|Fama and French: Three Factor Model|
In 1992, Eugene F. Fama of the University of Chicago and Kenneth R. French of Yale University developed a three-factor model, adding two fundamental factors to better describe the differences in the returns among stock asset classes over time.
|Spam-a and French's: Three Slice Lunch|
They concluded that exposure to three risk factors in their fancy model — i.e., market, size, and price (book-to-market) — together could explain about 90% of the variability of returns of diversified portfolios. Can anyone explain why there are fancy Dijon mustards and no fancy Dijon ketchups?
Fama and French showed how much of average annual returns each of the three factors explained. Over 85 years, the size factor (the difference between small and large stocks) and the value factor (book value to market value) explained as much as the market factor (exposure to equities minus T-bills). See bar chart at left.
Comparing some individual stocks you can see how value pays off. I love this comparison of a growth stock like Motorola (MSI on the NYSE) and the value stock for makers of SPAM, Hormel Foods Corporation (HRL on the NYSE). Over 25 years, Motorola is up over 1000%, while Hormel Foods is up over 10,000%.
You can take advantage of the three factor model in your investing. Dimensional Fund Advisor funds tap into the Fama and French investing philosophy and previously were available to high-net-worth clients through a small group of fee-only advisors. Alternatively, ETF portfolios have been developed to also match the Fama and French philosophy - the model ETF portfolio below has a weighted MER of 0.36% and assumes 60% equities and 40% fixed income.
Asset class Allocation Exchange-traded fund MER
Canadian core equity 12% Claymore Canadian Fundamental (CRQ) 0.68%
Canadian small-cap equity 8% iShares S&P/TSX Small Cap (XCS) 0.55%
U.S. core equity 8% PowerShares FTSE RAFI US 1000 (PRF) 0.46%
U.S. value equity 4% Vanguard Value (VTV) 0.14%
U.S. small-cap equity 4% Vanguard Small-Cap (VB) 0.14%
International core equity 8% Vanguard Europe Pacific (VEA) 0.15%
International value equity 4% iShares MSCI EAFE Value (EFV) 0.40%
International small-cap equity 4% Vanguard FTSE All-World ex-US Small-Cap (VSS) 0.40%
Emerging markets equity 4% Vanguard Emerging Markets (VWO) 0.27%
Global real estate 4% Claymore Global Real Estate (CGR) 0.70%
Short-term bonds 40% iShares DEX Short Term Bond (XSB) 0.25%
You can hold the Dimensional Fund Advisor Mutual Funds at Questrade. If you do, you can also minimize adviser fees by reclaiming up to 0.9% of the trailer fee with their Mutual Fund Maximizer Rebate. The rebates kick in after a monthly processing fee is reached (capped at $29.95 per month). Questrade has Dimensional funds available including:
- DFA US Value
- DFA US Small Cap
- DFA International Value
- DFA International Small Cap
- DFA 5-Year Global Fixed Income
- DFA Canadian Core Equity
- DFA International Core Equity
- DFA US Core Equity
- DFA Global Real Estate Securities
Get creative and you can mix and match Dimensional mutual funds and ETFs - you can buy the ETFs for fee at Questrade and benefit from the trailer rebate. Advisors have developed model portfolios using this approach (they charge a minimum of 1% on top of the MER, but their fees can be tax-deductible on non-registered investments). Below are suggested weightings of DFA funds and ETFs from Vanguard if you want to put the portfolio together your self based on your risk profile.