High Minus Low (HML): Definition and Uses in Finance

Published

Mon, 2023-Dec-04 05:59:30

File Photo: High Minus Low (HML) File Photo: High Minus Low (HML)

What Is High Minus Low (HML)?

The value premium, or High Minus Low (HML), is one of three components in the Fama-French model. Economic analysts Eugene Fama and Kenneth French created the three-factor model for stock returns. HML explains the value-growth-return gap. This method claims that value equities beat growth stocks due to their high book-to-market ratios.

Knowing High Minus Low

HML requires knowledge of the Fama-French three-factor model. In 1992, Eugene Fama and Kenneth French created the Fama-French three-factor model, which includes HML, to explain excess returns in a manager’s portfolio.

The model assumes that portfolio managers’ returns are partly attributable to external variables. Over time, value stocks have beaten growth equities and smaller firms have outperformed larger ones.

The typical outperformance of small and value stocks over large or growth-oriented ones explains most portfolio performance.

The first element, value stock outperformance, is HML, while the second, more minor company outperformance, is SMB. The model’s user may measure the manager’s competency by estimating how much of their performance is due to these elements.

The model reveals if managers use the value premium to gain abnormal returns by investing in equities with high book-to-market ratios (HML factor). If the manager buys solely value stocks, the model regression indicates a positive link to the HML component, indicating that the value premium drives portfolio performance. The model explains more of the portfolio’s performance, reducing the manager’s excess return.

Five-Factor Model by Fama and French

Fama and French added five features to their model in 2014. Along with the original three, the new model includes profitability, the idea that firms with more considerable future earnings have better stock market returns. Investment, the fifth component, refers to the company’s internal investment and returns. Companies that actively invest in expansion projects may underperform.

HML Finance FAQs

Why is Fama French better than CAPM?

The Fama-French three-factor model expands on the CAPM for asset pricing. To overcome CAPM’s shortcomings, Eugene Fama and Kenneth French created the Fama and French Three-Factor Model.1A 2012 study found that the Fama and French Three-Factor Model better explains projected returns than CAPM. This study uses the CAPM, Fama, and French Three-Factor Model to estimate the returns of an NYSE portfolio. However, portfolio construction affected the results, according to the study.

What is the meaning of HML Beta?

High Minus Low (HML) is a value premium that compares returns for firms with high and low book-to-market value ratios. Linear regression can get the beta coefficient from the HML component. The HML beta coefficient might be positive or negative. A portfolio with a positive beta is positively associated with the value premium or acts similarly to one with value stock exposure. A negative beta makes your portfolio act like a growth stock portfolio.

Conclusion

HML, often known as the value premium, is one of three components in the Fama-French three-factor model.
Economic analysts Eugene Fama and Kenneth French created the three-factor model for stock returns.
This method claims that value equities beat growth stocks due to their high book-to-market ratios.
Along with Small Minus Big (SMB), High Minus Low (HML) estimates portfolio managers’ excess returns.
The typical outperformance of small and value stocks over large or growth-oriented ones explains most portfolio performance.

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