Factor models explain the returns of an asset through its exposure to different risk factors. This approach allows us to decompose portfolio performance and identify sources of alpha and beta.
While the Capital Asset Pricing Model (CAPM) considers only market risk (Beta), empirical evidence shows that other factors also drive returns.
The general movement of the stock market.
Small-cap stocks tend to outperform large-cap stocks over time.
Value stocks (high B/P) tend to outperform growth stocks.
The 5-factor model expands the original 3-factor model by adding Profitability and Investment factors to better capture the cross-section of expected returns.
We use these models to ensure our portfolio isn't accidentally over-exposed to a single risk factor and to verify if the "Alpha" we generate is truly independent of known market anomalies.