NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesHard
An investment adviser is evaluating a client's portfolio performance using the Fama-French Three-Factor Model. The model suggests that a significant portion of the portfolio's excess returns can be attributed to exposure to small-cap stocks and value stocks. Which of the following is the MOST accurate interpretation of this finding?
- AThe portfolio has a high beta, indicating strong correlation with the overall market.
- BThe portfolio manager possesses superior market timing ability.
- CThe portfolio's returns are explained by systematic risk factors, specifically size and value premiums.
- DThe portfolio exhibits a high level of unsystematic risk, requiring further diversification.
Show answer & explanationAnswer & explanation
Correct answer: C. The portfolio's returns are explained by systematic risk factors, specifically size and value premiums.
The Fama-French Three-Factor Model explains returns based on market risk (beta), size (small-cap premium), and value (value premium). If excess returns are attributed to small-cap and value stocks, it indicates these systematic factors are driving performance, not necessarily market timing or unsystematic risk.
Why the other options are wrong
- A. While beta is a factor in the model, the attribution to small-cap and value specifically refers to the size (SMB) and value (HML) factors, not just overall market correlation.
- B. The Fama-French model attributes returns to specific risk factors, not market timing ability.
- D. Unsystematic risk is firm-specific risk, not explained by broad market factors like size or value premiums; these are systematic factors.
Fama-French Three-Factor Model
An asset pricing model that expands on the Capital Asset Pricing Model (CAPM) by adding size risk (SMB) and value risk (HML) factors to the market risk factor (beta) to explain stock returns.
- SMB (Small Minus Big): accounts for the historical outperformance of small-cap stocks.
- HML (High Minus Low): accounts for the historical outperformance of value stocks (high book-to-market ratio).
- Aims to explain a greater proportion of portfolio returns than CAPM alone.
Memory trick: Fama-French: Market, Small, Value – a triple threat.