I'm reading into Fama-French 3- and 5-factor models. I notice that they use the returns from market portfolios to "predict" stock excess returns. But obviously we cannot know ahead of time the returns from these market portfolios, and the returns from the market portfolios already incorporate the returns from individual stocks. By the time we know the returns for those market portfolios, we'll also know the returns for all the stocks. So what's good are these models? It seems to me that the proper use of them is to explain returns, rather than predict, which means one cannot use them to trade, no?

  • $\begingroup$ The FF model generates an expected rate of return based on past data and this is then compared to the actual return in a later period in the empirical test. So it is indeed a predictive model. $\endgroup$ – Alex C Oct 15 '19 at 18:35
  • $\begingroup$ Right, but how do we calculate all those market portfolio returns? We need them to generate the expected excess returns. But then how can we know the market returns ahead of time? It seems to me FF model is for evaluate fund managers only, to see are they really creating alphas or are simply riding the market. $\endgroup$ – TimD Oct 15 '19 at 18:40
  • $\begingroup$ OK, I see your point. FF models cannot be used for trading (which would require prediction of return for a future day, week, month, etc). However they can be used for "factor investing" i.e. to build (long-only) portfolios that will have exposure to SMB, HML, etc. and good long term performance iff the impressive past performance of those factors continues in the future. It is a form of "riding the market" but different from traditional indexing. "Riding the market" cheaply and intelligently is not a bad thing IMHO. Several big firms do this. $\endgroup$ – Alex C Oct 16 '19 at 16:33

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