Understanding Fama/Frenchs' Five Factors - Returns or Excess Returns?

Question

two short questions:

If I download the five factor data from Kenneth French's website (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and for example calculate the average of the SML-portfolio, I get an excess return and not only a return, right?
If I want to prove, that the CAPM is a weak model, I just put the factor portfolios in a figure, where I also put the CAPM-predicted Security Market Line. The Security Market Line goes from the risk free rate on the y-axis through the average market return at beta=1. For the factor portfolios I calculate their CAPM-Betas by doing a regression. But wat is their return? Is their return equal to their excess return oder do I have to add the risk free rate on top of the calculated average excess returns?

python_enthusiast · Accepted Answer · 2017-11-04 11:45:03Z

2

For the first question: you get the excess return of small minus large (SML).

For the second question: if you want to find the average return, you have to add the risk-free rate to the average excess return.

answered Nov 4, 2017 at 11:45

python_enthusiast

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$\begingroup$ And if I want to valuate for example SML using the CAPM, do I regress the return on SML on the return of the market portfolio minus the risk free rate or do I regress the return on SML minus the risk free rate on the market portfolio minus the risk-free rate? $\endgroup$
– known user
Nov 5, 2017 at 17:18
$\begingroup$ The way the model goes is the following: (R_i - r_f) = a + b1*SML +b2(R_m-r_f) +b3*HML, where SML is the excess return that small companies have over large ones, HML is the excess return that high book-to-market ratio companies have over low book-to-market ratio companies and (R_i-r_f) is the excess return over the risk-free rate (m here is the market porfolio and i is the company you are studying). $\endgroup$
– python_enthusiast
Nov 5, 2017 at 19:44

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