High Minus Low (HML), often referred to as the value premium, is a financial metric used in the Fama-French three-factor model to explain stock returns. The model, which expands on the traditional Capital Asset Pricing Model (CAPM), includes three factors: market risk (market excess return), size (small minus big, SMB), and value (high minus low, HML).
HML represents the difference in returns between value stocks, typically characterized by high book-to-market ratios, and growth stocks, usually having low book-to-market ratios. The metric captures the premium investors receive for holding value stocks over growth stocks.
Historical Context of HML
The Development of the Fama-French Three-Factor Model
The Fama-French three-factor model was developed by Eugene Fama and Kenneth French in the early 1990s. The model was introduced to address empirical anomalies that could not be explained by the CAPM. By incorporating HML, Fama and French provided a more comprehensive framework for understanding stock returns.
The Evolution of Value Investing
Value investing has its roots in the early 20th century, with notable proponents like Benjamin Graham and later Warren Buffett. The advent of HML provided an empirical measure to gauge the performance of value stocks systematically.
Calculation of HML
HML is calculated by subtracting the returns of growth stocks from the returns of value stocks. The formula can be expressed as:
To quantify HML, stocks are typically sorted into high and low book-to-market ratio portfolios, and the return difference between these portfolios is computed.
Applications in Finance
Portfolio Management
HML is a critical factor for portfolio managers who employ the Fama-French model to construct more diversified and risk-adjusted portfolios. By considering HML along with market risk and size, managers can better anticipate returns and adjust asset allocations.
Risk Assessment and Performance Evaluation
Investors use HML to assess the risk factors associated with their investments. A deeper understanding of the value premium helps in evaluating past performance and predicting future returns.
Academic Research
HML has extensive applications in academic research, where it is used to analyze market anomalies, improve asset pricing models, and study the behavior of value versus growth investing strategies.
Examples of HML in Practice
To illustrate the concept of HML, consider two portfolios: one consisting of high book-to-market (value) stocks and another comprising low book-to-market (growth) stocks. If the value portfolio yields an average return of 8% per year, while the growth portfolio returns 5%, the HML factor would be:
This 3% represents the value premium investors can expect from holding value stocks over growth stocks.
Comparisons and Related Terms
Size Premium (SMB)
While HML focuses on the value premium, the size premium (small minus big, SMB) captures the return difference between small-cap and large-cap stocks. Both are crucial components of the Fama-French model.
Capital Asset Pricing Model (CAPM)
The CAPM is an earlier model that explains stock returns based on market risk alone. The Fama-French model, with HML and SMB, offers an expanded view, addressing limitations in CAPM.
FAQs
1. Is HML relevant in all market conditions? HML tends to be more prominent in certain market cycles, particularly when value stocks outperform growth stocks. However, its relevance may diminish in different economic climates.
2. Can individual investors use HML for stock selection? While HML is primarily used by institutional investors and academics, individual investors can incorporate the concept into their investment strategies, especially for value investing.
3. How has the value premium performed historically? Historically, the value premium has provided a positive return, although its magnitude and consistency can vary over different periods.
References
- Fama, E. F., & French, K. R. (1993). “Common risk factors in the returns on stocks and bonds”. Journal of Financial Economics.
- Graham, B. (1949). “The Intelligent Investor”. Harper & Brothers.
- Buffett, W. (1984). “The Superinvestors of Graham-and-Doddsville”. Hermes: The Columbia Business School Magazine.
Summary
High Minus Low (HML) is a pivotal factor in the Fama-French three-factor model, providing insights into the value premium in stock returns. It differentiates the performance of value stocks from growth stocks and is vital for portfolio management, risk assessment, and academic research. Understanding HML enables better investment decisions and offers a more comprehensive approach to evaluating financial markets.
