How to calculate 3-factor (Fama-French) and 1-factor (CAPM) alpha

/How to calculate 3-factor (Fama-French) and 1-factor (CAPM) alpha

How to calculate 3-factor (Fama-French) and 1-factor (CAPM) alpha

By | 2017-08-18T17:03:27+00:00 October 6th, 2014|Value Investing Research, Investor Education|4 Comments

We’ve had a few questions related to 3-Factor Fama-French and 1-Factor (CAPM) alpha calculations recently (maybe it is midterm season?)

We’re here to help!

Below is a an old video (note the TurnkeyAnalyst reference) I put together that describes how to calculate alpha:

http://youtu.be/mrfWCUKX1Qw



Here is the source excel file for the video tutorial:

how to calculate alpha

Our old post on the subject is at the following:

http://www.alphaarchitect.com/blog/2012/01/12/alphacalculation/

Note: Here is an epic post on the history of factor investing that might help students generate a better understanding of factor models.


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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • Alex

    Thank you for the video. I do have a question: what order should one regress the dependent variable on the independent variable given that there are more than one dependent variables? For example, in the video you did the price to cash flow variable (PCF) after you already had the Fama-French SMB and HML variables. What difference would it make if you did the PCF variable first, and then SMB and HML? Thank you

  • There can only be 1 dependent variable–strategy X or strategy Y, etc. In the video we looked at p/cf as the ‘strategy’ we were trying to assess. We then regress this strategy on the independent variables, which try and control for various risk factors (beta, value, size, etc). The intercept term represents the “alpha”
    Does that make sense? or just more confusion?

  • Alex

    Thank you. That means if I did a multi-factor regression, I can always have multiple independent variables but only one dependent variable, correct? That means the order of my independent variables is not relevant

  • Jack Vogel, PhD

    That is correct, you can have multiple independent variables but only one dependent variable. The order of the independent variables does not affect the alpha, but will affect the betas (you will get the same beta coefficients, just in a different order).