Speaker 1: Look ahead, imagine more, gain insight for your industry with
Speaker 1: forward thinking advice from the professionals at Cone Resnick. Is
Speaker 1: your business ready to break through? Find out more at
Speaker 1: Cone resnick dot com. Slash Breakthrough. This week on the podcast,
Speaker 1: I have an extra special guest. He's an old friend.
Speaker 1: His name is Wes Gray, and he is not your
Speaker 1: usual quant slash money manager. He is the founder and
Speaker 1: CEO of Alpha architect Um, and he's also an unusual guy.
Speaker 1: He uh comes out of uh University of Chicago in
Speaker 1: an MBA PhD program and decides to take a little
Speaker 1: time off in order to join the Marines, which he
Speaker 1: did as a captain, went overseas in Iraq, where he
Speaker 1: served as an information order officer embedded with the Iraqi Army,
Speaker 1: and Um wrote a book about it, Colds Embedded and
Speaker 1: Really a fascinating uh An unusual background discusses throughout his
Speaker 1: career how Iraq and and the prosecution of war are
Speaker 1: in some ways very similar to investing. Alpha architect is
Speaker 1: a quantitative firm. Uh West crunches a lot of numbers.
Speaker 1: He's a big believer in factor investing. He has long
Speaker 1: since been a proponent of both momentum and value, which
Speaker 1: is a somewhat unusual combination, but they are two of
Speaker 1: the six main factors UH that are out there. I
Speaker 1: thought the conversation was absolutely fascinating. If you are a
Speaker 1: fan of quantitative investing, or if you enjoyed our previous
Speaker 1: podcasts with people like Ammanual Derman or MEB Fabor or
Speaker 1: any of the other quants we've spoken with, UH, you'll
Speaker 1: really enjoy this. So, with no further ado, my conversation
Speaker 1: with Wes Gray. This is Masters in Business with Barry
Speaker 1: Ridholts on Bloomberg Radio. My special guest today is Dr
Speaker 1: Wesley Gray. He is a former captain in the United
Speaker 1: States Marine Corps. West graduated Magnicum Laudy from Morton. He
Speaker 1: earned both his m b a. And PhD in finance
Speaker 1: from the University of Chicago before becoming a professor of
Speaker 1: finance at Drexel University. He currently runs the site Alpha Architect,
Speaker 1: as well as running an asset management shop for high
Speaker 1: net worth individuals. He is the author of three soon
Speaker 1: to be four books on quantitative investing, as well as
Speaker 1: numerous academic articles. Wes Gray, Welcome to Bloomberg. Very happy
Speaker 1: to be here. So let's talk a little bit about
Speaker 1: your background, because it's kind of unusual. Lots of people
Speaker 1: take some time off between college and grad school. What
Speaker 1: did you do between college and grad school? So what
Speaker 1: I did is basically, right out of undergrad actually directly
Speaker 1: enrolled in the University of Chicago paced program at ripe
Speaker 1: old age of two, spent two years there getting hazed,
Speaker 1: you know, fighting against Russian math champs to compete. And
Speaker 1: then after two years in a PhD program, you you
Speaker 1: get to your comps stage and I passed the comps
Speaker 1: and I said, you know what, um twenty four, I'm
Speaker 1: hating finance at the moment. I needed to do something
Speaker 1: that I always wanted to do, and that was serve
Speaker 1: in the military. So I asked for a special four
Speaker 1: year sabbatical uh to basically serving the Marine Corps at
Speaker 1: left for four years, which is probably first time that's
Speaker 1: ever happened, I imagine in Chicago finance PhD program history,
Speaker 1: and then came back and finished up. So let's not
Speaker 1: skip over that middle part. Those four years were the
Speaker 1: middle of the Iraq War. You were embedded with the
Speaker 1: Iraqi Army as a captain or lieutenant. What was your rank.
Speaker 1: When I was there as a lieutenant lieutenant, I called
Speaker 1: you a first lieutenant. Yeah, well I got out as
Speaker 1: a captain, but okay, I serving there as a first
Speaker 1: lieutenant and your nickname amongst the Iraqis was Jamal. How
Speaker 1: did that come about? Basically? I was the intel guy
Speaker 1: in our our mid team military transition team, and so
Speaker 1: the intel guy is supposed to know how to speak
Speaker 1: the language, you know, how to influence the people. And
Speaker 1: one of the things you learned about reading about Arab
Speaker 1: culture is it's really important to learn the language and
Speaker 1: hang out with the people in order to you know,
Speaker 1: be able to better influence them. So I used to
Speaker 1: hang out in what they call the swats Uh and
Speaker 1: I was down there and they would always call me
Speaker 1: lulas um gay because they can't say ours very well.
Speaker 1: And I was like, you know what, guys, let's try
Speaker 1: to find a language so instead of gay, instead of great.
Speaker 1: You know, and it's usually not the greatest idea to
Speaker 1: walk around with a bunch of Marines when when I
Speaker 1: ras are calling you malasam gay, you just get some
Speaker 1: ridicule subtimes um and they just couldn't say it, so
Speaker 1: as like, can you guys, name me, and they literally
Speaker 1: had like a naming party where there was probably fifty
Speaker 1: Iraqis in the uh in this swaha it's maybe you know,
Speaker 1: thousand square foot you know, cardboard building type thing, you
Speaker 1: can think about it. And they came up with Jamal,
Speaker 1: and then I was called Malasam Jamal, and uh, I
Speaker 1: kind of like I actually that was my identity. Even
Speaker 1: when I came back, I still felt like I was
Speaker 1: Malasam Jamal. That's funny. So how did the Marines and
Speaker 1: your your time in Iraq helped prepare you for a
Speaker 1: career as a quant in in finance. I'd say the
Speaker 1: biggest thing is just understanding that in all endeavors, humans
Speaker 1: are involved. And when humans are involved in any sort
Speaker 1: of decision making or activity where there's a lot of emotion,
Speaker 1: stress and chaos, they do crazy things. There's certainly a
Speaker 1: level of emotion involved there. And I think in the
Speaker 1: military what you learn is it's all about standard operating procedures,
Speaker 1: training to do things that seem you know, mundane and
Speaker 1: dumb and checklist driven now, but when you get into
Speaker 1: a chaotic situation, you think, God, you did that, so
Speaker 1: you don't rely on your natural action you're rely on
Speaker 1: your standard operating procedure. You know. Perfect example might be
Speaker 1: I remember I was in the palm groves, an area
Speaker 1: called Haditha, which is kind of you think out in
Speaker 1: Alomar Province where a lot of the isis guys are
Speaker 1: now and I was on Iraqi patrol and literally a
Speaker 1: dude gets shot in the chest fifteen feet in front
Speaker 1: of me. You know, natural action is hit the deck,
Speaker 1: you know, go to the ground as fast as possible.
Speaker 1: Another natural action, which you're not supposed to do, is
Speaker 1: go run to the person who just got shot and
Speaker 1: see what beat on him? And now that and they're
Speaker 1: gonna go shoot me now, so what. But what you
Speaker 1: train to is when there's a casualty, the first thing
Speaker 1: you do is hit the deck, fine cover, figure out
Speaker 1: where the other guys are, to make sure you secure
Speaker 1: the area. The only way that you you have a
Speaker 1: reaction to do that because you have stand operating procedure
Speaker 1: and you're trained to that standard. Just like in financial markets,
Speaker 1: I think a lot of time, like let's say there's
Speaker 1: a fifty draw down in your portfolio, your gut reaction
Speaker 1: is sell everything. But that's not what you should probably do.
Speaker 1: So you need to have a process or something in
Speaker 1: place before you hit chaos. So when you're actually in chaos,
Speaker 1: you you know, you're act in a more rational, i'd
Speaker 1: say logical way, And I think that you see a
Speaker 1: lot of that between military and investing. You know, I
Speaker 1: started on a trading desk. The head of the desk
Speaker 1: was a former Marine jungle combat instructor. There was someone
Speaker 1: else who was a former seal on the desk. Now,
Speaker 1: what I always found fascinating wasn't just the standard operating
Speaker 1: procedure for what to do. It was preparing emotionally for
Speaker 1: the firefight. Like, how can an investor prepare emotionally for
Speaker 1: those big draw downs? Yes, so I think it's just
Speaker 1: like in the military. You try to train as close
Speaker 1: as you can to fight and have ultimate faith and
Speaker 1: confidence in the leadership and the decisions and the process
Speaker 1: that you believe in. And when you have that, i'd
Speaker 1: say belief in what you're doing, and you really put
Speaker 1: a you know, good faith effort into working on that.
Speaker 1: When you hit chaos, if you believe in your training,
Speaker 1: you're more likely than not to stick with that process.
Speaker 1: I'm Barry Ridhults. You're listening to Masters in Business on
Speaker 1: Bloomberg Radio. My special guest today is West Gray. He
Speaker 1: is a former captain in the Marines, served as an
Speaker 1: in bed with the Iraqi Army on behalf of the
Speaker 1: U S Marines. He runs a shop called Alpha Architect
Speaker 1: and has written numerous books on quantitative investing. Let's talk
Speaker 1: about a book of viewers that I really enjoyed quantitative value.
Speaker 1: When we think of quantz and we think of value investors,
Speaker 1: we really don't think of those as having a big overlap. Up.
Speaker 1: Tell us how you came to the idea of value
Speaker 1: that was quantitatively driven. Sure, so I had start out
Speaker 1: with this being a total bible thumping Ben Graham intelligent
Speaker 1: investor stockpicker did that for ten years my own personal money,
Speaker 1: and thank god I had the opportunity to eat a
Speaker 1: lot of humble pie along the way, and I was thinking,
Speaker 1: you know what, this whole Warren Buffett Ben Graham idea
Speaker 1: makes total sense to me. But after you get engaged
Speaker 1: in the activity of stockpicking, you realize that you get
Speaker 1: very emotionally involved. And even if you understand the biases
Speaker 1: you've memorized. You know Kniman's book, even if you know it,
Speaker 1: and you know how the biases influence you. You start
Speaker 1: to realize you still can't control against the biases. So
Speaker 1: I thought, hey, you know, fundamentally, value investing makes sense
Speaker 1: by cheap stuff everyone hates. Great. The problem is hold
Speaker 1: it for a long time, hold your nose when inevitably
Speaker 1: it told the underperforms for potentially multi air stretches um.
Speaker 1: But at the same time, how can we implement this
Speaker 1: process in an objective discipline way such that I can
Speaker 1: pull out monkey brain from making bad decisions, uh, you know,
Speaker 1: from trying to be a stock picker, because I learned
Speaker 1: my lessons basically on that. That's quite fascinating. So some
Speaker 1: of the things you reference in the book. Obviously the
Speaker 1: benefits of using a quant approach is you're taking out
Speaker 1: the human elements. One of the things you reference in
Speaker 1: the book is the importance of finding the highest quality stocks.
Speaker 1: So first, what does it mean when we say a
Speaker 1: stock is high quality? And then how do you screen
Speaker 1: for those? Sure? So, so stepping back, it's really important
Speaker 1: when we when we talk about quality in the context investing,
Speaker 1: to understand given it's already cheap. So with value investing
Speaker 1: the way we look at it, you have to be
Speaker 1: buying the stress cheapest securities in the market. Only within
Speaker 1: the cheap does quality start to help add value. So
Speaker 1: if you just look at quality as a standalone, you know,
Speaker 1: characteristic of a security, it's unclear that it adds any
Speaker 1: quote unquote alpha or edge. It's all about looking at quality.
Speaker 1: Given you're in the cheap stocks everyone hates. So the
Speaker 1: step one is screened for an expensive stock. Step two
Speaker 1: is within those cheap stocks. So how do you identify
Speaker 1: what's quality and what's not amongst the cheap So, given
Speaker 1: we're in the in the cheap bin, which are security,
Speaker 1: obviously there's something going on and that's why they're cheap.
Speaker 1: We have a table like the we call it the
Speaker 1: quality table. There's two legs to it. There's understanding the
Speaker 1: fundamental quality of the business and there's another thing called
Speaker 1: current financial strength. So in assessing economic mode, we try
Speaker 1: to objectively ascertain is this company a good business? How
Speaker 1: do we do that? We look at things like long
Speaker 1: term geometric means on return on assets, return on capital.
Speaker 1: We look at long term free cash flow generation, profit
Speaker 1: margin dynamics, like if you have fifty percent margin year
Speaker 1: and year out, that's probably good business and we want
Speaker 1: to quantify the quality of this business to essentially generate
Speaker 1: returns hopefully an excess of their cost of capital. But
Speaker 1: that's not enough. That's leg one because we're dealing with
Speaker 1: cheap stocks that have issues. So we can one ascertain
Speaker 1: that there historically have some indication of being a good business.
Speaker 1: But then current financial strength is now at ten point
Speaker 1: checklist where we want to make sure are you going
Speaker 1: to survive the next few years? I e. Are you
Speaker 1: making money? Are you're paying down debt? Are your repurchasing stock?
Speaker 1: Is your current ratio is improving? Uh, it's literally like
Speaker 1: a pre flight checklist. So are you a quality business
Speaker 1: organically and do you have the current financial stature to
Speaker 1: live for the next few years? So eventually hopefully you
Speaker 1: can get revalued up to not be a value stock
Speaker 1: anymore and hopefully be a growth stock in the future.
Speaker 1: So is it safe to say that companies with strong
Speaker 1: balance sheets have stocks that outperform? Or is that overstating it?
Speaker 1: I think it is. I think cheap stocks with strong
Speaker 1: balance sheets on a risk adjusted basis and from a
Speaker 1: you know, betting standpoint, or better than cheap stocks with
Speaker 1: bad balance sheets independently. No, because there's a few reasons
Speaker 1: why everyone knows Google is great, Facebook's great, Procter and
Speaker 1: Gambles great, So what's the edge? And then secondly, it's
Speaker 1: also easy to buy those names for someone to recommend them.
Speaker 1: So it's emotionally. Emotionally or are you referring to the
Speaker 1: principal agency issue the principal agent problem? And also just emotionally,
Speaker 1: it's easy to own high quality securities. But when you
Speaker 1: look at it objectively from like an evidence based standpoint,
Speaker 1: just as an independent analysis to I, we think quality
Speaker 1: is not that valuable and it doesn't make any sense
Speaker 1: it would have edge were cheapness. Everyone hates these things.
Speaker 1: They're hard to own, like it's crazy, They're hard to hold.
Speaker 1: There's a lot of pain involved and unfortunately, you know,
Speaker 1: just like in the Marine Corps, no pain, no gain.
Speaker 1: You know that that BAC holds and financial markets unfortunately
Speaker 1: as well. So let's talk about stocks that can cause
Speaker 1: permanent loss of capital. There's a chapter in the book
Speaker 1: where you discuss that how do you avoid these stocks?
Speaker 1: What do you look for to avoid owning names that
Speaker 1: are going to go down and never come up? The
Speaker 1: classic value trap, the value trap. Yeah, you catch the
Speaker 1: falling knife, as they called on the way down. So, uh,
Speaker 1: three of them are basically there's there's two or three
Speaker 1: ways you can think about permanent loss of capital, and
Speaker 1: these are One would be like a fraud or manipulation.
Speaker 1: So if it comes out that the business you thought
Speaker 1: that was making a billion dollars a year is actually
Speaker 1: making zero, that's gonna be a bad news for equity holders.
Speaker 1: I would guess, Yeah, same thing with manipulation, like oh
Speaker 1: we thought we had this, now we have this other thing.
Speaker 1: And then the other one that's that's obviously is financial
Speaker 1: distress or bankruptcy. You can own the best business in
Speaker 1: the world, but if you're an equity holder and this
Speaker 1: firm is in distress, the debt holders might end up
Speaker 1: owning that great company, not you as the stockholders. So
Speaker 1: so by the time that news comes out, it's too late.
Speaker 1: What can investors do to avoid owning those names? What
Speaker 1: signs should they be looking for? Sure? So, so we
Speaker 1: do is we leverage a lot of uh, I guess
Speaker 1: you call them technologies in academic literature where people have
Speaker 1: built up statistical constructs to try to predict who's most
Speaker 1: likely or red flagged as being a manipulator, fraud ster,
Speaker 1: or potentially going to be in a financial distress situation,
Speaker 1: and we just at the outset say hey, if you're
Speaker 1: extreme red flagging on any of these sort of things,
Speaker 1: you're not in our You're not even gonna be in
Speaker 1: our potential. Just remo. We're removing, yeah, because we don't
Speaker 1: want to buy your falling knife situation. I'm Barry Hults.
Speaker 1: You're listening to Masters in Business on Bloomberg Radio. My
Speaker 1: special guest today is Wes League Gray. He is a
Speaker 1: retired captain in the U. S. Marine Corps, an m
Speaker 1: b A and PhD out of the University of Chicago.
Speaker 1: He now runs Alpha Architect, which is a unique quantitative
Speaker 1: asset management firm. And the first book he wrote was
Speaker 1: called Embedded, which is something that you pretty much pens
Speaker 1: right after getting out of the Marine Corps and after
Speaker 1: spending was it four years in Iraq? Is that about right?
Speaker 1: It was four years in the service I did uh.
Speaker 1: I was there for a standard Marine seven months deployment
Speaker 1: in a place called Haditha which down el Ombar Province there.
Speaker 1: So what motivated you to sit down and write a
Speaker 1: book when you get back that had nothing to do
Speaker 1: with finance. That was strictly about your time with the Marines.
Speaker 1: When it was is you know, I remember before the
Speaker 1: Iraq War, had Colin Pale show us that little white
Speaker 1: you know bottle that you're all gonna die, and I
Speaker 1: was like, you know, this is kind of maybe a
Speaker 1: survive of a war. This is a pretty important thing.
Speaker 1: I'm a buyer, I'm a believer. And then you know,
Speaker 1: so when in a Marine Corps, not really for that reason.
Speaker 1: I just want to do my service. But when I
Speaker 1: was I thought, hey, this is a mission that makes sense.
Speaker 1: You know, it's a win win for America and hopefully
Speaker 1: for the Rockies what have you. But then after actually
Speaker 1: living and being embedded with the people, I started to
Speaker 1: realize that, you know, culture matters, and we're we're in
Speaker 1: a in this war now, we're really taking on a
Speaker 1: fifty two year commitment because we're gonna try to change
Speaker 1: culture and not easy to do. Not easy to do.
Speaker 1: And I would argue it's very, very time intensive and costly,
Speaker 1: and that's fine as a decision, but let's weigh that
Speaker 1: against the potential benefits um and that book just really
Speaker 1: opened my eyes to understanding. I would say just Arab
Speaker 1: culture in general, and how the way they think about
Speaker 1: the world is just so much different than us. And
Speaker 1: then the idea that we can impose, you know, our
Speaker 1: ideas and how we think about the world on them,
Speaker 1: it just doesn't work. And I have an analogy here.
Speaker 1: It's like, you know, it's a fish trying to tell
Speaker 1: me how to breed it underwater, Like I understand I
Speaker 1: need gills and understand you need to get oxygen, but
Speaker 1: it doesn't work for me. Like it's just we all
Speaker 1: understand each other kind of, but we just it's not
Speaker 1: gonna work. Um. And that that was the biggest insight
Speaker 1: when I had to share it, because it changed my
Speaker 1: mind about the whole thing one eighty about why are
Speaker 1: we here? And is this really a positive MPV project
Speaker 1: for us? So so you can't really just walk into
Speaker 1: a country with a completely different set of mores and
Speaker 1: cultures and say here's how you do it. That's not
Speaker 1: gonna fly, no, no, yeah, yeah exactly. It seems obviously
Speaker 1: trivial after the fact, but yeah, but beforehand, you know,
Speaker 1: that's the classic hindsight bias. It's easy to say these things.
Speaker 1: Acts in In early two thousand three, a handful of
Speaker 1: people were warning about that. Everybody remembers the big Eric
Speaker 1: san Seki, the Army general, warning about you're not gonna
Speaker 1: do this with a hundred thousand troops. You need a
Speaker 1: half a million troops. It's more than just hearts and minds.
Speaker 1: It's really a long process. Nobody wants to hear that
Speaker 1: before you go in. Yeah, the biggest insight I got action.
Speaker 1: And also it's a lot of the things I cite
Speaker 1: and embedded. It is just my conversations with the actual
Speaker 1: Rocky people about why they thought we were so weird
Speaker 1: and crazy and the things that we did say that
Speaker 1: was that the readers, these Americans are crazy. Um. They
Speaker 1: try to explain to me their perspective, and a perfect
Speaker 1: one is okay. So you guys want to go bring
Speaker 1: democracy and freedom to the Rocky people, and you've done that.
Speaker 1: But here's the problem. When you let a country of
Speaker 1: cage lions totally free out of their cage, you don't
Speaker 1: give them freedom and Rocky to give them anarchy because
Speaker 1: you guys in America have a lot of implicit structures,
Speaker 1: either legal, culturally or trust. Like we're tribal here, guys
Speaker 1: like like we don't have a lot of that kind
Speaker 1: of ether in your culture there that it's in stitutionalized
Speaker 1: here there exactly. In fact, you wrote, the tribe matters
Speaker 1: much more than the state. There, you got it. So
Speaker 1: so the idea that you can bring us freedom and
Speaker 1: democracy and that's a great thing, and you're helping us, No,
Speaker 1: you're giving us anarchy. And everyone has a house with
Speaker 1: one ak in thirty round seven six to mag And
Speaker 1: guess what if there's not enough police, if I don't
Speaker 1: like my neighbor, I'm gonna go shoot him because that's freedom.
Speaker 1: And you guys don't do that in America. You're not
Speaker 1: really that free. You're still constrained by civil laws and
Speaker 1: and all these other things. And the idea that when
Speaker 1: you give us freedom, you somehow are gonna help us out, No,
Speaker 1: you're you're you're destroying all law and order in anything
Speaker 1: that resembled a society here. So so let's bring this
Speaker 1: back to finance. So what did you learn from the
Speaker 1: experience there that you were able to bring to the
Speaker 1: world of finance. You know, I think it's a lot
Speaker 1: of times like coming from a you know, PhD. University
Speaker 1: of Chicago, everyone's rational. This is how the markets work,
Speaker 1: and yeah, they're probably right, but that fails to consider humans.
Speaker 1: And there's humans operate in the economy, not agents, rational agents.
Speaker 1: So I think just like when when we go to
Speaker 1: a situation like Irock on paper, Yeah, go bring him freedom, democracy,
Speaker 1: and they will become like America and everyone will have
Speaker 1: a you know, a pick, white picket fence and three kids.
Speaker 1: But then you start realizing, wait a second, there's cultural
Speaker 1: issues here. There's human elements. Same thing in finance. Yeah,
Speaker 1: you should go buy cheap stocks and do it, Warren
Speaker 1: Buffett does. Why doesn't everyone do that? Well, because there's
Speaker 1: humans involving finance, and it's really really hard. It's really
Speaker 1: really hard, and we always need to consider the behavioral
Speaker 1: human element of decision making. I'm Barry rid Hilts. You're
Speaker 1: listening to Master's in Business on Bloomberg Radio. My special
Speaker 1: guest today is West Gray. He runs the quantitative asset
Speaker 1: management firm Alpha Architect. Let's talk a little bit about
Speaker 1: quants on Wall Street. So, first question, what do people
Speaker 1: misunderstand about quants and their models in the world of finance. Sure,
Speaker 1: so I probably can't speak on behalf of all quants
Speaker 1: because like every walks of life. There's a lot of
Speaker 1: varieties within that segment. In one corner when it when
Speaker 1: you talk about a quant you think about the physics
Speaker 1: PhD who's never read a finance book ever. He's data mining,
Speaker 1: building crazy models and C plus plus and do whatever
Speaker 1: they do. That that's not the type of quant analysis
Speaker 1: that we bring to the table. We're we're essentially economists
Speaker 1: that are trying to think about how the machine works,
Speaker 1: and we just leverage quantitative analysis and tools that basically
Speaker 1: allow us to conduct what we consider like scientific method
Speaker 1: as best we can. So we have competing hypotheses about
Speaker 1: how the world works. We grab data, we test these
Speaker 1: competing hypotheses, and we're always trying to get better evidence
Speaker 1: space investing. It's not just let's data mind, because we've
Speaker 1: got better computers and more physics PhDs like we're we're
Speaker 1: basically fundamental investors that use quantitative tools to help our
Speaker 1: process and how we think about things in the world.
Speaker 1: So from your perspective, then models are really never finished.
Speaker 1: You're constantly testing them and seeing how can I make
Speaker 1: this better? Where can it be improved, or what may
Speaker 1: have changed in the market. That means that this model
Speaker 1: is no longer delivering any sort of advantage or edge
Speaker 1: that it might have been previously. Sure, there's an element
Speaker 1: of that, and then but the other element is is
Speaker 1: understanding that when you start going down the model creep situation,
Speaker 1: it's it's like the old game where the kids, like
Speaker 1: the little girl first says, hey, you know, the princess
Speaker 1: kissed the fraud and by the end of the circle,
Speaker 1: it's like, you know, Spider Man beat up he Man.
Speaker 1: So it's a total different story. And it's all because
Speaker 1: you have small little changes where you end up in
Speaker 1: a total object place you wanted to end up in
Speaker 1: the first place. So when when we build models, and
Speaker 1: when we think about it, it's very very time and
Speaker 1: ten set of an R and D intenses up front
Speaker 1: to build the simplest, most robust model we can Simpilicity
Speaker 1: beats complexity definitely, because we want to look for the
Speaker 1: what is the real signal here, not the noise, and
Speaker 1: let's just focus on that signal. And what we've found
Speaker 1: is that in financial markets, frankly, nothing's changed. Human behavior
Speaker 1: is pretty constant, and incentives, specifically like this principal agent
Speaker 1: delegating asset management problem, those are two constants, and they
Speaker 1: derive a lot of predictions about what works and what
Speaker 1: doesn't work. And we keep coming back to the same themes.
Speaker 1: Value by cheap stuff, momentum by relatively strong stuff, and
Speaker 1: trend being good trends and everything we look at at
Speaker 1: having memorized, like most of these databases at this point,
Speaker 1: it's it's those three simple muscle limits usually drive all
Speaker 1: other perturbation of anomaly or fact or whatever the heck.
Speaker 1: Super looking, So, how do you have momentum and trends
Speaker 1: as the same group, because normally when you're saying by
Speaker 1: trends you're buying strong stuff going up, but value you're
Speaker 1: buying weak stuff that everybody hates. Yeah, So so really
Speaker 1: the way we look at value and momentum in particular,
Speaker 1: is there really two sides of the same behavioral coins.
Speaker 1: So if you look at value, one of the arguments
Speaker 1: for why it outperforms is obviously it could be more risky,
Speaker 1: and we can't discount that. That's surely one component. But
Speaker 1: there is a mispricing component, we think, and that's what
Speaker 1: is that an inefficiency? It is, but it's it's hard
Speaker 1: to arbitrage, which we can discuss. But what values driven
Speaker 1: by we think, and by we I mean, like the
Speaker 1: academic research community, is an overreaction to bad news. Essentially,
Speaker 1: they throw the baby out at the bathwater. On average momentum,
Speaker 1: it turns out is there's two competing theories, Like we're
Speaker 1: talking about relative strength momentum, which is the classic kind
Speaker 1: of stock selection momentum academics discuss, and that the proponse
Speaker 1: of the evidence is that it's an under reaction to
Speaker 1: positive news, so values and overrea to bad news. The
Speaker 1: evidence in general seems to suggest that momentum is more
Speaker 1: of an underreaction to positive news that's being signaled in
Speaker 1: the price. But because people are overconfident in their own
Speaker 1: information set, even though the price keeps telling them yeah,
Speaker 1: and there's disposition effects. You know, you're supposed to let
Speaker 1: your winners ride and cut your newsers short. What do
Speaker 1: people do the opposite? So there's a lot of kind
Speaker 1: of organic, you know, fake supply that comes on the
Speaker 1: market for high momentum stocks, and they're only because they're
Speaker 1: a winner. People are hey, hit the bed. Nobody. I
Speaker 1: when I started, I used to hear this all the time,
Speaker 1: and it turns out to be terrible advice. Nobody ever
Speaker 1: went broke taking a profit. Yeah, exactly, And that's the
Speaker 1: worst just supply for for a momentum. Yeah, it just
Speaker 1: puts supply into the market when maybe the fundamental should
Speaker 1: be the stocks should be worth a hunted and starts
Speaker 1: at eighty, but it can only go to ninety because
Speaker 1: as it starts moving, and who wants to be the
Speaker 1: last guy owning it on the highest peak? Fear of
Speaker 1: looking stupid? Yeah, fair looking stupid. So I love the
Speaker 1: symmetry of overreaction on the value side undreaction on the
Speaker 1: momentum side. Let me throw a little bit of a
Speaker 1: curve ball again. What I learned early in the career,
Speaker 1: which may or may not be true, is hey, you
Speaker 1: know managers, when you look at the big institutions, hedge funds,
Speaker 1: mutual funds, endowments, they have their favorite names, and especially
Speaker 1: if it's a fund that has a lot of four
Speaker 1: one K or that sort of inflow, there's only so
Speaker 1: many names they're gonna buy in. As fresh money comes
Speaker 1: in over the transom every week, they put it to
Speaker 1: work in the same names, and that's why you see
Speaker 1: some form of of persistency of price action. Is that
Speaker 1: a fair description of momentum or is that just a
Speaker 1: narrative that I think that that's basically like the fund
Speaker 1: flows arguments. And there's actually a new paper that I
Speaker 1: can't remember. It's some new like germ of finance papers,
Speaker 1: a theory paper this trying to explain the value and
Speaker 1: momentum effect via fun flows. Were like one fund is
Speaker 1: like losing because they own like the you know, the
Speaker 1: value stocks, so they're getting out of there. Then other
Speaker 1: funds they're they're winning, they own the winner stocks, and
Speaker 1: then you know, because they're winning, they get more fun flows,
Speaker 1: and then those keep moving and eventually, like the value
Speaker 1: stocks get too cheap, they may in revert. Momentum stocks
Speaker 1: unless you keep staying in the high momentum eventually crash
Speaker 1: and burn. And there's all these theories about trying to
Speaker 1: explain value momentum, not via behavioral like overreaction to bad
Speaker 1: news unreaction to good news theory, but through like a
Speaker 1: fun flows argument. There could be something to it. I think,
Speaker 1: I think all no one really knows exactly how and
Speaker 1: while this works, but it's all about what is the
Speaker 1: proponance of the evidence kind of tilt you towards because
Speaker 1: God only knows what really explains value, So you really
Speaker 1: don't need to know why it works. You just need
Speaker 1: to know this works. This doesn't stay with what works
Speaker 1: avoid what doesn't to some extent. And you know, as
Speaker 1: this has a great quote about like we all knew
Speaker 1: the world was flat before, or it wasn't flat before
Speaker 1: we could explain exactly, you know, why it was. Some
Speaker 1: of us still held out, Yeah, exactly, and value something.
Speaker 1: I think that's way more understood because it's more intuitive.
Speaker 1: Um by cheap stuff everyone hates, you get kind of distress. Premium,
Speaker 1: you know, careers, premium were momentum. You know this. We
Speaker 1: just wrote a whole book dedicated trying to understand this.
Speaker 1: You know, there seems to be this underaction to the
Speaker 1: good news. But there's another thing when I started reading about,
Speaker 1: like what Soros talks about with with reflexivity, at some level,
Speaker 1: price action itself can actually influence fundamentals. And here would
Speaker 1: be an example. Let's say we're out in the valley,
Speaker 1: like Silicon Valley. We have Google, who's got great price
Speaker 1: action linked in who just dropped the hunter you know
Speaker 1: fifty until recently here, But so what do you think
Speaker 1: when most of your comp and it's all human capital.
Speaker 1: Business is tied to your stock price Linkedins, so their
Speaker 1: price movement momentum fundamentally is changing their fundamentals. And if
Speaker 1: marketplace can't anticipate kind of the second derivative or nonlinear change,
Speaker 1: they'll always kind of underappreciate the benefit of good prices
Speaker 1: because you also get lower cost of capital on the street.
Speaker 1: If I'm a high flying stock, every banker in the
Speaker 1: world is going to help me go sell that over
Speaker 1: priced stock to fund acquisitions and what have you. If
Speaker 1: I'm a total Loserville stock, you know, I gotta pay
Speaker 1: cash like LinkedIn yeah now, and now I gotta like
Speaker 1: pay real market cost of capital. And you're at a
Speaker 1: competitive disadvantage compared to this company that can you know,
Speaker 1: check out overvalued stock to do acquisition until Microsoft comes
Speaker 1: along advise you at a nice fat premium. So there's
Speaker 1: there's momentums complex. You mentioned momentum and you mentioned Cliff Assness.
Speaker 1: Am I correct in saying both you and Cliff had
Speaker 1: Eugene Fama as your thesis h advisors at Chicago? Is
Speaker 1: that right? We have more similar than that, even he
Speaker 1: was also a working undergrad. So unfortunately both of your
Speaker 1: your dissertations were on momentum to the guy who essentially
Speaker 1: invented the efficient market hypothesis. That's right. So so we
Speaker 1: apparently like a lot of pain and english and fighting
Speaker 1: uphill when we probably don't have to. Maybe that's a
Speaker 1: shared characteristics of Cliff and I is what it seems.
Speaker 1: You guys have put out a few e t F
Speaker 1: You've worked and advised on other e t f s.
Speaker 1: How has the exchange traded fund shift changed the game
Speaker 1: in terms of cost and execution? I think it's it's
Speaker 1: revolutionized access to retail I would say more typical investors.
Speaker 1: In the old days, you could always get clean, process
Speaker 1: driven factor exposures as institutional investor, but you never could
Speaker 1: do it as a retail investor with tax efficiency and
Speaker 1: reasonable fees. And now the world is your oyster. You
Speaker 1: can go on your you know, Schwab account by you
Speaker 1: know a really great factor exposure for low costs with
Speaker 1: tax efficiency and full transparency. And I think that's revolutionizing
Speaker 1: the asset manager business as we speak. So, if people
Speaker 1: want to read more about your writings and your research,
Speaker 1: where's the best place for them to find you? Best
Speaker 1: places just go to ALF architect dot com and sign
Speaker 1: up for the blog, and that's that's how we communicate
Speaker 1: to our audience. We have been speaking with Captain Wesley Gray,
Speaker 1: formerly of the U. S. Marine Corps, now with Alpha Architect.
Speaker 1: If you've enjoyed this conversation, be sure and hang out
Speaker 1: for our podcast where we keep the tape rolling and
Speaker 1: continue chatting about all things quantitative. Be sure and follow
Speaker 1: my daily column on Bloomberg dot com or follow me
Speaker 1: on Twitter at rit Halts. I'm Barry rit Halts. You're
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Speaker 1: Resnick Accounting, Tax Advisory. West, thanks so much for being
Speaker 1: so generous with your time. UM, so there's so much
Speaker 1: stuff to go over. We blew through so many questions. UM,
Speaker 1: but I really enjoy you, know West, I know West
Speaker 1: for a good couple of years. I've followed Alpha Architect
Speaker 1: for a while and everybody in my shop loves reading
Speaker 1: his work. Uh. He is another one of the collection
Speaker 1: of people who are really and I think you made
Speaker 1: this clear during the the radio portion. He is evidence
Speaker 1: based and data driven. So much of of finance is
Speaker 1: filled with myths and heuristics and and shorthand rules of
Speaker 1: thumb that turned out not to be true. Looking at
Speaker 1: the actual data um really makes a really makes a
Speaker 1: big difference. So let's let's go over a few questions
Speaker 1: we we didn't get to, including a quote of yours
Speaker 1: that I that I really like. And I don't remember
Speaker 1: which book this was, but you said sustainable Alpha requires
Speaker 1: sustainable clients. What does that mean? Sure? So I've always
Speaker 1: been puzzled with this question of we find this factor
Speaker 1: it generates the access for terms. Why is this there?
Speaker 1: And why will it continue because you know? Sorry? And
Speaker 1: why why hasn't everybody found this and stayed with it
Speaker 1: if it's generally exactly and you have open secrets called
Speaker 1: value momentum value as the strategy has been around for
Speaker 1: a hundred years. Momentum was talked about like also two
Speaker 1: hundred years ago, so it's not like these are secrets,
Speaker 1: and yet they continue to work. So I needed to
Speaker 1: intellectualize how is this possible? And what I started thinking
Speaker 1: about is is I started thinking about behavioral finance and
Speaker 1: the two real building blocks of it, which are one
Speaker 1: understanding human behavior and to understanding institutional incentives to arbitrage
Speaker 1: bad behavior. So most factors exist typically because there's some
Speaker 1: sort of expectation are on behalf of investors that creates
Speaker 1: a dislocation from fundamental prices, so that that would be
Speaker 1: either the something like that, because you've got to have
Speaker 1: someone can't be a perfectly rational buyer and seller, because
Speaker 1: then prices would never deviate from their fundamental value in
Speaker 1: efficient market, ipocess would hold. But clearly there's overwhelming evidence
Speaker 1: that that happens. But the question is wise does it sustain?
Speaker 1: And so that's where we got to look at the
Speaker 1: incentives of those who manage the capital and for easy
Speaker 1: things that are easy to arbitrage, Like if we see
Speaker 1: a twenty dollar bill on this table, well let's grab it.
Speaker 1: What if we see a twenty dollar bill on the table,
Speaker 1: but there's a grizzly bear over it, Like is that
Speaker 1: rational that a twenty dollar bills there no, but the
Speaker 1: problem is to pick up this twenty it's a grizzly
Speaker 1: bear there. So sometimes it's it's not frictionless to arbitrage prices,
Speaker 1: which is a cordline assumption of the Fisher market, I passes,
Speaker 1: is that competition will always drive prices to fundamental because
Speaker 1: it's assumed it's easy to arbitrage. But that is totally
Speaker 1: not true. And I would say the biggest issue with
Speaker 1: quote unquote arbitrage on things like value or momentum is
Speaker 1: career risk because to do those strategies, they're really long
Speaker 1: duration kind of expected winners, but in the short one
Speaker 1: they can get destroyed relative to standard benchmarks. We were
Speaker 1: discussing the pain trade. The pain trade exactly and pain
Speaker 1: trades ironically are the exact trades you want to own
Speaker 1: if you want to have a sustainable out of sample
Speaker 1: chance at outperformance, because now there's you want to have
Speaker 1: a credible reason why other people on the side of
Speaker 1: this trade or not make a good decision over overreaction,
Speaker 1: bad news, unreaction, good news, or what have you. Then,
Speaker 1: on the other hand, we understand, well, what are the
Speaker 1: other competitive players in the market doing and why aren't
Speaker 1: they already doing this? And it's usually because they like
Speaker 1: their jobs a lot more than they like actually take
Speaker 1: advantage of anomalies. That that's the famous Kings quote. Better
Speaker 1: to fail conventionally than succeed un convention exactly. And there's
Speaker 1: tons of research about this. It all boils down what
Speaker 1: they call the principal agent conflict. There's there's a classic
Speaker 1: theory paper um under Cipher and rob Vision and in
Speaker 1: general Finance ninety seven is called limits of arbitrage, and
Speaker 1: they make this very simple point. We all know what works.
Speaker 1: The problem is in the short run, it may not work,
Speaker 1: especially relative to other stuff. And to the extent that
Speaker 1: I can't credibly convince my investors that I'm not an idiot,
Speaker 1: even though I just lost twenty points to the index
Speaker 1: and they pull my capital, I'm actually not in a
Speaker 1: position to take advantage of this, so I kind of
Speaker 1: hold back. So the only way to really exploit true
Speaker 1: active anomalies is you need to one have a process
Speaker 1: that takes advantage of some bias problem. But then more
Speaker 1: importantly is you need to couple the capital that's there
Speaker 1: to exploit and make sure it has the same duration
Speaker 1: as the anomaly it's trying to exploit, which is long term,
Speaker 1: so long term duration on the capital, long time duration
Speaker 1: on the anomaly, short term human behavior getting in the
Speaker 1: way exactly. And its analogy is like the bank that
Speaker 1: that we discussed earlier, where a bank lands long borrows
Speaker 1: short great most of the time, but sometimes you have
Speaker 1: a run on the bank. Same thing with value strategies,
Speaker 1: long duration opportunity that more often than not gets coupled
Speaker 1: with short duration capital. Sometimes there's a run on the bank.
Speaker 1: And when that run on the bank occurs, the winner
Speaker 1: in that trade ends up being the Warren buffets, the
Speaker 1: guys that just hold onto these things like grim death
Speaker 1: and will not sell. I have a friend who runs
Speaker 1: a value hedge funds, if there's such a thing, and
Speaker 1: he says he'll go through the pain trade for quarters
Speaker 1: and years at a time, and he said he's been
Speaker 1: doing it for forty years. He knows when the portfolio
Speaker 1: is going to start out performing because usually just before
Speaker 1: he starts getting all sorts of inquiries about redemption and
Speaker 1: people have had enough, and it's usually at that moment
Speaker 1: when when the wheel is turning definitely, we we we
Speaker 1: know multiple multibillion dollar hedge for manasures with heavy value
Speaker 1: focus that are literally out of business because of the
Speaker 1: back half of two thousand fifteen because deep value just
Speaker 1: got destroyed and redemptions just overwhelmed their ability to convince
Speaker 1: the capital stage. So so let's talk about career risk,
Speaker 1: and let's talk about running money in real time. You
Speaker 1: run a model, you run multiple models, multiple ETFs, but
Speaker 1: you run a model that essentially is two sleeves. One
Speaker 1: is value and the other is is the momentum side.
Speaker 1: And invariably one of those two sleeves. And by the way,
Speaker 1: I've explained this to people and the like, so wait,
Speaker 1: they first they screened for value and then they screen
Speaker 1: for momentum. No, these are a dual model where there
Speaker 1: is simultaneously offsetting value and momentum. Uh, two different screens
Speaker 1: and two different pools of stocks. But invariably one of
Speaker 1: those sleeves is getting She'll act usually when one is
Speaker 1: doing well, the other is doing poorly. Number one, how
Speaker 1: does that make money over the long haul? And Number two?
Speaker 1: What happens in the real world with all but the
Speaker 1: most savvy institutions or individuals who may have money in
Speaker 1: a portfolio like that. Sure, So so the way um
Speaker 1: that value momentum work in a combination, whereas you mentioned,
Speaker 1: it's not about an integrated package. It's about pure value
Speaker 1: focusing on that religion, and then pure momentum focused on
Speaker 1: that religion, combining the two and they happen to have
Speaker 1: this very great dynamic relationship where they're like Yin and yang.
Speaker 1: When one is blown up, the other one on average
Speaker 1: tends to be working. So you get amazing diversification benefits.
Speaker 1: Whereas if you look at either of those strategies as
Speaker 1: a standalone basis, you know you're gonna want to jump
Speaker 1: off a bridge it's too volatile. But that combination basically
Speaker 1: gives you more survivability. From like a human psychology standpoint,
Speaker 1: pure value, how you im pure momentum combined ran in
Speaker 1: a very active way, can still have opportunities to have
Speaker 1: multi year underperformance, but it's more sustainable than just being
Speaker 1: a pure value person or a pure momentum person where
Speaker 1: you could go for five ten years in theory of underperforming,
Speaker 1: and who can do that? Even I would have problems,
Speaker 1: you know, sticking to the model probably and I'm like
Speaker 1: a cold believer in this stuff. So so what do
Speaker 1: you say to somebody who says, hey, I'm in this
Speaker 1: portfolio for three years. I understand it intellectually, but you're
Speaker 1: under performing the benchmarked by forty basis points for three years.
Speaker 1: How do you communicate, Well, that's part of the model
Speaker 1: that's not unexpected, and soon it will be out performing
Speaker 1: and by a substantial by file undred basis points. How
Speaker 1: do you communicate that? So, the way we communicated is
Speaker 1: this is not for everyone, it's for we have a
Speaker 1: very segmented component of the marketplace where we need to
Speaker 1: identify long duration cap roll that's really sophisticated and has
Speaker 1: minimal agency conflicts where their career doesn't really amiable consultants,
Speaker 1: No consultants, no, it's it literally who wants to take
Speaker 1: care of their money best, the guy who owns their
Speaker 1: own money because they actually have horizon, they don't have careers,
Speaker 1: not gonna fire themselves, and they just want to maximize
Speaker 1: their best chance of long term expected compounding. That is
Speaker 1: the segment that we talked to. That's a really specific,
Speaker 1: very specific niche, and the reason we're so hyper focus
Speaker 1: on that niche is going back to that sustainable, active
Speaker 1: framework where you need a couple long duration arbitrage with
Speaker 1: long duration capital in order for it to be a victory.
Speaker 1: You that's the only way you can believably exploit these
Speaker 1: anomalies is the capital. The source of capital, and the
Speaker 1: education of that capital and its ability to stick to
Speaker 1: the program is more important than the nuance of your model. Yeah, Like,
Speaker 1: we can do a billion perturbations of buy cheap, they're
Speaker 1: all gonna be nine correlated. Do we think ours is
Speaker 1: marginally better than Joe blows down the street. Sure, but
Speaker 1: you know if you stuck a gun to my head
Speaker 1: and said which value molo do you want, I'd be like,
Speaker 1: they're all good. That's not the hard part. The hard
Speaker 1: part is making sure the money that's in it is
Speaker 1: able to actually exploit it the duration of that. Yeah,
Speaker 1: and so we that's why we have this saying, like
Speaker 1: most products on the street, they're they're sold, not bought.
Speaker 1: For our strategies, we say no, no, we have to
Speaker 1: have our products be bought, not sold, because it's more
Speaker 1: important that our clients and investors understand explicitly, maybe even
Speaker 1: more than we even understand it, how and why this works.
Speaker 1: Because it's not it's not about us being smarter than
Speaker 1: the next guy. There's already hundred peach d guys around here.
Speaker 1: They got higher i q s and I could ever
Speaker 1: dream of. That's not our edge, our edges getting the
Speaker 1: capital matched with a reasonable process that's good enough for
Speaker 1: our you know, not brains, that's gonna be. That's the
Speaker 1: buffet trade basically. So let's talk about your dissertation with
Speaker 1: Eugene Fama. We we mentioned that he was your your advisor.
Speaker 1: What's it like pitching momentum to the father of the
Speaker 1: efficient market hypothesis? So Cliff did value and momentum to
Speaker 1: the vastness. I actually pitched him on value exclusive. I
Speaker 1: wasn't going to touch the momentum, pain trade and a
Speaker 1: dissertation because I wasn't that a wild as Cliff was. Um.
Speaker 1: But what I did is, you know, I don't I
Speaker 1: has always been a stock picker. Reading Ben Graham, warm
Speaker 1: off its stuffed, I was blue in the face. I
Speaker 1: believed that that was the way of the world. Um.
Speaker 1: And so obviously, you know, you have the most famous
Speaker 1: guy in the world that says no, that's never gonna work.
Speaker 1: Screw this guy. I'm gonna figure out how to like,
Speaker 1: you know, let's see if we can an outsmart this guy.
Speaker 1: So what I did is, um, I'm sure if we
Speaker 1: were like Joe Greenblatt, a little little book, little yeah,
Speaker 1: great book, great ideas. He has this organization called Value
Speaker 1: Messrs Club UM, which is ah, it's basically like an
Speaker 1: invite only group of all these hedge fund managers and
Speaker 1: really smart kind of fundamental stock pickers UM. And you've
Speaker 1: been doing it since two thousand. I was like, hey,
Speaker 1: this is a really great data source where there's all
Speaker 1: these like full scale stock pitches from the by side.
Speaker 1: Let's look at how it's done over time's let me
Speaker 1: guess they stunt the joint on. Well no, actually interesting enough.
Speaker 1: Well it's kinda but in an indirect way. So when
Speaker 1: you actually look at the performance of as a whole,
Speaker 1: they're actually pretty good. Like these people had real value.
Speaker 1: It's unclear that if you paid in their funds after
Speaker 1: the but there's certainly evidence that these guys have some
Speaker 1: skill and an especially when you get that segmented down
Speaker 1: to like the small value, there's no doubt these this
Speaker 1: group has a ton of skill. There's a shortage of information,
Speaker 1: there's not a lot of coverage, there's more risk's whole bunch.
Speaker 1: When you read there, when you read their thesis, a
Speaker 1: lot of these guys are talking about long duration anomalies
Speaker 1: and like, hey, the cell side is crazy because they're
Speaker 1: trying to beat the So a lot of it made
Speaker 1: intuitive sense, um, and it was all good. I literally
Speaker 1: read every single one of these stock pitches catalog did.
Speaker 1: I had them all database by, Like what did they
Speaker 1: mentioned as to why they liked this idea? Would have
Speaker 1: you one part of it? I had a theory papers well,
Speaker 1: which was beyond this discussion. But um, right, this thing up.
Speaker 1: It actually says that these value investors actually do have skill.
Speaker 1: And you know the fisher marketypothsis. It just it seems
Speaker 1: to be some slack in it, which is fine, um,
Speaker 1: you know. So so I sent it off to him
Speaker 1: and of course, I you know, the first team I
Speaker 1: get is basically no, this is wronging a conclusions false. Um.
Speaker 1: So I'm like, great, it just wastes the year of
Speaker 1: my life and I'm totally scared. But you have to
Speaker 1: you can he I'm told he's pretty open minded, very
Speaker 1: openustness said, listen, I think you're wrong, Prove I'm I'm
Speaker 1: not correct exactly so. And and this is my like,
Speaker 1: oh my god, I'm dead moment. So of course I
Speaker 1: run down. I'm like, you know, and everyone calls him
Speaker 1: prof fam I'm sure like Clifaz's price, I would never
Speaker 1: call him by his first team. Yeah he's so gane.
Speaker 1: Let me tell you why. Yeah, he's just too He's
Speaker 1: too steadily. Like I just feel like, you know, I
Speaker 1: don't want so many people I have a lot of
Speaker 1: I'm not a big E M H guy, although I
Speaker 1: the weak version of it makes sense, but there are
Speaker 1: so many people I have all this respect for who
Speaker 1: just sing say the world about him? Yeah, I mean, yeah,
Speaker 1: a little off track, but as just a human being.
Speaker 1: You know, the guy grinds every day. He's super honest,
Speaker 1: super humble, works his face off, Like I don't care
Speaker 1: if he's bacon donuts. I like this dude. Um. He
Speaker 1: happens to be a Nobel Prize winner and that's awesome,
Speaker 1: but but it's more about a fundamental respect for just
Speaker 1: working his whole process. Yeah, what he's all about, like
Speaker 1: not even death act. He's a financial economists. I just
Speaker 1: like his the way it carries himself. You know. That's
Speaker 1: why I said the exact same thing about Charlie Ellis,
Speaker 1: who was a guest on the show Who and I
Speaker 1: and I after the show, we walked downtown. I spent
Speaker 1: like an extra hours with him, and I came away
Speaker 1: with like, this is the finest human being I've ever
Speaker 1: met in my life. And I'm hearing the same sort
Speaker 1: of thing from the same thing. Just good dude, Like
Speaker 1: like if I was in the Marine Corps and I
Speaker 1: could transplant him fifty years or I want to, like,
Speaker 1: this guy is good to go it regardless of what
Speaker 1: he knows about finance. But so back to that, I
Speaker 1: ran down there and and it was the same thing.
Speaker 1: Like his Cliff said, he's very very open minded empirical evidence,
Speaker 1: scientific focus, like if you got the evidence, you run
Speaker 1: the right robustant tests, like all good. Um, so go
Speaker 1: down there. And you know, in my dissertation in the
Speaker 1: abstract for this particular paper, you know, I made an
Speaker 1: overstated claim. I said value investors beat the market. You know,
Speaker 1: He's like, no, the sample value investors you analyze be
Speaker 1: at the market. And so literally it was like that
Speaker 1: two or three word difference that because semantics matter and
Speaker 1: that kind of stuff, because one is an overstatement and
Speaker 1: the other is within the sub slept set of value managers.
Speaker 1: I analyzed, they clearly have some skill, but you can't
Speaker 1: say that value the market. And I was like, he's
Speaker 1: being very precise, very precise, which was a great lesson.
Speaker 1: And then and to be more precise on that particular thing.
Speaker 1: This is not really in the dissertation because it's this
Speaker 1: is a little bit too practitioner focus, I would say.
Speaker 1: But after the fact we said, wow, this is incredible.
Speaker 1: You have all these people that spend all this time,
Speaker 1: incredible effort in data collection information come up with a
Speaker 1: thesis on the stock pitch. Um, I'm really curious, can
Speaker 1: this be quanted out? Turns out that we looked at
Speaker 1: like that quant value agorithm, which basically is is essentially
Speaker 1: a computer version of what the Value Investors Club guys
Speaker 1: do by cheap high quality firms with a ton of
Speaker 1: analysis on like the quality component, but cheapness is is
Speaker 1: a is a primary. Turns out that the correlation between
Speaker 1: just buying like a superactive cheap high quality basket is
Speaker 1: essentially the same and very very highly correlated with kind
Speaker 1: of what quote unquote the alpha generation is from these
Speaker 1: stock picker people. So you know it's you know, what
Speaker 1: is alpha? What is beta? Who knows? Um? You know,
Speaker 1: alpha is just intercept on a regression where if you
Speaker 1: put enough factors in there, obviously alpha is always zero,
Speaker 1: but to some extent of you know, super concentrated. Wait
Speaker 1: when you say, obviously alpha is always zero, but is
Speaker 1: it always zero? It is if you keep adding factors
Speaker 1: that explain the variants. Because because alpha, so you risk adjusted.
Speaker 1: You once you once you go through all those different dimensions,
Speaker 1: since we're talking about Chicago, eventually you can rationalize where
Speaker 1: all that alpha comes and eventually alpha becomes beta. Yeah, exactly,
Speaker 1: because all it is Alpha is literally just when you
Speaker 1: calculate this stuff formally, beta is the coefficient on the factor.
Speaker 1: Alpha is just kind of the average intercept, the kind
Speaker 1: of the extra you get that's unexplained for. So the
Speaker 1: deviation that you're looking for, why it occurs? Yeah, after
Speaker 1: controlling for all these other quote unquote risk factors. But
Speaker 1: let's take momentum for example. Okay, let's say we think
Speaker 1: momentum is alpha. If you run momentum and you control
Speaker 1: for market size, value, blah blah blah, you're gonna have
Speaker 1: a huge alpha. So what do you do to control
Speaker 1: for the alpha momentum? Throw a momentum factor on there. Now,
Speaker 1: what happens the momentum strategy they have no alpha. So
Speaker 1: now is that because they don't work and they're not
Speaker 1: miss price or is that just because you controlled for
Speaker 1: the momentum factor to say that momentum doesn't work anymore. Well, no,
Speaker 1: momentum still works and it's been embraced in the factor.
Speaker 1: But that doesn't necessarily mean that that factor is a
Speaker 1: true risk factor. What if the returns associated with it
Speaker 1: are associated with miss pricing problem, not like fundamental risks,
Speaker 1: like it co varies with your future consumption or whatever
Speaker 1: you know, fancy you know macro or model that some
Speaker 1: economists is coming up with. And so I think the
Speaker 1: problem with that the idea of alpha's and beta's is
Speaker 1: alpha is an intuitive concept, is excess return controlling for
Speaker 1: a bunch of risks. But the mechanical construct, it's a
Speaker 1: statistical item and it can be totally manipulated. Where obviously
Speaker 1: all alpha can become beta because you just put the
Speaker 1: alpha generator on the beta side and you can go
Speaker 1: buy it. But just because it can be beta, that
Speaker 1: doesn't mean it's not alpha doesn't mean it's not real
Speaker 1: or at least for that subset, And it doesn't mean
Speaker 1: it's It's not easy to explain, right, because momentum is
Speaker 1: a great example. Momentum is underperformed as a long short
Speaker 1: factor for arguably five to ten years. Everyone's like, oh,
Speaker 1: it's dead. Yeah. One of my old bosses, Chris Gates,
Speaker 1: he wrote the paper like the long World's longest back tests.
Speaker 1: They get data back and he actually expecially says in
Speaker 1: the abstract momentum factor has underperformed for tenure cycles like
Speaker 1: seven times. So this is this underperformance recently a momentum Yeah,
Speaker 1: it's not all that operational, it's just so so one
Speaker 1: of the one of the things you mentioned before about
Speaker 1: the two two issues you look at, which is the
Speaker 1: behavioral side and and the principal agent side. So I
Speaker 1: would imagine someone like you looks at the FED with
Speaker 1: Quie and up and all that stuff and says, yeah,
Speaker 1: we don't care about that. It's not. What matters is
Speaker 1: is the behavioral and the agency issue, not all these externalities.
Speaker 1: It's all about what is the signal? What is the noise?
Speaker 1: The signal is the huge It just driven from the
Speaker 1: humans evolved in the game and the dynamics and the
Speaker 1: rules of the game they play and how that shapes
Speaker 1: their own synips. That doesn't change no matter what. I
Speaker 1: don't care about g DP what the FED says, because
Speaker 1: it's relevant. Human behavior stay indo chain, stay in the
Speaker 1: same in human incentives are stay in the same in
Speaker 1: the institutional construct that we currently live in, which is
Speaker 1: primarily driven by a lot of delegated asset management. That's
Speaker 1: funny because as we're as we're recording this, the FET
Speaker 1: is meeting and uh literally the news is coming out
Speaker 1: the second and we won't even talk about it because
Speaker 1: it's meaningless. Instead, let's in the last ten or fifteen
Speaker 1: minutes I have you, let's get to some of my
Speaker 1: favorite questions. Um, well, you mentioned Cliff ass Nests. Who
Speaker 1: else were other quants that you you admired or who
Speaker 1: were mentors of yours? Tell tell us the people who
Speaker 1: who influenced your approach to invest in Sure, I'd say
Speaker 1: the danser directly like the quants that I admire. Obviously,
Speaker 1: Cliff as nous I like a lot. He does value momentum.
Speaker 1: HRS a great firm. Uh, you know, booth at Ata
Speaker 1: is great. They figured out how to capture small value premium.
Speaker 1: And I think probably the most underrespected or under appreciated
Speaker 1: quant is Jack Bogel at Vanguard because indexing is a
Speaker 1: form of systematic quant investing. It's just your your systematically
Speaker 1: buying these market capuited passive indices. And for all intents
Speaker 1: and purposes, he is a quantitative, systematic investor, and clearly
Speaker 1: that's in a world of good for society. And his
Speaker 1: alpha is we recognize that the cost structure is the
Speaker 1: most important element investing, and if we could do everything
Speaker 1: we can to reduce the cost factor, that's gonna our
Speaker 1: beta is everybody else's is actually a form of alpha
Speaker 1: if only you've given enough time. Yeah, costs and taxes,
Speaker 1: or if you can minimize those somehow, that that is
Speaker 1: always the answer now and that even they talk about
Speaker 1: like active active is only bad to the extent that
Speaker 1: it's the cost of achieving it. The net benefit is
Speaker 1: not positive, it's negative because it goes in taxes and
Speaker 1: fees to some idiot people. People are surprised when I said,
Speaker 1: you know, Vanguard has a trillion dollars in active funds
Speaker 1: that like really has anybody written a paper or or
Speaker 1: or a column, and I may have to if nobody
Speaker 1: has Jack Bogel the quant. I don't know if anyone has.
Speaker 1: But so now now you've forced me to do this,
Speaker 1: that's what's gonna happen. I think he might be the
Speaker 1: world's greatest quant, just that no one really appreciate it.
Speaker 1: I'm gonna have to quote you in this and you've
Speaker 1: just given me an idea. Now I have to get
Speaker 1: this out before the podcast goes up, so uh, it'll
Speaker 1: it'll be pretty interesting. So you've mentioned Buffett, You've mentioned Graham.
Speaker 1: What other investors have influenced your approach? I would say, um,
Speaker 1: not much beyond that, Like Graham taught me about, you know,
Speaker 1: thinking about businesses or stocks is businesses. Buffett actually didn't
Speaker 1: add any thing onto that. But I just like his
Speaker 1: like transparent approach and the whole idea that integrity is
Speaker 1: everything and in the end that's what you live and
Speaker 1: die by. And he has that old what were you know?
Speaker 1: You know, integrity spends a lifetime to build, five minutes
Speaker 1: to destroy, which it has nothing to do with investing,
Speaker 1: but it has everything to do with investing. Well, it
Speaker 1: has everything to do with working in the investment field exact.
Speaker 1: It's always you know, my my favorite line is no
Speaker 1: one has a patience to get rich slowly, and the
Speaker 1: people who are in a hurry invariably run into trouble.
Speaker 1: You got it. It's amazing. Let's talk about books you
Speaker 1: mentioned one or two earlier. What are some of your
Speaker 1: and fiction, nonfiction, investing, whatever, what What are some of
Speaker 1: your favorite books? Yeah, so, unfortunately I'm not a one
Speaker 1: of my weaknesses is I'm very pragmatic and I just
Speaker 1: read stuff that helps me get better. So you're reading
Speaker 1: more academic papers, Yeah, I read. I read a lot
Speaker 1: of journals, four books. Some of the things that heavily
Speaker 1: influenced the way I've thought about things, and I know
Speaker 1: you know it very well, like Dan Kahneman's book The
Speaker 1: Fastest Epic. Another one is, you know Taylor sustained that
Speaker 1: Nudge book. The whole idea of like liberty Ryan paternalism,
Speaker 1: I thought made a ton of sense because I used
Speaker 1: to be a libertarian. I was like, wait a secondaris
Speaker 1: humans involved and they make bad decisions. You have to
Speaker 1: have some bumpers up otherwise that someone just someone just
Speaker 1: ran maybe with Samantha b at the Libertarian convention, and
Speaker 1: one of the guys got booed for saying, I believe
Speaker 1: that we should have um people, the states should mandate
Speaker 1: tests for driving. We don't just give anyone a car.
Speaker 1: And they were booed by the Libertarians, and it's like, oh,
Speaker 1: so you guys don't understand humans at all. Yeah, yeah,
Speaker 1: and that's my big I mean, I'm a I'm gonna
Speaker 1: be a Gary Johnson voter. He was the one who
Speaker 1: was booed when he said, yes, you should. He's a
Speaker 1: pragmatic hematic libertarian. That's a subset of the part. And
Speaker 1: guess what, none of these political folks appealed to the
Speaker 1: pragmatic part. You always get extremes because that's what sells well.
Speaker 1: Was but yeah, give me one more book, the other one,
Speaker 1: a whole bunch of them. Chardini's books on like the
Speaker 1: science of persuadion, influence, influence, fifty scientific ways to say yes,
Speaker 1: like after re and that guy's stuff. It just made
Speaker 1: me rethink the whole world of of like human thinking
Speaker 1: and decision making from the perspective of like a marketing person,
Speaker 1: and how you get influence and bombarded every day in
Speaker 1: subconscious ways to do things you may or may not
Speaker 1: want to do. But it's very important, I think, to
Speaker 1: be aware of this influenced tactics out there, so one
Speaker 1: you can defend against it, and then too, you can
Speaker 1: use it to your advantage, you know, in a sensible,
Speaker 1: you know, high integrity way. I'm gonna out myself embarrassingly.
Speaker 1: I've had that book on my bookshelf for years. I
Speaker 1: still haven't read it. Unlivable. You're not the first want
Speaker 1: to say that. All right, we're down to our last
Speaker 1: few favorite questions. So if somebody, if a millennial's coming
Speaker 1: to you and says, I'm beginning my career in finance,
Speaker 1: what sort of uh, what sort of advice would you
Speaker 1: give them? So back to our discussion about manual labor,
Speaker 1: I would say, first, get mentally tough. So do sports.
Speaker 1: Do things that are painful that allow you to be tough.
Speaker 1: Adapt because we're in the world where it's gonna change,
Speaker 1: it's gonna be tough, it's gonna be adapting, and you're
Speaker 1: competing not with Americans, you're competing with the globe now.
Speaker 1: So you know, we have a lot of you know,
Speaker 1: my old students are Chinese guys, and these guys grind,
Speaker 1: they work harder, faster, stronger, and that's who you're competing
Speaker 1: with out there. So unless you're you gotta rate rise occasion.
Speaker 1: I hear, I hear a lot of marine corps. Yeah,
Speaker 1: so I would say, just get mentally tough, don't It
Speaker 1: doesn't even matter what you learn. Get mentally tough and
Speaker 1: know how to adapt and overcome. And then the other
Speaker 1: thing I said here I just write down my notes
Speaker 1: is you know, I become a either a robot salesman
Speaker 1: or a robot manufacturer because I feel like in the
Speaker 1: very near future robots are taken over and so you
Speaker 1: might as well adapt and train to the future and
Speaker 1: not you know, be a basket weaver guy anymore because
Speaker 1: it's not gonna pay um. And our final question, what
Speaker 1: is it that you know about investing today that you
Speaker 1: wish you knew fifteen years ago? Well, I wrote down
Speaker 1: the Big Three, which have been uh, you know, endowed
Speaker 1: upon me by a lot of our investors who are
Speaker 1: all insanely rich. And I'm like, wow, that's pretty cool.
Speaker 1: How how do you guys do that? And there's literally
Speaker 1: three themes that come out of every single one of
Speaker 1: these stories. Minimize tax burdens, defer to for to for
Speaker 1: have horizon, and live below your means. So always be humble,
Speaker 1: you know, never rise to the level of what you
Speaker 1: can afford. Just you know, live within your means and
Speaker 1: enjoy your life with what you got. Um and and
Speaker 1: those are the three things and you'll be all right.
Speaker 1: West Gray, thank you so much for for doing this this.
Speaker 1: This has just been absolutely fascinating. We have been speaking
Speaker 1: with Captain Wesley Gray, formally of the U. S. Marine
Speaker 1: Corps now with Alpha Architect. I would be remiss if
Speaker 1: I did not think our producer Charlie Vhmer, my booker
Speaker 1: Taylor Riggs, and Mike bat Nick, my head of research,
Speaker 1: our recording engineer Jennie. If you have enjoyed this conversation,
Speaker 1: be sure and look up an Inch or Down an
Speaker 1: Inch on Apple iTunes and you will see any of
Speaker 1: the nineties six other such podcasts that we've had. Uh,
Speaker 1: be sure and check out the list of upcoming guests,
Speaker 1: which is really quite astonishing. I'm Barry rit Halts. You're
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