Climate Risk Factor Estimation

How V-Lab calculates the factor exposures shown in climate fund analysis

What This Page Explains

This page describes the methodology V-Lab uses to estimate Fama-French style risk factors for climate fund analysis. The Factor table on climate analysis pages shows Alpha, Beta, SMB, and HML values—this document explains how those values are calculated.

Why Factor Analysis Matters

When analyzing investment performance, we need to separate genuine skill from simple exposure to common market risks. A fund might appear to perform well simply because it holds risky assets that happened to do well, not because of any particular investment insight.

Fama-French factors capture three major sources of stock market risk: overall market movements (Market), differences between small and large companies (SMB), and differences between value and growth stocks (HML). By measuring a fund's exposure to these factors, we can see how much of its return comes from these common risks versus genuine outperformance.

Professor Ken French publishes factor data on his website, but it updates with a lag. V-Lab uses ETF data to calculate similar factors in real-time, providing more timely risk analysis. Ken French Data Library

How the Factors Are Calculated

V-Lab constructs factor returns from five ETFs that together capture the key dimensions of stock market risk. These ETFs span the size spectrum (large-cap vs small-cap) and the style spectrum (value vs growth), allowing us to measure each fund's exposure to these risk dimensions.

ETFs Used

Ticker	ETF Name	Purpose
VTI	Vanguard Total Stock Market ETF	Represents the overall market
IWD	iShares Russell 1000 Value ETF	Large companies, value style
IWF	iShares Russell 1000 Growth ETF	Large companies, growth style
IWN	iShares Russell 2000 Value ETF	Small companies, value style
IWO	iShares Russell 2000 Growth ETF	Small companies, growth style

Factor Construction

Factor	How It's Built
Market	`VTI return − risk-free rate` Captures overall stock market movement. A fund with high market exposure rises and falls with the market.
SMB (Small Minus Big)	`(IWN + IWO) − (IWD + IWF)` Small-cap ETF returns minus large-cap ETF returns. Positive SMB exposure means the fund tilts toward smaller companies.
HML (High Minus Low)	`(IWD + IWN) − (IWF + IWO)` Value ETF returns minus growth ETF returns. Positive HML exposure means the fund tilts toward value stocks; negative means growth tilt.

The Regression

To measure factor exposures, V-Lab regresses each fund's excess return (return minus the risk-free rate) on the three factor returns. This regression finds the combination of factor exposures that best explains the fund's returns:

Regression equation:

$(r_{a} - r_{f}) = α + β \cdot (r_{VTI} - r_{f}) + β_{SMB} \cdot SMB + β_{HML} \cdot HML + ε$

where:

r_{a}

= fund return

r_{f}

= risk-free rate

α

= unexplained return (alpha)

β

= market sensitivity

β_{SMB}

= size factor loading

β_{HML}

= value factor loading

ε

= random variation

The regression estimates four key values: alpha (α), beta (β), SMB loading, and HML loading. These appear in the factor table on each fund's analysis page.

Interpreting the Results

The factor loadings tell you what risks the fund is exposed to. Think of the fund as being built from a blend of these ETF-based factors—the loadings show how much of each factor is in the blend.

Alpha (α)
The return that remains after accounting for all factor exposures. Positive alpha means the fund outperformed what you'd expect given its risk profile. This is the key metric for genuine skill or unique strategy value.
Always check the t-statistic. Alpha is only meaningful if statistically significant (t > 2). Small alpha values could easily be due to chance.
Beta (β)
Sensitivity to overall market movements. A beta of 1.0 means the fund moves in lockstep with the market. Beta above 1.0 means more volatile than the market; below 1.0 means less volatile.
SMB Loading
Exposure to the size factor. Positive SMB means the fund behaves more like small-cap stocks; negative means it behaves more like large-cap stocks. Many climate funds have positive SMB because clean energy companies tend to be smaller.
HML Loading
Exposure to the value/growth factor. Positive HML means the fund behaves like value stocks; negative means it behaves like growth stocks. Climate funds often show negative HML because clean energy and technology companies are typically growth-oriented.

What This Means for Climate Investing

The Fama-French model captures major stock market risks, but it doesn't include climate-specific factors. This is actually useful for climate analysis: if a climate fund shows significant alpha, that unexplained return might reflect climate-related performance that traditional factors don't capture.

For example, if a clean energy fund has positive alpha after controlling for market, size, and growth exposures. This suggests it's capturing something beyond these standard risks, such as a climate factor premium.

V-Lab extends this analysis by also measuring fund exposures to explicit climate factors like the Stranded Assets (SA) benchmark. But understanding the traditional factor exposures first helps separate what's truly climate-related from what's just size or growth exposure in disguise.

Data Sources

ETF returns are obtained from market data providers and updated daily. The risk-free rate is the daily Treasury bill rate. Factor returns are calculated each day from the ETF returns shown above.

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