For decades, investors sought to explain why some stocks consistently outperform others. Enter the Fama and French Three Factor Model—a landmark framework that’s still reshaping investment strategies around the world, including right here in Australia. If you’re seeking a smarter, evidence-based way to build your portfolio in 2025, understanding this model is crucial.
What is the Fama and French Three Factor Model?
Developed by Nobel laureate Eugene Fama and economist Kenneth French in the early 1990s, this model moves beyond the traditional Capital Asset Pricing Model (CAPM) by adding two additional factors. Instead of just looking at market risk, it considers the effects of company size and value characteristics. The three factors are:
- Market Risk (Beta): The return of the overall market versus risk-free assets.
- Size (SMB – Small Minus Big): The tendency for smaller companies to outperform larger ones over time.
- Value (HML – High Minus Low): The premium earned by investing in companies with high book-to-market ratios (“value” stocks) compared to those with low ratios (“growth” stocks).
This expanded view helps explain variations in stock returns that CAPM often misses, providing a more nuanced picture of what drives performance.
Why the Model Matters for Australian Investors in 2025
Fast forward to today—Australian investors are facing an environment defined by volatility, higher interest rates, and increased focus on data-driven decisions. In 2025, the Fama and French model is more relevant than ever. Here’s why:
- Evidence-Based Investing: Many leading Australian super funds and wealth managers are now using factor-based investing, inspired by Fama and French, to build robust portfolios that aim to outperform traditional benchmarks.
- Policy Updates: APRA’s 2025 reforms encourage greater portfolio transparency. As a result, fund disclosures now often include factor exposures, making it easier for retail investors to see how much of their returns come from size and value tilts.
- ETF Proliferation: The ASX has seen a surge in factor-based ETFs, allowing everyday Australians to target the size and value premiums with low-cost, diversified vehicles.
For example, Vanguard and BetaShares have launched Australian equity ETFs specifically designed to capture small cap and value factors, reflecting Fama and French’s insights in accessible products.
How to Apply the Model in Your Investment Strategy
Understanding the three factors isn’t just academic—it can help you make practical decisions:
- Diversify Beyond Market Beta: Don’t rely solely on broad index funds. Consider adding small cap and value-focused exposures to potentially enhance returns.
- Assess Fund Managers and ETFs: Use factor analysis tools (increasingly available via platforms like Sharesight or Morningstar Australia) to see if your chosen funds are delivering genuine size or value exposure—or just charging higher fees for market-like returns.
- Monitor Performance Cycles: Be aware that factor premiums can be cyclical. For instance, value stocks lagged during the tech boom but surged during the post-pandemic recovery. Staying patient and diversified is key.
Real-world example: In 2023-2024, Australian small cap value stocks rebounded sharply after a prolonged slump, rewarding investors who stuck with the factors identified by Fama and French. This cycle underscores the importance of long-term discipline when pursuing a factor-based strategy.
Critiques and the Evolving Factor Landscape
No model is perfect. Critics point out that the size and value premiums can disappear for years, and that newer factors—like profitability and investment—have since been proposed (including by Fama and French themselves in their later five-factor model). However, the original three-factor framework remains the bedrock for modern portfolio construction.
For Australians, the message is clear: while past performance isn’t guaranteed, integrating proven factors into your investment approach can boost your odds of long-term success—especially as policy and technology make these strategies more accessible than ever.
