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Bogleheads on Investing Dr. Wes Gray – Episode 9

Post on: May 30, 2019 by Rick Ferri

Dr. Wesley R. "Wes" Gray is our guest in Episode nine, and our focus is on "factor" investing. Dr. Gray is the CEO of Alpha Architect, an author, portfolio manager, United States Marine, Iraq War vet, and a former professor of finance at Drexel University. He earned an MBA and a Ph.D. in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country.

You can discuss this podcast in the Bogleheads forum here.

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Rick Ferri: Welcome to Bogleheads on Investing podcast, episode number nine. In this episode I’ll be speaking with Dr. Wesley Gray, CEO of Alpha Architect, where he and his colleagues are breaking new ground, and the author of three books on quantitative investing.


Rick Ferri: Hi everyone. My name is Rick Ferri, and this is Bogleheads on Investing. This episode is sponsored by the John C. Bogle Center for Financial Literacy, a 501(c)(3) corporation. Today we’re speaking with Dr. Wesley Gray.

After serving in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago, where he studied under Nobel Prize winner Eugene Fama. He then took a job in academia before starting his investment management company, where he is on the cutting edge of new insights into factor investing. With no further ado, let’s bring in Dr. Wesley Gray.

Welcome to the show. How are you today?

Wesley Gray: I’m great Rick. I appreciate you bringing me on.

Rick Ferri: You very much impressed me the very first time I, I learned about you, and I talked with you. The stuff you’re working on is cutting edge. I really believe that you are the new jedi out there in the quant world. Before we get into what you’re currently doing now, I want to start at the beginning. Where did you go to get your undergraduate degree?

 Wesley Gray: I went to undergrad at University of Pennsylvania at the Wharton School. So I kind of started off with uber finance geek undergrad, and kind of my first way I parlayed myself into academic research is, I walked into this gentleman’s office named Chris Gates, who now writes a lot of papers on the 200 year history and momentum or relative strength or value or what have you. And I just said, “I love this stuff. Can you teach me how to be a professor?” And he basically said, “Hey, see that shelf right there, grab these ten books and read them and come back in two weeks and let’s talk.” That was my initial starting to geeking out and getting into academic research and moving along my initial path, which was to be a finance professor.

Rick Ferri: But there was also another side to you. You had this idea that perhaps you could figure out ways of outperforming the market?

Wesley Gray: Well, yeah, kind of simultaneous to deciding I wanted to be a finance professor, I was also trading my own money doing a lot of investing. I was there from 98 – 2002. And so that was obviously during the internet bubble. And so I had this exposure where I come off, you know, reading every book, everything I could get my hands on related to Ben Graham and Warren Buffett and the value investment philosophy. You know, pets.com’s going up 1,000% a day.  My dad’s telling me to go buy the Janus Global Tech Fund, and I’m sitting here, like, I’m a, I’m a value by nature person, and I’m watching these markets, thinking they’re crazy, I’m obviously trading in value names getting destroyed, but then on the other side of my life, I’m like, Hey, I just, you know, actually like this. And, I was like, hey, I want to study this forever. So it was kind of a weird barbell in the sense that I was sitting there trading stocks and then on the other hand, I was reading stochastic calculus books, just trying to get baselines, essentially to be a research assistant for Gates. And so what happened is, I kept doing all the investment stuff, kept doing my stock picking, and then I started, essentially I became for the Wharton finance department, I don’t want to use the computer monkey, I was like the data monkey, so if someone needed to have something coded up in MATLAB, that was my job. So like I kind of became like a little mini workhorse for the department. So like fast for a couple years, and seeing all these guys are also, by the way, Chicago PhDs, because for whatever reason Chicago tends to feed the Wharton faculty, and Chris Gates he is like, hey, you’re going to apply to Chicago, and that’s it. I was like, well, aren’t there other schools like, should I consider other PhD programs and he’s like no you got to go to Chicago. They’re like, we’ll get you in. And I’m like, Okay, how does that work? They’re like take all your tests and do all your stuff and we’ll write your recommendation letters.

And then, so sure enough, I applied to University of Chicago PhD program, just straight out of undergrad which is also not normal because typically you go get a masters or what have you. But I had a lot of kind of close holes in the department that were writing letters for me. In PhD programs, they only accept a handful of people every year. So it’s a much more kind of one-off deal. It’s not like applying to an MBA program. Long story short, I got in, like, wow, I guess I’m going to actually do this. Essentially entered the program in 2002. The Chicago School at the time, and it still is, to a certain extent, it’s just, we’re going to take you in, and we’re just going to beat you up, like you are going to get destroyed in problem sets, workload, and let’s just see if you survive. And so the first two years are just literally I was studying like 15 hours a day, seven days a week just trying to stay above water, because I came in obviously, without having a lot of experience or grad school or what have you. So it’s actually pretty difficult but I made it. And after the first two years there, I don’t say I was burned out, but I was 24, I’d been slaving away doing quant academic geek stuff forever. And I just thought, hey, I need to maybe take a break or do something else.

Rick Ferri: So you, you really did do something else, I would say that what you did was quite radical. And of course, I’m proud of you for it.

Wesley Gray: So what I did is I decided that I was going to join the Marine Corps, which you’re an alumnus of. And it certainly seems radical. But what was super interesting at the time, is I would say good 20 to 30% of the Chicago finance PhD program were actually former military officers, a lot of them from Israel or Finland, or what have you. So they were all like, “Oh, yeah, of course you should do that.” Whereas many people outside are like, “But you must be the first time anyone’s ever done that”. But it was super interesting, inside the program, like my other fellow PhD Mates were like hey, that’s, that’s pretty cool. And so yeah, I went down to Professor Fama, and at the time Professor Thaler who, which is crazy, it has these two Nobel Prize winners were actually like the, you know, it wasn’t my dissertation, but are my curriculum paper advisors. And I just had to ask them permission to get a four year sabbatical. And Professor Fama was actually like, super cool about it. He’s just like, “Oh, that’s awesome, like, proud of you.” Yeah, happy to sign, you know, didn’t even think twice about it. And then professor Thaler, he was more curious. He was definitely like, “You’re going to what?” But eventually, I got both those gentlemen to sign off and then submitted it to the PhD program coordinator and took a four year sabbatical.Rick Ferri: That’s amazing that you could actually do that take four years off.

Rick Ferri: That’s amazing that you could actually do that take four years off.

Wesley Gray: Well, you so you can’t, you can take technically one year off. And so that’s the reason I had to go and have them sign off on this special kind of extended sabbatical. Because it was a unique circumstance where most people don’t go on sabbatical to do service, the PC program director kind of agreed, like, “Hey, this is a unique circumstance, as long as you get your advisors to sign off on it we’re cool with it.” And so I had to do a few extra hoops to jump through to actually make it happen.

Rick Ferri: Well, that’s great. And then you went down to Quantico and went through Officer Candidate School.

Wesley Gray: Yep. So then I went to OCS, which is Officer Candidate School, then went to TBS, The Basic School, and then my MOS was a ground intelligence officer. You go through your job officer course you kind of do everything that the interim officers do, and then they go pick up their platoons, whereas ground intelligence officers then go down to Dam Neck and do another six months of intelligence officer training, and then you go hit the fleet. So it’s the longest pipeline, besides, you know, helo and fixed wing people. But it’s about a year and a half, almost two years of training pipeline.

Rick Ferri: And from there they shipped you off to… Okinawa.

Wesley Gray: I went right to Okinawa and then right when I was in Okinawa, they sent me down to one of the islands in Japan, and did a bunch of like, joint training missions with them, spent about a month there. And then I got sent directly down to the Philippines. And at the time, this was, I think, was 2004 – 2005. That we were, there’s a bunch of activity going on on this island called Holo, which is a bunch of Muslim extremists and what have you. But then there was this thing called the Leyte Mudslide disaster and a coup.

So I started in the Philippines, you know, going crazy for a couple of months there. And then right when I got back to Okinawa, which I was assigned there, but I rarely ever hung out there for like maybe a day or two, the colonel calls me in the office and he basically says, “Hey, you’re going to Hawaii.” And I was like, “All right, what am I going to Hawaii?” Like, they’re like, “Oh, you’re on a MiTT team, a military transition training team, and you’re going to get deployed to Iraq.” So then I went out to Hawaii, did a big workup. And then yeah, then we deployed out, I was on one of the training teams–where you embed with Iraqis–and try to help them avoid shooting themselves in the foot.

Rick Ferri: In fact you wrote an entire book about your experience working with the Iraqis. The name of the book was called Embedded. And it was a fascinating insight into what was going on.

Wesley Gray: Yeah, so I kind of went into the service. I didn’t join the service because I want to go to war, per se. I just, I just wanted to do my time. But I’m certainly under the belief when you probably remember but Colin Powell showed that little powder of, that white powder and said, “Hey, we’re all going to die.” Kind of believe that. I was like, all right, we probably need to do something here.

Fast forward. Now I’m actually deployed, living in an Iraqi battalion, training up these Iraqi soldiers to kind of take over their defense duties. And I really got an opportunity to actually live with these people, eat with these people, talk with these people and kind of get a better insight to the culture and kind of how they operate. And that experience, honestly, just floored me and I took a whole 180 right, I said, I don’t know what we’re doing here. This is crazy. Like, I was not expecting this, these people are tribal, they’re totally different. Like, what we’re trying to achieve here does not jive at all with their society.

I need to tell the story because there’s probably a lot of guys like me that you know, “rah, rah, let’s go to war,” and they don’t realize it. So I just got inspired like, I’ve got to share the story. So I had to just read a whole book basically about my time being embedded with the Iraqis and just trying to explain like their cultural nuance, and why what we were trying to do, like bring freedom and democracy to their society just seemed like, you know, maybe it wasn’t a great idea. That’s pretty much what that that book was about, just sharing my experiences there, which were highly enlightening to me and I just wanted to make sure other people got to really experience it through at least my book, even if they can’t be there themselves.

Rick Ferri: I understand that you speak Arabic and that you taught yourself.

Wesley Gray: I did. So I mean, I could probably converse in it as if I got warmed up. But yeah, so I was the intelligence officer and the more I read beforehand, because I knew we were going to war in these areas that like, you know, speaking Arabic, like the actual language there is it means a heck of a lot more because it’s associated with the religion, you know, because it’s, you know, from a lot, so, you know, it’s kind of a big deal. So the more, if you want to win in those sort of culture wars, you got to really, you know, establish bonds with the people you’re working with. And so learning the language is, I thought, was a main effort.

So yeah, I just put a ton of time up front to train extremely hard both on learning how to kill people and everything, but also how to learn this language. And then when I got there, I just forced myself to literally embed with the people and not use a terp [interpreter]. And then if you sit there long enough and get tired of using hand signals and not understand each other, eventually you can start maneuvering.

So yeah, I got to a point where I actually served as a terp for our team, and we were going on convoys, and I would be the terp to interface between our team and the Iraqis. Yes, and I definitely highly recommend, if anyone has to do that mission ever again to spend way more time learning the language and lot less on tactics per se, because it gives you a lot more, let’s say, with what the Iraqis called wasta, like, you know, kind of karma and the ability to interact with them and have them actually listen to you. If you actually know their language.

Rick Ferri: That’s fascinating. Well, you did that. Did you stay for four years?

Wesley Gray: Yep, did my, did the four year active duty.

Rick Ferri: And then after that, you went back to the University of Chicago

Wesley Gray: Got out when it was, like, early 2008, and then I just I, my mind well, you know, being in service is just obviously, way different than being in a PhD program at University Chicago, so I got out.

Rick Ferri: Just slightly.

Wesley Gray: Yeah, yeah, kind of like 180 and so literally, for the first three months, I just had to relearn everything because my curriculum paper had a bunch of math in it. And honestly, I couldn’t even read my own paper. I was like, I don’t even know what this person is talking about. But it was me so I just I just put the basics I’m like, hey, here, I gotta relearn calculus, all this stuff. And it is true that it is like, you know, riding a bike where if you know how to do it, if you just get you know, back into it, you do quickly learn. So, yeah, re-entered the program, moved back to Chicago. And you know, I was in much more like, it was in discipline mode versus a lot of my, you know, comrades there at the PhD program who were in students because I’d kind of come out with a new look on life. So I was like, I’m getting out of here in two years. And because usually you don’t get out of the PC program and in a collective four years, usually it’s five, six years, but I just didn’t want to mess around. So I spent three months relearning everything, and then I immediately went to work on dissertation. So yeah, and that, because my goal was I need to get out of this place by 2010 or my wife’s, she’s not going to be happy living on a ramen noodle salary for longer than that.

Rick Ferri: And who was your mentor on your dissertation?

Wesley Gray: So I went back to my old curriculum paper advisors, and it was Thaler and Fama were the top two and then another gentleman, Andrea Frazzini, who’s also famous now but he actually left and went to AQR. So when I came back basically Frazinni’s already gone to go be a, you know, millionaire over AQR. Thaler’s gotten too famous, so he obviously wasn’t going to mess with PhD students anymore. So really who I was left with was Fama because he was the only link in the chain that hadn’t been broken. So I essentially went to him and he was kind of like, you know, my core advisor and then another gentleman, Stavros Panageas, he helped me a lot because I had a theory paper as well as part of my dissertation. Pietro Vironesi, was another one, so I had a handful of them. But I’d say the most influential, and obviously the one who had the most experience in empirical asset pricing work was obviously Professor Fama. So he was kind of the one that hazed me the most I would say in the dissertation writing stage.

Rick Ferri: Your paper, if I’m not mistaken was about active management.

Wesley Gray: Yeah, so you know, being a marine and probably a little hard headed, I came back and I’d always been like I was telling your before a stock picker, specifically a big believer in value investing, in value investing stock picking. And so what I decided was, I want to highlight to Professor Fama that, you know, active stock picking can add value, because this whole efficient market thing seems a little too crazy to me.

Rick Ferri: So you’re going to tell Eugene Fama, the future Nobel laureate, that he was wrong?

Wesley Gray: Is at least out that was my going in. And so what I did is like, well, how am I going to highlight this? Well, it turns out that there’s this organization called Value Investors Club, where a bunch of super sophisticated stock pickers, a lot of them associated with hedge funds, they would submit huge theses on basically stock pitches, right so you know, Best Buy’s under valued, there’s my DCF, here’s the hundred reasons why.

And so what I thought is like, hey, I’ve been following this club since 2000, I’m a member of this club. You know, I think they add a lot of value, they seem to have really good ideas. I’m going to read every single one of these stock pitches, systematically enter them into a database and do the quant analysis on it to then assess, hey, do these people actually add value or have quote unquote alpha? Long story short, they do, at the margin. And so I submitted this as part of my dissertation, and somehow by the grace of God, you know, Fama agreed with the analysis; he had some quibbles on, you know, takeaways, but at least at the margin, I highlighted that there is some segment of the market where active stock picking might work at the margin. So that was a small victory for me.

Rick Ferri: How did you meet up with Jack Vogel, who you ultimately became partners with Alpha Architect?

Wesley Gray: Sure. So what happened is when I graduated from the program there, I went on the academic professor market. And also my wife was going on the academic market — she’s a PhD in history, which is a way less, I’d say, marketable profession than being a finance professor — so I went out to market and my wife’s from Philly, and she needed a job as a history professor. And I ran into Drexel, who gave me what they call an exploding offer. So they gave me this offer I couldn’t refuse. They gave me three days to decide on it. They say, “hey, come to Philly, your wife’s from here, we’ll get her a job. And we’ll give you the best gig ever. And we’ll assign you a PhD student who will do all your dirty work.” So I was like, “Okay, well sign me up.” You know, What are you going to do?  How often have you got to twist my arm?

So I entered Drexel, and then part of my package was having a dedicated research assistant, and that happened to be Jack Vogel. So just by circumstance and a lot of great luck, you know, I just had a gentleman who was you know, insanely smart, extremely well, or extremely good at computer programming and doing all this data analysis and we just hit it off immediately. So we’ve been working ever since you know 2010 when I took that job. 

Rick Ferri: So the way I understood it was you know, Jack had read your dissertation and he said, “Yeah, all this is great. These people have alpha, they’re outperforming the market but I can replicate that using a computer.” So are they really outperforming the market? Can you tell me about that?

Wesley Gray: Well, yeah, so so that was that was an insight that that that actually I had before I met Jack and kind of the takeaway from, well the interesting take away from the dissertation was I catalog all this data on these individual stock pickers and it’s sure enough they had alpha relative to you know, Fama, French, Miles, what have you, but essentially what they were doing for all intents and purposes was small cap value investing in certain element of concentration because there’s only so many ideas that they would produce. It’s not like you go buy 500 names at a time. So there’d usually be like five or six ideas a month, sometimes 10. So on a rolling basis, this portfolio would have anywhere from 50 to 100 stocks. So essentially what they were doing from a quant perspective is buying smaller stocks, they were super cheap, generally higher quality and doing it in somewhat concentrated fashion.

And sure enough, you could also just have a computer essentially do the same idea, right, concentrated, small, cheap, quality. And lo and behold, it basically replicates what all these stock pickers were doing, which was certainly, well it was kind of disheartening because at the time I was still kind of believing in stock picking because I was still being a stock picker. But that kind of analysis there proved to me, why am I banging my head against the wall so hard to do these dissertations on these stocks when you can essentially replicate a lot of the core ideas with just using an algorithm. And so that was really kind of the straw that broke the camel’s back as they say, that moved me much more heavy into just pure quant and less into, you know, thinking I was going to be Warren Buffett, I think the proof was in the numbers.

Rick Ferri: And Jack Vogel, your research assistant was doing a dissertation similar to that?

Wesley Gray: So Jack’s dissertation was a little bit different. So what he looked at is there’s a huge argument over whether value investing which defined in academic terms just means buying cheap stocks, right, on book to market or price earnings or what have you. He was looking into the argument, is this a risk based phenomenon? Or is this a behavioral based phenomenon? Where, just to explain the two ideas simply, the risk based hypothesis essentially says that the reason cheap stocks earn higher returns is because cheapness is a proxy for fundamental risk. So the reason you’re getting paid more on average is because these stocks are just fundamentally riskier. The behavioral argument, which is on the other side of the coin, is like, no, it’s not because the stocks are riskier; it’s because the market generally throws the baby out with the bathwater. And that’s more related to a mispricing story that, you know, sentiment throws these names out and beats them up too bad. And so his dissertation was about how do we empirically identify whether value is risk, or mispricing. And the short story is that it seems like, if anything, it’s more likely mispricing versus risk that explains the value premium. Obviously, this is highly debatable, but that’s what his dissertation was all about.

Rick Ferri: And after all of that, you decided you were going to go out and create a company together.

Wesley Gray: Well, kinda. It actually, all this happens simultaneously. And it’s one of the probably the crazier stories in our industry. So right when I actually got my job, it actually was during the time I was on the professor markets, at the time I was writing a blog and obviously, my dissertation is out there, I got a cold called by a very large real estate family in New York and the son had been put in charge of essentially managing, it was around $4 billion of like their liquid wealth. And they were in the middle of just living through 2008. And they were big in hedge funds, big in active management, and they got smoked and they’re like, we’re firing every one of these people. We’re going to take control of our wealth. We’re going to do this in-house. We’re going to do it with quant, we need someone to help us. And he had just been out there googling around and somehow he found me, and he calls me up. He’s like, ‘Hey, can you help me manage this $4 billion? We want to use computers. I really like your dissertation. How do we do this?”

So went up there, met him, again, this is all at the same time I’m sitting here thinking I’m going to be a professor. Because I wasn’t 100% sure if this would actually lead to anything, but it initially kind of led to like a basic consulting gig, where the gentleman said, “Help me for a couple years. If you guys do a great job, you know, we’ll seed your business on the asset management side.” Because they just got out of the whole asset management hedge fund world, they’re like, we’re never going to seed or do that ever again. And then I was putting the ask on the table, so they said, “Hey, give me two years.” And so since I kind of helped them initially, and then I got Jack involved immediately because it kept scaling up bigger and bigger. And then so after two years, in 2012, they essentially seeded $20 million in the quantitative value strategy, which we have a book about. And then very quickly, they ramped it up to 50. And they put the other part in the international quantitative value. And this was all going on simultaneous to when I was being a professor as my day job. It just, things kept happening in the background. So it was very hectic time in my life, I would say.

Rick Ferri:  And you were having children at the same time?

Wesley Gray: Yeah, I was up to two and we’re working on three. And yeah, it was getting crazy. And then essentially what happened is after I think it was around three years into it, like this was clearly becoming a real business because we were managing a $50 million managed account, we’ve got like a huge consulting contract. I’m also moonlighting now at this point, basically, as a finance professor, and I was just thinking, hey, I need to one way or the other here. And so I talked to my boss at Drexel, the head of the department. I just told him I was like, “Listen, I, I think I need to resign. But I don’t want to screw you over here”. But you know, because recruiting for professors is like a total nightmare, like at least like a one year cycle. So he’s like, “Hey, put in one more year, so we can least recruit for your position, and then you can, you know, go out into the sunset.”

So that’s essentially what happened. After my third year, being a prof for all intents and purposes, I was all in on the business, but I was still technically professing until they could recruit for my position. And then, you know, basically kicked me out the door. Another interesting thing along the way, is through this whole time period, it wasn’t just this large family office. For whatever reason, people liked what we were putting out there. We were just being super transparent about putting our research, putting our ideas. So a bunch of random rich people would call us up and say, “How do I do this?” And we’d say, “Well, we have a managed account. That’s how you could do it.”

And so we kept building the business up. We would do tax loss harvesting to try to minimize tax impact, because everyone we’re dealing with is taxable money, and another thing happened along this way. Another couple hundred million gentlemen out in the Midwest, we’re working for them as well. And he had a tax problem. And it was one of these situations where he had a low basis stock that was going to get bought out by a large conglomerate for cash. And he was very afraid that he was going to have to incur a huge capital gain event. So he says, “Go figure this out”. And you know, this is like one of these impossible things where like, hey, go figure out how to not pay tax but you know, if the rich guy says jump, you know, I say how high.

And so that’s what I did; I went on this mission: how am I gonna deal with this problem? And I ran into a gal at a bake-and-structure product [note: in quant world jargon, meaning “this concludes”] and this is not something you could really do anymore but it was all related to the ETF structure. And I started learning about how the ETF structure, since it allows assets to come in at mark to market basis, the ETF can then dump any asset out even if it has low basis onto a market maker with no tax liability, and it’s essentially kind of a laundry mat for capital gains liabilities. And just, you know, a light went off in my head, like, holy cow, if I’m doing strategies that involve trading and turning over and taxes, or, you know, essentially Uncle Sam’s 50% performance fee, you know, this seems like a good idea. So, long story short, we, now about in around 2014 we say we’re going to get into this ETF business, because we thought it was a better structure to deliver these concentrated factor portfolios than doing them in SMA with tax loss harvesting.

Rick Ferri: Just out of curiosity, all that work you did on the ETFs structure of how with the creation and the redemption, how you can push out any unrealized gains on to the authorized participants. You had that one client in the Midwest who had this big capital gain problem. And then you had this ETF over here. I’ve always wondered, is there any kind of a structured product, or can there be a structured product where you could take people who have these stocks out there and put them all together, and bring it in and just issue them shares of an ETF and then take the stock, then that they put in kind into the ETF, and then give it to an authorized participant to get rid of, and now their cost basis is in the ETF? It’s diversified. Is that possible? 

Wesley Gray:  Yes. Yes and no, the long story short is, in the old days, yes. But what happened is, all the big banks got smoked out on a bunch of tax things a few years ago, and they just cut off anything that could even be perceived as being on the edge because they didn’t want to make Treasury angry. So my understanding from the inside baseball of talking to people that deal in this world is in the old days, they would actually do stuff like that for super ultra high net worth clients and, you know, where they control like the cussing and clearing pipes. But my understanding is nowadays, that doesn’t go on. But I certainly feel like an enterprising entrepreneur that had the time and energy to try to figure that out, it could be possible. We’ve looked into it from like fifty different angles and haven’t been able to figure it out. But yeah, there’s certainly, there’s something there, I just haven’t solved it.

Rick Ferri: I believe there’s something there too. I believe that, you know, this thing called direct indexing where you can buy 250 or 300 stocks and then you individually sell off the ones that are at a loss and do a tax swap. And at the end when that’s all played out four or five years down the road, when there is no really longer any ability to do a lot of tax swapping, you’ve got this portfolio of 200- 300 stocks that have a low cost basis. But that looks an awful lot like an index. So if you could just take that and just turn that into an ETF provider, and get shares of a more diversified ETF with a cost basis of the ETF is the cost basis of all your stocks in aggregate, but it’s a lot more easy to manage with one security than 400.

Wesley Gray: Yeah, so yeah, I agree 100% and I get in fights all the time with people arguing over do you do the ETF structure or do you do the tax loss harvesting structures? And, I still believe there’s a marginal benefit, like even if you’re doing pure passive, like say for example, like the parametric solution like S&P with tax loss harvesting, or just go buy the Vanguard fund. I still believe that the Vanguard fund is better, because a lot of people also forget, and to your point, that eventually you get basis in everything. But the index changes, like firms get bought out for cash. Guess what, you can deal with that problem in an ETF structure, you can’t if you only have a security, right, like if you have low basis and you know, Joe Blow wants to buy the company out for cash, you’re going to eat tax liability that’s easy to cleanse in an ETF.

So I think, and then there’s the fee differential, like those tax loss harvesting solutions are 20, 30, 40 bps, you know an S&P 500 ETF is basically zero. So if you annuitize that cost differential over the life of investment, the lump sum of that’s maybe 2%-3% of your wealth, does that make sense? Probably not. You know, is that the value of the tax loss shield you’re going to get? I don’t think so. So, I think tax loss harvesting and direct indexing is total hype, overblown versus just buying the passive index or an ETF structure for zero. That seems like a better long term solution to me. But reasonable people can disagree.

Rick Ferri: Let’s move on a little bit. So all of a sudden you decide you’re going to launch Alpha Architect and you open the world headquarters, which I’ve been to several times now.

Wesley Gray: Yeah, for sure. So, the original world headquarters was in a little house I had in New Jersey. But that was five minutes from my mother in law. So both my wife and I agree that hey, we should probably move a little bit further away. So we moved over here to the Pennsylvania side. And at that I’d spent a year doing a commute from Baltimore to Philly when I was first year as a professor there because we still had a place down there. And I came out of the service, I’d swore off commuting, because I actually wanted to hang out with my kids. I like exercising. So I said, You know what, I’m going to set up a business in my house and if people don’t like it, like that’s fine. But it’s good for my mental physical health. It’s going to make me operate more efficiently. Why not?

And so we bought this place out in Pennsylvania. It’s kind of a compound of sorts. And now it’s Alpha Architect global headquarters. But yeah, essentially we just built an office inside this residence you know got it zoned and everything and you know, start off with obviously no AUM hardly at all and now we have almost a billion but you know, it functionally achieves the goal, it keeps our costs down low and it keeps commuting time down, so we’re kinda stuck with it. So it’s a bit awkward, but in the world of zero percent management fees, you got to do weird things sometimes.

Rick Ferri: And understand some interesting artifacts went along with that house?

Wesley Gray: Yeah, so we got this place from a big game hunter, who was basically, had a tragic situation. He had pancreatic cancer. And he was basically going to die in three months. So it was kind of a liquidation opportunity of some sort, both the house, and our friends we have, he was, like I said, a big game hunter. So we acquired a grizzly bear, leopard and much other really cool taxidermy mounts, and one of which we keep in the office, the grizzly bear, because we like to say that, you know, we try to kill bear markets, and we have evidence of it by having our grizzly bear here. So it’s definitely a unique experience, visiting Alpha Architect headquarters.

Rick Ferri: It was for me because when the first time I went to visit you, I’m driving down this residential street and I’m saying, “This can’t be it.”

Wesley Gray: Yeah, we’ve had many very, very wealthy people and a lot of famous folks roll through here with that exact same expression, “What in the world did this guy talked me into. Why am I hanging out in a residence in the suburbs of Philadelphia? Is this person crazy or what?”

Rick Ferri: So things have gone well, you’ve launched several ETFs. And the way in which you do ETF and factor investing, I find it to be kind of the right way of doing it. It’s almost like the next generation of factor investing because it’s so deep and so concentrated, that if you want to do factor investing, that it seems to me, you should be paying for as much exposure to these factors in a concentrated form as you can get. So it appealed to me right away when I found out, you know how you were doing it.

Wesley Gray: Yeah. So essentially, the genesis of this idea is, when we’re working for the family office, they were going to do the typical thing where they’re like, let’s go buy our cheap beta but then we need to figure out how to replicate a lot of these different exposures that we used to get from these hedge fund people. And hedge funds obviously aren’t doing like cheap beta stuff. They’re usually doing concentrated bets in, you know, with stock picking but what’s essentially is factors like small value quality, but they’re doing in a much more focused way.

So we naturally thought, Well, if we want to replicate these more unique exposures out there, we need to replicate them how they need to be replicated, and that means we’re going to do maybe factors but we’re not going to hold 500 securities and focus so much on how how close this tracks the index. We’re going to do 50 stock portfolios, and just tell people up front that this is not a closet index, with a little tilt to like the value factor. This is pure value, where we’re literally buying the cheapest 40 or 50 securities on a different metric. We use enterprise multiples, but keep it simple, like PE ratio. So yeah, and that’s just what we did. And we just told people up front of the downside, which is, of course, the tracking error and the relative performance, that this stuff can bounce around both good and bad, you know, over long time periods, and should just be prepared for that. It’s not the Vanguard fund. And we just wanted to deliver it, you know, transparently, affordably, and be very upfront about the potential pain associated with the style of investing.

Rick Ferri: And I think that’s all very interesting. Let’s say that you want to have a slice of your portfolio to additional risk factors. And the reason is additional risk factors is because I actually interviewed Gene Fama one time, and I said, you know, if beta is a factor, so what do you call these other things? You call them Smart beta, or do you call them? What do you call them? His answer was they are additional risk factors. So there are additional betas. I said, Okay so let’s say you wanted exposure to something other than beta. I guess you could do it by going long/short, correct. But that would be expensive in many ways. So here you’re going long only but you’re doing it very concentrated and you’re keeping the cost down.

Wesley Gray: Yes, that’s right. So you got it. So the concept, to Professor Fama’s point, and our portfolios are constructed in a way that is much more akin to how academics form portfolios, and that’s what all the evidence shows like, look how great they are, the idea is, we’re not going to go long/short to your point, because it’s much more expensive to run, operate and just access those exposures. And so we’re going to stick on the long side, but it’s not going to be broad market beta exposure, it’s going to be some beta, obviously because it’s long only, but we’re going to focus as much as we can on capturing the value risk premia, or the momentum risk premia. And again, it’s very important for us to communicate this element that this is a risk premia, and this is very different, because frankly the biggest issue with doing different risk is that they’re different than what a lot of people see on the news channel, like on the S&P 500. And if they’re not mentally prepared for that, they’re oftentimes going to be in at the wrong time, out at the wrong time, and kind of ruin the whole reason for holding additional risk premia, which is to help your long, long term performance and to kind of diversify away from just owning generic beta.

Rick Ferri: You and I went back and forth on Twitter a little bit about what does the word “long term holding” mean? You know, how long is long and I think I said it, A lifetime and you said no, it’s only 20 years. And I said, Okay, we will compromise at 25 years. But, you know, this idea of holding these factors for a long, long time is really critical to the success of an investor.

Wesley Gray:  Yeah, it’s just the advice from Bogle is actually timeless and it applies everywhere. Like when he talks about holding equity, he doesn’t suggest you should go buy the S&P 500 fund or VT or VTI and just trade it every year. He’s like, no, this is like basically your permanent holding, because you want to capture the equity risk premia. Well same thing here. We’re trying to capture some specific factor risk premia. And the same advice applies, you’re not going to capture it by trying to time it, day trade it, bounce around all over the place. You’ve got to hold the thing and actually earn the associated risk premia with it. Which means you need to look at it more as a long term strategic holding, and not as a kind of a short term trading vehicle, because that’s not what it’s really designed for.

Rick Ferri: So let’s get down to the nitty gritty then, the bottom line on all this, it’s going to cost me more money to go after those additional betas because they have to pay a fee every year that’s higher than the, basically beta is free now. So anything other than beta, which is now free out there, I’m going to decide to add additional betas or additional factors to my portfolio. Using yeah, using your funds. But your funds are not free. Your funds have cost. So number one I have to get over that hurdle rate of the cost. And there’s a thing out there called, where we talk about it as an alpha decay or a premium decay that’s going on as more and more people are doing what you’re doing. There seems to be a decay going on as to the expected return from these additional factors. Can you see that? Have you measured it? Are your funds going to produce- because I have to take money out of beta to put it into the additional factors, they have to literally, it’s a long only, so I’m taking a slice of my total market index fund. And I’m going to add to your fund, and I’m going to pay you a higher fee. And I need to at least get beta, which I know I’m going to get in the market but I’ve got to get above and beyond that. Is it worth it?

Wesley Gray: So yeah, there’s a lot of questions in there. And it’s all about costs and benefits. So in general, when you look at any of these sort of factors, like the cheaper you can get them, the better, right? And a lot of times the price is going to be associated with the scarcity of said factor. If something has massive insane capacity, well, at the margin that’s something that Vanguard can deliver at scale. An example of a factor like that might be market beta, right? That’s obviously something that has trillions of dollars of capacity, you can jam tons of money into it, not, infinite amount of money, by the way, but you know, in general, that would make sense. 

But then there’s other sort of strategies where if you’re actually going to do the actual factor, like, for example, like what we do: 40 stocks, mid cap a lot of times, small cap weight, like you just can’t jam a trillion dollars into that strategy, right? So there’s going to be a natural limit on capacity, which means you can’t just scale it to infinity, which means the cost can’t be free, because you gotta pay the fixed costs and the bills and operational things for running this damn thing, right. So that’s just kind of the economics of general capturing any exposure that doesn’t have infinite scale. The second question relates to, well, what do these premiums actually deliver. So for example, value, let’s say, and you could do value investing just generic, let’s just call it low PE investing, you could do it one of two ways we’ll just make up. One way is you could go buy a portfolio of, say, 40 stocks that have low PE.

Wesley Gray: So yeah, there’s a lot of questions in there. And it’s all about costs and benefits. So in general, when you look at any of these sort of factors, like the cheaper you can get them, the better, right? And a lot of times the price is going to be associated with the scarcity of said factor. If something has massive insane capacity, well, at the margin that’s something that Vanguard can deliver at scale. An example of a factor like that might be market beta, right? That’s obviously something that has trillions of dollars of capacity, you can jam tons of money into it, not, infinite amount of money, by the way, but you know, in general, that would make sense. 

But then there’s other sort of strategies where if you’re actually going to do the actual factor, like, for example, like what we do: 40 stocks, mid cap a lot of times, small cap weight, like you just can’t jam a trillion dollars into that strategy, right? So there’s going to be a natural limit on capacity, which means you can’t just scale it to infinity, which means the cost can’t be free, because you gotta pay the fixed costs and the bills and operational things for running this damn thing, right. So that’s just kind of the economics of general capturing any exposure that doesn’t have infinite scale. The second question relates to, well, what do these premiums actually deliver. So for example, value, let’s say, and you could do value investing just generic, let’s just call it low PE investing, you could do it one of two ways we’ll just make up. One way is you could go buy a portfolio of, say, 40 stocks that have low PE.

Another way is you could go and weight, you could go take the S&P 500 stocks and kind of tilt more weight towards the low PE less weight to the high PE. But, on net you’re basically not really doing much, you’re kind of tilting one way or the other. So clearly, the potential value add from the so called value factor is going to be a lot higher in the concentrated one than in the diluted one.

So that’s one element, like how’s the thing constructed, but then the other important element is this premium going to pay off in the first place? Because if let’s just say value just doesn’t work at all, well, then if I have it in a concentrated format or having a diluted format, it’s not going to do anything for me. And that gets back to the question of, well, why does a factor pay off in the first place? Because it’s an open secret, and because a lot of people know about it, and because a lot of people are perceived to be doing it, will that make it decay? Well, why that’s we got to step back and say, Why did these things get, why did they pay off in historical sense? 

Well, value generally paid off, because to Fama’s point it’s riskier. So unless you were to believe that risk preferences have changed, then one would probably want to believe that exposure to the value factor will probably pay off at some point in the future. Currently, it hasn’t paid off very well in the last five or 10 years. But just like generic market beta doesn’t pay off all the time, you know, it’s had 10-20 year droughts as well, there’s a reason to believe from an economic perspective that value will pay off just because a lot of times it’s fundamentally riskier.

And then the second point is that if someone is going to do value, and you believe even in the mispricing component of value, like people throw the baby out with the bathwater, there’s this aspect of what they call career risk. So just because everyone knows about something, doesn’t mean they may go and do it. Because if you go out and buy concentrated portfolios of value stocks, like right now, it’s very likely that you have a high probability of getting fired. Because these things can bounce all over the place. You know, you’re going to get destroyed by the S&P 500 sometimes and people think you’re an idiot, and you get booted out of the job. So this is its own what we call career risk premium.

So to the extent that a lot of people are, quote-unquote, doing these things, but these strategies earn premiums for a reason, i.e., they’re risky, and they stink to do, one would expect that over the long haul, they’re probably going to earn some premium. I don’t know what that will be. You know, historically, like a concentrated value portfolio like what we’re doing, maybe, I don’t know, maybe 3% to 4% over a generic index, which is going to be sourced from being smaller, being cheaper, you know, for the most part, let’s say that cuts in half to 2%. Right, because at the margin, it gets more efficient, so you may earn this 2% premium, but this is not like an arbitrage. This means you’re going to deal with probably more risk, probably more evolved, probably well definitely way more pain and anguish in a relative sense to like common benchmarks, so you’re probably going to earn this return. But then the question is, well, how much does it cost me to access this 2% premium?

Well, if it cost me 200 bps, that’s probably a bad idea. If it costs me zero, that’d be a great idea, right? And then there’s somewhere in between. So what we do is like, on our stuff, we, for the domestics, we charge 49 basis points so just under 50 bps, which is obviously way more expensive than zero – I wouldn’t call it outrageous – but the idea is, the bet on our stuff would be Hey, over the next 20 years, do I believe that the excess return associated with the factor exposures that I’m getting here are in excess of 49 basis points? If not, then why would I do this? If so, okay, I might want to do this. But then the second question would be, well, can someone else deliver it even cheaper? Because maybe Vanguard’s got some concentrated value factor fund for 30 bps, right? And the process is very similar and I like it, well, okay, I think I project it’s worth 1%, you know, over the long haul or 2%, you know, it cost me 30 bps here, I’ll go do that one, right?

So it’s just it comes down to the trade off between, what do you expect this premium to pay off over the long haul? What do I gotta pay for it? And obviously, you want to pay less and earn more as best you can. Which is what I argue a lot of these people that do factor investing are doing today, they are not buying and holding our fund for 20 years, they’re like day trading the iShares factor funds; that’s not that’s not arbitraging extra premiums, that’s in the end, probably contributing to make them even higher in the future.

Rick Ferri: But that’s a baby speed dating factor funds rather than marrying one?

Wesley Gray: Yeah, yeah, exactly. The only way you can pull premium out of the market is you need to have massive amounts of permanent capital sticking in something because it’s kind of taking supply off the market. But if all you got is more day traders throwing money around sloshing around in factors, that’s not arbitraging away the factor, that’s just money sloshing around and it’s adding volatility to the factor but unless that money is like all mini Warren Buffetts, you know, holding for 20 years, through thick and thin, it’s not going to depress the risk premium associated with them, or it’d be very unlikely to do so.

And I frankly don’t see that sort of mentality amongst factor investors in the marketplace. Nor do I see that as an incentive for product manufacturers because they’re in the business of activity. So the more I can get you to day trade them, do this, that and the other thing that’s good for the business out there. So I think people have an incentive to promote activity in factors.

Rick Ferri: And you’ve written a lot about this. You’ve got three books out there, numerous papers. The books are Quantitative Value, Quantitative Momentum, and then DIY Financial Advisor. I’ve read the book and it’s not as easy as I think you make it out to be in that book, how you can do all of this as a do it yourself investor, but…

Wesley Gray: Well, yeah, I would say just like on Bogleheads, you can go review the “Start Here,” here’s how it’s done. And yeah, you can read it and there’s the cookbook, but at the right price, sometimes people will still like, you know what, thanks, I really appreciate the transparency, I understand what you’re going to do, but I have better uses for my time, and rather pay you to do this for me. So but there are people that definitely are DIY, but there’s certainly a lot people, you know, like my grandma, for example, where she’s probably not well suited to DIY, even if she read the book and thought it was cool because her grandson wrote it with a bit of a misnomer on the title.

Rick Ferri: We’re coming up on the end of our time. Just like to switch gears here for one last second. Could you talk about your March for the Fallen, and what that’s all about?

Wesley Gray: Yeah, so March for the Fallen is a 20 mile march held at the Pennsylvania National Guard Training Unit. And the idea here is, you’re out there representing on behalf of those who lost loved ones in the military. So we’re supporting Gold Star families and people who have lost people in war. It’s not a charity in the sense that you give money. It’s a charity in the sense that people that have lost their loved ones like to know that other people are  remembering and honoring the fallen. So that’s what you’re doing. You’re out there and your charities, kind of your blood, sweat and tears to represent and, you know, let them know that we still appreciate, you know, sacrifices they gave as a family. And they go out there and hang out, and it’s a great cause and you meet a lot of great people. And I really enjoy promoting it and trying to encourage as many folks as possible to come out.

Rick Ferri: And if somebody was interested in joining your group, you’ve got a pretty large group that you’ve put together.

Wesley Gray: Yep, so last year we had around 150. This year, I imagine we’ll have probably 200 plus. All you got to do if you want to be on notification is obviously reach out direct, or just if you go to AlphaArchitect.com/mftf, there’s a whole website about training plans, nutrition, how to sign up and all these sort of other things. And all you gotta do is just show up, we take care of lodging and chow and I think it’s like 35 bucks you got to pay to the National Guard. So it’s very low cost, super efficient, great cause, you meet a bunch of great people. And I think everyone should at least do one time in their life.

Rick Ferri: Thank you Wes. It’s been a great conversation. I really appreciate you joining us here on Bogleheads on Investing.

Wesley Gray: You got it. It’s been an honor and keep doing what you guys do over at Bogleheads, I love the education and love the effort for DIY investors out there.

Rick Ferri: This concludes the ninth episode of Bogleheads on Investing. I’m your host, Rick ferry. Join us each month to hear a new special guest. In the meantime, visit bogleheads.org and the Bogleheads wiki, participate in the forum and help others find the forum. Thanks for listening.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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