the Fama and French model is used. The other two factors give two extra axes, therefore, the regression lives in fourth dimension.

Total Stock Market Index

r

Small Value Index

Standard Deviation

1.2- Markowitz portfolio theory

Portfolio theory deals with the value and risk of portfolios as against FF model which deals with stock returns. It is often called modern portfolio theory or Markowitz portfolio theory.

In contrast to FF Model, in this theory, the volatility is less than the weighted average of the volatilities of its securities. It does not deal with individual securities. Most importantly, its results are dealing with the construction of efficient portfolios.

In spite of being the description of portfolio risk and return, Markowitz portfolio theory is not universally accepted. This theory analyzes how risks can be reduced and how wealth can be invested in assets as against FF Model which focuses on stock returns. Further FF Model takes risk for high return while MPT reduces risk through diversification.

Modern Portfolio Theory (MPT) assumes that volatility defines the risk. It states that investors are risk adverse i.e. they accept more risk for higher payoffs and lower returns for a less volatile investment.

MPT attempts to maximize return for an amount of portfolio risk, or minimize risk for a level of expected return. MPT defines risk as the standard deviation of return, models a portfolio as a weighted combination of assets so that the return of a portfolio is the weighted combination of the assets' returns, and models an asset's return as a normally distributed function (Markowitz, H.M., 1999).

MPT makes various assumptions about markets and investors. Which are not completely true, but each them have compromise with MPT up to some degree. Further, in MPT, the used correlation, risk, and return measures are based on expected values. These are mathematical statements about the future.

Diversification increases the systematic risk whiling decreasing non-systematic risk.

1- Important facts of FF

2.1- Explanations, Advantages and Disadvantages

The factors SMB and HML mimic risk factors associated with book-to-market and size. SMB, the Small Minus Big is the average return of a long position in portfolios with small stocks and a short position in portfolios with big stocks. HML High Minus Low is the average return of a long position in portfolios with value stocks and a short position in portfolios with growth stocks.

There are as many different kinds of a "factor-based analysis" (FBA) but the well-known and most powerful is the "three-factor model" of Fama and French.

2.2- Advantage/disadvantage

The study found that Fama and French Model has not financial theory support in new variable effect to return rate and risk of both variable that put in CAPM but only found from study that keep the relation of both variable and return rate.

Moreover, the risk in Stock Exchange might have other variable that appropriate or involve more than size effect and value effect.

Furthermore, CAPM has advantage in respect of being general and plain method that is lacking by Fama and French Model as it is difficult in procedure effect to FF Model.

2.2.1- Advantages

2.2.1.1- Reduction of variables

It is the combining of two or more variables into a single factor. Usually, factors are selected by grouping related items.

2.2.1.2- Identification of interrelated variables

It is the knowing of how interrelated are related to each other.

2.2.2- Disadvantages

2.2.2.1- Less valid measures

Factor analysis can only be better as far as the data allows it. When researchers rely on less valid and less reliable measures such as self-reports, this will be a problem.

2.2.2.2- More interpretations

Factor analysis interpretation is based on the use of "heuristic." This is the convenient solution though not absolutely true. As more interpretations may be made of the same data, therefore, the factor analysis will not identify causality (Kosowski R, Timmermann A, Wermers R, White H., 2006).

2- Assumptions

Initially, Fama and French structured their Three-Factor Model on a survey of stocks. They established an orderly model that managed while using regression techniques which managed to define market returns.

According to their assumption, an investor can influence his/her return by three factors:

1. How much stock market exposure to accept

1. The size ranking of the companies bought

1. The book to market ratio

Though Fama and French were able to discover a functional model, but they continue their struggle to identify the hidden risks that may explain the aforementioned anomalies (Fama, EF., 1998).

The abovementioned assumptions are relatively restraining as these contain stocks specific to the three factors. As this model is based on empirical research, therefore, it does not have a great significance with relevance to economic reasoning as well as economists.

3- Why did Markowitz extend the original theory?

Reasons, problem and solution, and its importance

Problems of financial engineering have been there since classical times which date back to Plato. After that, dialogues in the Old and New Testaments also specify these in a disguise.

Most importantly in history, Italian bankers used an intimate relation between money lending and money changing which was collectively known as the Lombards. This system was introduced for avoiding prohibition on charging interest on loans by the church (Dar, H.A., and Presley, J.R., 1999).

Further advances in finance, particularly on the fixed income side, were marked by the rise of the British Empire. Furthermore, the extraordinary growth of the financial system in the United States facilitated the economic growth over there.

In the year 1900, the French mathematician, Louis Bachelier published the now famous memoir entitled "Theorie de la Speculation." Bachelier. This work established the era of modern development of financial engineering. Finally, the mean-variance portfolio selection theory was developed by Markowitz in 1959.

The financial engineering continued to mature rapidly in the 1960s. Subsequently, Sharpe (1964), Lintner (1965), and Mossin (1966) extended the Original Markowitz theory and formulated their Capital Asset Pricing Model (CAPM).

In this regard, in the early 1970s, the most important advance happened when Merton (1973) and Black and Scholes (1973) discovered a consistent pricing formula for stock options. This mentioned formula depends on the volatility of the underlying stock and the riskless interest rate at which the money can be borrowed (Sharpe, W.F., 1964).

The course of investment has been altered overtime by the there have been three significant trends. Firstly, investors increasingly know that at any point in time from the damages of the markets, their retirement portfolios might be exposed to larger-than-acceptable risks. This "point in time" risk became particularly evident in stock prices that occurred between 2000 and 2002 when investors saw the threat to their retirement security.

Secondly, to meet the changing needs of today's investors, the majority of whom are boomers who are approaching their age of retirement, most traditional concepts of investing may no longer be adequate.

Thirdly, the combination of fixed-income securities and equities may not provide adequate diversification. According to many investors, investment in bonds and stocks provides diversification.

But bonds and stocks occasionally move in the identical direction. To enhance investors' returns over the long run is the ultimate goal of a contemporary portfolio theory which is aimed to provide better risk-adjusted absolute returns.

Generally, MPT has used performance measures of bonds and stocks portfolios over single periods as long-only investments with symmetrical return patterns. However, bonds and stocks markets not only move in random ways, but oftentimes move in tandem.

Oftentimes, the diversification benefits of used equity or fixed-income allocation strategies can be halted by this correlation phenomenon.

Markets are fully efficient and prices of securities fully reflect existing information is the core principle of MPT. This principle of MPT recommends that it is difficult for investors to get an informational advantage while selling and buying…