Bogleheads® on Investing Podcast 009 – Dr. Wesley Gray, host Rick Ferri (audio only)

00:00:00.000 | [MUSIC PLAYING]

00:00:09.920 | Welcome to Bogleheads on Investing, episode number 9.

00:00:13.800 | In this episode, I'll be speaking

00:00:15.600 | with Dr. Wesley Gray, CEO of Alpha Architect,

00:00:21.520 | where he and his colleagues are breaking new ground.

00:00:24.800 | And the author of three books on quantitative investing.

00:00:28.440 | [MUSIC PLAYING]

00:00:37.580 | Hi, everyone.

00:00:38.360 | My name is Rick Ferry, and this is Bogleheads on Investing.

00:00:42.400 | This episode is sponsored by the John C. Bogle Center

00:00:46.160 | for Financial Literacy, a 501(c)(3) corporation.

00:00:51.560 | Today, we're speaking with Dr. Wesley Gray.

00:00:55.360 | After serving in the United States Marine Corps,

00:00:57.800 | Dr. Gray earned an MBA and a PhD in finance

00:01:01.360 | from the University of Chicago, where

00:01:03.040 | he studied under Nobel Prize winner Eugene Fama.

00:01:07.040 | He then took a job in academia before starting his investment

00:01:11.400 | management company, where he is on the cutting

00:01:14.320 | edge of new insights into factor investing.

00:01:19.840 | With no further ado, let's bring in Dr. Wesley Gray.

00:01:23.800 | Welcome to the show.

00:01:24.720 | How are you today?

00:01:25.800 | I'm great, Rick.

00:01:26.960 | I appreciate you bringing me on.

00:01:28.720 | You very much impressed me the very first time

00:01:30.880 | I learned about you and I talked with you.

00:01:33.440 | The stuff you're working on is cutting edge.

00:01:36.280 | I really believe that you are the new Jedi out there

00:01:40.840 | in the quant world.

00:01:42.320 | Before we get into what you're currently doing now,

00:01:45.800 | I want to start at the beginning.

00:01:47.360 | Where did you go to your undergraduate degree?

00:01:49.480 | I went to undergrad at University of Pennsylvania

00:01:52.520 | at the Wharton School.

00:01:53.880 | I kind of started off with the Uber finance geek undergrad.

00:01:58.320 | And my first way I parlayed myself into academic research

00:02:03.840 | is I walked into this gentleman's office

00:02:06.320 | named Chris Gatesy, who now writes

00:02:08.920 | a lot of papers on the 200-year history of momentum

00:02:12.320 | or relative strength or value or what have you.

00:02:15.560 | And I just said, I love this stuff.

00:02:17.480 | Can you teach me how to be a professor?

00:02:20.200 | And he basically said, hey, see that shelf right there?

00:02:23.000 | Grab these 10 books and read them and come back in two weeks

00:02:25.880 | and let's talk.

00:02:26.800 | That was my initial start into geeking out and getting

00:02:29.480 | into academic research and moving along my initial path,

00:02:33.240 | which was to be a finance professor.

00:02:35.920 | But there was also another side to you.

00:02:38.520 | You had this idea that perhaps you

00:02:40.480 | could figure out ways of outperforming the market.

00:02:43.160 | Well, yeah, kind of.

00:02:45.120 | Simultaneous to the sign I want to be a finance professor,

00:02:48.760 | I was also trading my own money, doing a lot of investing.

00:02:52.400 | I was there from '98 to 2002, and so that was obviously

00:02:56.520 | during the internet bubble.

00:02:58.040 | And so I had this exposure where I'd come off

00:03:01.320 | reading every book, everything I could get my hands on related

00:03:04.280 | to Ben Graham and Warren Buffett and the value investment

00:03:08.160 | philosophy.

00:03:09.760 | Pets.com's going up 1,000% a day.

00:03:13.200 | My dad's telling me to go buy the Janus Global Tech Fund.

00:03:17.160 | And I'm a value-by-nature person,

00:03:22.480 | and I'm watching these markets thinking they're crazy.

00:03:25.120 | I'm obviously trading in value names, getting destroyed.

00:03:28.640 | But then on the other side of my life,

00:03:30.440 | I'm like, hey, I just intellectually like this.

00:03:33.000 | And I was like, hey, I want to stay this forever.

00:03:36.480 | So it was kind of a weird barbell in the sense

00:03:39.120 | that I was sitting there trading stocks,

00:03:41.920 | and then on the other hand, I was reading stochastic calculus

00:03:45.600 | books, just trying to get baseline, essentially

00:03:48.880 | to be a research assistant for Gatesy.

00:03:51.360 | And so what happened is I kept doing all the investment stuff,

00:03:55.400 | kept doing my stock picking.

00:03:57.320 | And then I started--

00:03:59.040 | essentially, I became, for the Wharton Finance Department,

00:04:02.480 | the--

00:04:03.480 | I don't want to use the-- the computer monkey.

00:04:06.160 | I was like the data monkey.

00:04:07.360 | So if someone needed to have something coded up in MATLAB,

00:04:11.360 | that was my job.

00:04:12.320 | So I kind of became like a little mini workhorse

00:04:17.040 | for the department.

00:04:18.560 | So fast forward a couple of years,

00:04:20.920 | and I was saying, all these guys are also, by the way,

00:04:23.560 | Chicago PhDs, because for whatever reason,

00:04:26.200 | Chicago tends to feed the Wharton faculty.

00:04:29.720 | And Chris Gatesy's like, hey, you're

00:04:31.720 | going to apply to Chicago.

00:04:33.560 | And that's it.

00:04:34.520 | I was like, well, aren't there other schools?

00:04:36.720 | Should I consider other PhD programs?

00:04:39.120 | They're like, no, you've got to go to Chicago.

00:04:41.080 | They're like, we'll get you in.

00:04:42.440 | And I'm like, OK, how does that work?

00:04:46.240 | They're like, hey, take all your tests and do all your stuff,

00:04:49.440 | and we'll write your recommendations letters.

00:04:52.120 | And so sure enough, I applied to the University of Chicago PhD

00:04:55.880 | program just straight out of undergrad,

00:04:58.840 | which is also not normal, because typically, you

00:05:01.520 | go get a master's or what have you.

00:05:03.440 | But I had a lot of kind of close holds in the department

00:05:07.520 | that were writing letters for me.

00:05:09.520 | And PhD programs, they only accept a handful of people

00:05:12.760 | every year, so it's a much more kind of one-off deal.

00:05:15.880 | It's not like applying to an MBA program.

00:05:18.440 | Long story short, I got in.

00:05:20.360 | I was like, wow, I guess I'm going to actually do this.

00:05:23.560 | Since you entered the program in 2002,

00:05:26.520 | the Chicago school at the time--

00:05:28.760 | and it still is to a certain extent--

00:05:31.000 | it's just, we're going to take you in,

00:05:33.480 | and we're just going to beat you up.

00:05:36.000 | You are going to get destroyed in problem sets, workload,

00:05:40.480 | and let's just see if you survive.

00:05:42.200 | And so the first two years are just--

00:05:45.160 | literally, I was studying like 15 hours a day,

00:05:48.000 | seven days a week, just trying to stay above water.

00:05:51.040 | Because I came in, obviously, without having

00:05:53.400 | a lot of experience or grad score or what have you.

00:05:56.480 | So it was actually, say, pretty difficult, but I made it.

00:06:00.760 | And so after the first two years there,

00:06:03.560 | I don't say I was burned out, but I was 24.

00:06:07.560 | I'd been slaving away doing quaint academic geek stuff

00:06:12.120 | forever.

00:06:12.880 | And I just thought, hey, I need to maybe take a break

00:06:16.560 | or do something else.

00:06:17.760 | So you really did do something else.

00:06:19.920 | I would say that what you did was quite radical.

00:06:22.640 | And of course, I'm proud of you for it.

00:06:24.880 | So what I did is I decided I was going

00:06:27.040 | to join the Marine Corps, which you're an alumnus of.

00:06:30.640 | And it certainly seems radical.

00:06:33.520 | But what was super interesting at the time

00:06:36.280 | is I would say a good 20% to 30% of the Chicago Finance PhD

00:06:41.200 | program were actually former military officers, a lot of them

00:06:45.080 | from Israel or Finland or what have you.

00:06:47.800 | So they were all like, oh, yeah, of course you should do that.

00:06:50.800 | Whereas many people outside are like,

00:06:53.000 | you must be the first time anyone's ever done that.

00:06:55.400 | But what was super interesting is inside the program,

00:06:58.600 | my other fellow PhD mates were like, hey, that's pretty cool.

00:07:02.560 | And so, yeah, I went down to Professor Fama.

00:07:05.920 | And at the time, Professor Thaler, which is crazy,

00:07:09.560 | I had these two Nobel Prize winners,

00:07:11.960 | were actually-- it wasn't my dissertation,

00:07:14.680 | but my curriculum paper advisors.

00:07:17.320 | And I just had to ask them permission

00:07:19.280 | to get a four-year sabbatical.

00:07:21.680 | And Professor Fama was actually super cool about it.

00:07:25.440 | He's just like, oh, that's awesome.

00:07:27.320 | Proud of you.

00:07:28.320 | Yeah, happy to sign.

00:07:30.280 | Didn't even think twice about it.

00:07:31.960 | And then your Professor Thaler, he was more curious.

00:07:34.920 | He was definitely like, you're going to do what?

00:07:37.560 | But eventually, I got both those gentlemen to sign off

00:07:40.040 | and then submitted it to the PhD program coordinator

00:07:43.440 | and took a four-year sabbatical.

00:07:45.800 | That's amazing that you could actually

00:07:47.400 | do that, take four years off.

00:07:49.720 | Well, so you can't.

00:07:51.080 | You can take technically one year off.

00:07:53.520 | And so that's the reason I had to go and have them sign off

00:07:57.480 | on this special kind of extended sabbatical,

00:08:00.440 | because it was a unique circumstance where most people

00:08:03.360 | don't go on sabbatical to do service.

00:08:06.240 | The PhD program director kind of agreed, like, hey,

00:08:08.800 | this is a unique circumstance.

00:08:10.640 | As long as you get your advisors to sign off on it,

00:08:14.120 | we're cool with it.

00:08:15.040 | And so I had to do a few extra hoops to jump through

00:08:18.320 | to actually make it happen.

00:08:20.120 | Well, that's great.

00:08:20.920 | And then you went down to Quantico

00:08:22.400 | and went through Officer Candidate School?

00:08:25.000 | Yep, so then I went to OCS, which

00:08:27.400 | is Officer Candidate School, then

00:08:29.600 | went to TBS, the basic school.

00:08:32.040 | And then my MOS was a ground intelligence officer.

00:08:35.400 | You go through the infantry officer course.

00:08:37.520 | You kind of do everything that the infantry officers do.

00:08:40.280 | And then they go pick up their platoons,

00:08:43.400 | whereas ground intelligence officers then go down

00:08:45.440 | to dam neck and do another six months of intelligence officer

00:08:50.160 | training.

00:08:50.960 | And then you go hit the fleet.

00:08:52.160 | So it's the longest pipeline besides, you know,

00:08:55.280 | Hilo and fixed wing people.

00:08:57.200 | But it's about a year and a half, almost two years,

00:08:59.760 | of training pipeline.

00:09:01.520 | And from there, they shipped you off to Okinawa.

00:09:05.640 | I went right to Okinawa.

00:09:07.560 | And then right when I was in Okinawa,

00:09:09.120 | they sent me down to one of the islands in Japan

00:09:13.200 | and did a bunch of, like, joint training missions with them.

00:09:16.560 | Spent about a month there.

00:09:17.680 | And then I got sent directly down to the Philippines.

00:09:20.840 | And at the time, this was, I think, was that 2004, 2005,

00:09:26.080 | there was a bunch of activity going on

00:09:28.280 | on this island called Holo, which

00:09:30.400 | is a bunch of Muslim extremists and what have you.

00:09:32.720 | But then there was this thing called the Leyte mudslide

00:09:35.120 | disaster and a coup.

00:09:36.880 | So I was in the Philippines, you know,

00:09:39.520 | going crazy for a couple months there.

00:09:41.880 | And then right when I got back to Okinawa,

00:09:44.560 | which I was assigned there, but I rarely ever hung out there

00:09:47.760 | for, like, maybe a day or two, the colonel

00:09:50.240 | calls me in the office.

00:09:51.800 | And he basically says, hey, you're going to Hawaii.

00:09:55.280 | And I was like, all right, why am I going to Hawaii?

00:10:00.080 | They're like, oh, you're on a MIT team, a military transition

00:10:04.320 | training team, and you're going to get deployed to Iraq.

00:10:07.240 | So then I went out to Hawaii, did a big work up.

00:10:10.320 | And then we deployed out.

00:10:11.940 | I was on one of the training teams

00:10:13.440 | where you're in bed with Iraqis and try

00:10:15.800 | to help them avoid shooting themselves in the foot.

00:10:18.880 | In fact, you wrote an entire book about your experience

00:10:22.200 | working with the Iraqis.

00:10:23.360 | The name of the book was called Embedded.

00:10:25.240 | And it was a fascinating insight into what was going on.

00:10:29.720 | Yeah, so I kind of went in to the service.

00:10:33.480 | I didn't join the service because I

00:10:35.020 | wanted to go to war, per se.

00:10:36.240 | I just wanted to do my time.

00:10:38.320 | But I was certainly under the belief when--

00:10:41.080 | I don't know if you probably remember,

00:10:42.660 | but Colin Powell showed that little powder

00:10:45.200 | of-- that white powder and said, hey, we're all going to die.

00:10:48.400 | I kind of believed that.

00:10:49.400 | I was like, all right, we need to probably do something here.

00:10:52.040 | Fast forward, now I'm actually deployed,

00:10:54.520 | living in an Iraqi battalion, training up these Iraqi soldiers

00:10:59.360 | to kind of take over their defense duties.

00:11:03.000 | And I really got an opportunity to actually live

00:11:06.160 | with these people, eat with these people,

00:11:07.920 | talk with these people, and kind of get

00:11:09.680 | a better insight to the culture and kind of how they operate.

00:11:13.680 | And that experience, honestly, just floored me.

00:11:17.080 | And I took a whole 180, where I said,

00:11:20.640 | I don't know what we're doing here.

00:11:22.320 | This is crazy.

00:11:23.800 | Like, I was not expecting this.

00:11:25.800 | These people are tribal.

00:11:27.560 | They're totally different.

00:11:28.960 | Like, what we're trying to achieve here

00:11:31.480 | does just not jive at all with their society.

00:11:35.400 | I need to tell the story, because there's probably

00:11:37.800 | a lot of guys like me that, rah, rah, let's go to war.

00:11:41.440 | And they don't realize it.

00:11:43.320 | So I just got inspired.

00:11:44.880 | I was like, I got to share the story.

00:11:46.700 | So I had to just write a whole book, basically,

00:11:48.800 | about my time being embedded with the Iraqis

00:11:53.240 | and just trying to explain their cultural nuance

00:11:56.400 | and why what we were trying to do,

00:11:58.120 | like bring freedom and democracy to their society,

00:12:01.520 | just seemed like maybe it wasn't a great idea.

00:12:05.640 | That's pretty much what that book was about,

00:12:07.840 | just sharing my experiences there,

00:12:09.800 | which were highly enlightening to me.

00:12:12.480 | And I just wanted to make sure other people got

00:12:14.440 | to at least experience it through at least my book,

00:12:18.260 | even if they can't be there themselves.

00:12:20.540 | I understand that you speak Arabic

00:12:23.320 | and that you taught yourself.

00:12:25.820 | I did.

00:12:26.420 | So I mean, I could probably converse in it

00:12:28.580 | if I got warmed up.

00:12:29.900 | But yeah, so I was the intelligence officer.

00:12:33.140 | And the more I read beforehand, because I

00:12:36.300 | knew we were going to war in these areas,

00:12:40.100 | speaking Arabic, the actual language there

00:12:43.780 | means a heck of a lot more because it's

00:12:45.700 | associated with the religion, because it's from Allah.

00:12:49.220 | So it's kind of a big deal.

00:12:50.900 | So the more-- if you want to win in those sort of culture wars,

00:12:54.460 | you've got to really establish bonds with the people

00:12:57.080 | you're working with.

00:12:58.140 | And so learning the language, I thought, was a main effort.

00:13:01.820 | So yeah, I just put a ton of time

00:13:03.820 | up front to train extremely hard,

00:13:07.140 | both on learning how to kill people and everything,

00:13:09.340 | but also how to learn this language.

00:13:11.780 | And then when I got there, I just

00:13:13.500 | forced myself to literally embed with the people

00:13:16.500 | and not use a terp.

00:13:17.660 | And then if you sit there long enough

00:13:20.380 | and get tired of using hand signals

00:13:21.940 | and not understand each other, eventually you

00:13:24.860 | can start maneuvering.

00:13:26.320 | So yeah, I got to a point where I actually

00:13:28.580 | served as a terp for our team.

00:13:30.660 | And we would go out on convoys.

00:13:32.340 | And I would be the terp to interface

00:13:35.340 | between our team and the Iraqis.

00:13:38.020 | Yes, and I definitely highly recommend,

00:13:41.260 | if anyone has to do that mission ever again,

00:13:44.300 | to spend way more time learning the language and a lot less

00:13:47.340 | on tactics, per se.

00:13:49.780 | Because it gives you a lot more, I'd

00:13:52.020 | say, what the Iraqis call wasta, kind of karma and the ability

00:13:56.980 | to interact with them and have them actually listen to you

00:13:59.540 | if you actually know their language.

00:14:01.580 | That's fascinating.

00:14:03.020 | Well, you did that.

00:14:04.780 | Did you stay for four years?

00:14:07.140 | Yep, did the four-year active duty.

00:14:10.620 | And then after that, you went back

00:14:11.980 | to the University of Chicago?

00:14:13.980 | Got out when it was early 2008.

00:14:16.740 | And then my mind-- well, you know, being in the service,

00:14:20.660 | it's just obviously way different

00:14:22.380 | than being in a PhD program at University of Chicago.

00:14:26.540 | Just slightly.

00:14:27.220 | I got out-- yeah, yeah, kind of like 180.

00:14:30.620 | And so literally for the first three months,

00:14:33.180 | I just had to relearn everything.

00:14:35.020 | Because my curriculum paper had a bunch of math in it.

00:14:38.420 | And honestly, I couldn't even read my own paper.

00:14:40.460 | I was like, well, I don't even know what this person's

00:14:42.700 | talking about.

00:14:43.780 | But it was me.

00:14:44.500 | So I just put the basics on like, hey, here,

00:14:47.380 | I got to relearn calculus and all this stuff.

00:14:50.460 | And it is true that it is like riding a bike, where

00:14:53.540 | if you know how to do it, if you just get back into it,

00:14:56.940 | you do quickly learn.

00:14:58.300 | So yeah, reentered the program, moved back to Chicago.

00:15:01.940 | And I was in much more like--

00:15:05.060 | I was in discipline mode versus a lot of my comrades

00:15:08.780 | there at the PhD program who were students,

00:15:11.340 | because I'd kind of come out with a new look on life.

00:15:14.300 | So I was like, I'm getting out of here in two years.

00:15:17.380 | And because usually you don't get out of the PhD program

00:15:20.460 | in a collective four years.

00:15:22.020 | Usually it's five, six years.

00:15:23.380 | But I just didn't want to mess around.

00:15:25.180 | So I spent three months relearning everything.

00:15:27.820 | And then I immediately went to work on dissertation.

00:15:31.460 | So yeah, because my goal was I need

00:15:34.900 | to get out of this place by 2010.

00:15:37.940 | Or my wife, she's not going to be

00:15:39.700 | happy living on a ramen noodle salary for longer than that.

00:15:44.980 | And who was your mentor on your dissertation?

00:15:49.340 | So I went back to my old curriculum paper advisors.

00:15:53.900 | And it was Thaler and Fama were the top two.

00:15:57.580 | And then another gentleman, Andrea Frazzini,

00:16:00.260 | who's also famous now, but he actually left and went to AQR.

00:16:03.660 | So when I came back, basically Frazzini had already

00:16:07.060 | gone to go be a millionaire over at AQR.

00:16:11.020 | Thaler had gotten too famous.

00:16:12.780 | So he obviously wasn't going to mess with PhD students anymore.

00:16:16.580 | So really who I was left with was

00:16:18.460 | Fama, because he was the only link in the chain that

00:16:21.060 | hadn't been broken.

00:16:22.260 | So I essentially went to him.

00:16:24.300 | And he was kind of like my core advisor.

00:16:27.580 | And then another gentleman, Stavros Panagias,

00:16:31.540 | he helped me a lot because I had a theory paper as well

00:16:34.820 | as part of my dissertation.

00:16:36.460 | Pietro Viranesi was another one.

00:16:39.460 | So I had a handful of them.

00:16:40.820 | But I'd say the most influential and obviously

00:16:43.700 | the one that had the most experience

00:16:45.300 | in empirical asset pricing work was obviously Professor Fama.

00:16:50.180 | So he was kind of the one that hazed me the most,

00:16:53.140 | I would say, in the dissertation writing stage.

00:16:56.220 | Your paper, if I'm not mistaken, was about active management.

00:17:00.540 | Yeah, so being a Marine and probably a little hardheaded,

00:17:06.060 | I came back.

00:17:06.740 | And I'd always been, like I was telling you before,

00:17:08.900 | a stock picker, specifically a big believer in value investing

00:17:12.180 | and value investing stock picking.

00:17:14.420 | And so what I decided was I want to highlight to Professor Fama

00:17:19.420 | that active stock picking can add value,

00:17:23.260 | because this whole efficient market thing seems a little too

00:17:25.740 | crazy to me.

00:17:26.860 | So you're going to tell Eugene Fama, the future Nobel

00:17:30.260 | laureate, that he was wrong.

00:17:32.460 | At least that was my going in.

00:17:34.340 | And so what I did is, well, how am I going to highlight this?

00:17:37.260 | Well, it turns out that there's this organization called Value

00:17:40.340 | Investors Club, where a bunch of super sophisticated stock

00:17:44.780 | pickers, a lot of them associated with hedge funds,

00:17:47.620 | they would submit huge theses on basically stock pitches.

00:17:52.020 | So best buys undervalued.

00:17:53.980 | Here's my DCF.

00:17:55.100 | Here's the 100 reasons why.

00:17:57.020 | And so what I thought is like, hey, I've

00:17:59.260 | been following this club since 2000.

00:18:01.660 | I'm a member of this club.

00:18:04.060 | I think they add a lot of value.

00:18:06.180 | They seem to have really good ideas.

00:18:08.100 | I'm going to read every single one of these stock pitches,

00:18:11.420 | systematically enter them into a database,

00:18:13.900 | and do the quant analysis on it to then assess, hey,

00:18:17.420 | do these people actually add value or have, quote unquote,

00:18:20.820 | "alpha."

00:18:21.940 | Long story short, they do, at the margin.

00:18:24.980 | And so I submitted this as part of my dissertation.

00:18:29.300 | And somehow, by the grace of God,

00:18:32.420 | Fama agreed with the analysis.

00:18:34.540 | He had some quibbles on takeaways.

00:18:37.860 | But at least at the margin, I highlighted

00:18:40.860 | that there is some segment of the market

00:18:42.660 | where active stock picking might work at the margin.

00:18:46.900 | So that was a small victory for me.

00:18:49.340 | How did you meet up with Jack Vogel, who you ultimately

00:18:52.220 | became partners with at Alpha Architect?

00:18:55.100 | Sure, so what happened is when I graduated from the program

00:18:59.380 | there, I went on the academic professor market.

00:19:02.820 | And also, my wife was going on the academic market.

00:19:06.340 | She's a PhD in history, which is a way less, I'd say,

00:19:10.620 | marketable profession than being a finance professor.

00:19:14.020 | So I went out to the market.

00:19:15.900 | And my wife's from Philly.

00:19:17.660 | And she needed a job as a history professor.

00:19:20.540 | And I ran into Drexel, who gave me what

00:19:23.420 | they call an exploding offer.

00:19:24.860 | So they gave me this offer I couldn't refuse.

00:19:27.340 | They gave me three days to decide on it.

00:19:29.100 | They say, hey, come to Philly.

00:19:30.820 | Your wife's from here.

00:19:32.100 | We'll get her a job.

00:19:33.500 | And we'll give you the best gig ever.

00:19:35.220 | And we'll assign you a PhD student

00:19:38.260 | who will do all your dirty work.

00:19:40.220 | So I was like, OK, well, sign me up.

00:19:43.100 | What are you going to do?

00:19:44.180 | How often do you got to twist my arm?

00:19:45.820 | And so I entered Drexel.

00:19:47.620 | And then part of my package was having a dedicated research

00:19:51.740 | assistant.

00:19:52.740 | And that happened to be Jack Vogel.

00:19:54.860 | So just by circumstance and a lot of great luck,

00:19:59.740 | I just had a gentleman who was insanely smart, extremely well--

00:20:05.340 | extremely good at computer programming

00:20:07.140 | and doing all this data analysis.

00:20:09.100 | And we just hit it off immediately.

00:20:10.780 | So we've been working ever since 2010 when I took that job.

00:20:16.140 | Well, the way I understood it was Jack

00:20:18.380 | had read your dissertation.

00:20:20.420 | And he said, yeah, all this is great.

00:20:22.340 | These people have alpha.

00:20:26.500 | They're outperforming the market.

00:20:28.100 | But I can replicate that using a computer.

00:20:31.540 | So are they really outperforming the market?

00:20:34.180 | Can you tell me about that?

00:20:35.460 | Well, yeah.

00:20:36.380 | So that was an insight that actually I

00:20:40.460 | had before I met Jack.

00:20:42.060 | And kind of the takeaway from--

00:20:44.540 | well, the interesting takeaway from the dissertation

00:20:47.900 | was I cataloged all this data on these individual stock pickers.

00:20:53.140 | And sure enough, they had alpha relative to Pharma, French

00:20:57.060 | models, what have you.

00:20:58.340 | But essentially what they were doing for all intents

00:21:01.660 | and purposes was small cap value investing

00:21:05.940 | in a certain element of concentration

00:21:07.800 | because there's only so many ideas that they would produce.

00:21:11.420 | It's not like you go buy 500 names at a time.

00:21:14.940 | So there would usually be like five or six ideas a month,

00:21:17.460 | sometimes 10.

00:21:18.660 | So on a rolling basis, this portfolio

00:21:20.820 | would have anywhere from 50 to 100 stocks.

00:21:23.780 | But essentially what they were doing from a quant perspective

00:21:26.980 | is buying smaller stocks that were super cheap, generally

00:21:31.240 | higher quality, and doing it in somewhat concentrated fashion.

00:21:35.780 | And sure enough, you could also just

00:21:38.300 | have a computer essentially do the same idea, right?

00:21:42.300 | Concentrated, small, cheap quality.

00:21:46.620 | And lo and behold, it basically replicates

00:21:49.820 | what all these stock pickers were doing,

00:21:52.100 | which was certainly--

00:21:54.380 | well, it was kind of disheartening because at the time

00:21:56.540 | I was still kind of believing in stock picking

00:21:58.900 | because I was still being a stock picker.

00:22:01.300 | But that kind of analysis there proved to me

00:22:05.620 | why am I banging my head against the wall

00:22:08.980 | so hard to do these dissertations on these stocks

00:22:13.060 | when you can essentially replicate

00:22:15.060 | a lot of the core ideas with just using an algorithm.

00:22:20.220 | And so that was really kind of the straw

00:22:22.900 | that broke the camel's back, as they

00:22:24.380 | say, that moved me much more heavy into just pure quant

00:22:28.380 | and less into thinking I was going to be Warren Buffett.

00:22:31.940 | I think the proof was in the numbers.

00:22:34.140 | And Jack Bogle, your research assistant,

00:22:36.660 | was doing a dissertation similar to that?

00:22:40.900 | So Jack's dissertation was a little bit different.

00:22:44.900 | So what he looked at is there's a huge argument

00:22:48.980 | over whether value investing, which

00:22:51.620 | in defining academic terms just means buying cheap stocks,

00:22:54.860 | right, on book to market or price

00:22:56.860 | earnings or what have you.

00:22:58.340 | He was looking into the argument,

00:22:59.740 | is this a risk-based phenomenon, or is this

00:23:03.140 | a behavioral-based phenomenon?

00:23:06.340 | Just to explain the two ideas simply,

00:23:08.980 | the risk-based hypothesis essentially

00:23:10.980 | says that the reason cheap stocks earn higher returns

00:23:15.620 | is because cheapness is a proxy for fundamental risk.

00:23:20.020 | So the reason you're getting paid more on average

00:23:22.540 | is because these stocks are just fundamentally riskier.

00:23:26.100 | The behavioral argument, which is

00:23:28.660 | on the other side of the coin, is like, no, it's

00:23:31.140 | not because these stocks are riskier.

00:23:33.700 | It's because the market generally throws the baby out

00:23:36.860 | with the bathwater.

00:23:37.980 | And that's more related to a mispricing story

00:23:40.980 | that sentiment throws these names out

00:23:43.820 | and beats them up too bad.

00:23:45.180 | And so his dissertation was about,

00:23:47.460 | how do we empirically identify whether value

00:23:51.340 | is risk or mispricing?

00:23:53.540 | And the short story is that it seems like, if anything,

00:23:57.500 | it's more likely mispricing versus risk that

00:24:01.140 | explains the value premium.

00:24:03.340 | Obviously, this is highly debatable,

00:24:04.980 | but that's what his dissertation was all about.

00:24:07.500 | And after all of that, you decided

00:24:09.060 | you were going to go out and create a company together.

00:24:12.380 | Well, kind of.

00:24:13.860 | Actually, all this happened simultaneously,

00:24:16.300 | and it's one of the crazier stories in our industry.

00:24:21.020 | So right when I actually got my job,

00:24:24.380 | it actually was during the time I was on the professor markets.

00:24:28.660 | At the time, I was writing a blog,

00:24:30.180 | and obviously, my dissertation was out there.

00:24:32.500 | I got cold called by a very large real estate

00:24:36.140 | family in New York, and the son had

00:24:39.500 | been put in charge of essentially managing--

00:24:42.340 | it was around $4 billion of their liquid wealth.

00:24:45.660 | And they were in the middle of just living through 2008,

00:24:49.580 | and they were big in hedge funds,

00:24:51.340 | big in active management, and they'd got smoked.

00:24:54.500 | And they're like, we're firing every one of these people.

00:24:58.060 | We're going to take control of our wealth.

00:24:59.860 | We're going to do this in-house.

00:25:01.540 | We're going to do it with quant.

00:25:03.220 | We need someone to help us.

00:25:04.660 | And he had just been out there Googling around,

00:25:07.220 | and somebody found me.

00:25:08.860 | And he calls me up, and he's like, hey,

00:25:11.220 | can you help me manage this $4 billion?

00:25:13.940 | We want to use computers.

00:25:15.100 | I really like your dissertation.

00:25:16.780 | How do we do this?

00:25:17.860 | So went up there, met him.

00:25:19.980 | Again, this is all at the same time

00:25:22.020 | I'm sitting here thinking I'm going to be a professor.

00:25:25.340 | I wasn't 100% sure if this would actually lead to anything,

00:25:28.540 | but it initially kind of led to a basic consulting

00:25:31.540 | gig where the gentleman said, help me for a couple of years.

00:25:35.780 | If you guys do a great job, we'll

00:25:38.660 | cede your business on the asset management side.

00:25:40.980 | Because they had just gotten out of the whole asset management

00:25:44.540 | hedge fund world, and they're like,

00:25:45.980 | we're never going to cede or do that ever again.

00:25:48.100 | And then I was putting the ask on the table.

00:25:49.940 | But they said, hey, give me two years.

00:25:52.020 | And so essentially, I kind of helped them initially.

00:25:54.660 | And then I got Jack involved immediately

00:25:56.900 | because it kept scaling up bigger and bigger.

00:25:59.860 | And then so after two years, in 2012,

00:26:03.220 | they essentially ceded $20 million

00:26:05.500 | in the quantitative value strategy, which

00:26:08.460 | we have a book about.

00:26:09.700 | And then very quickly, they ramped it up to 50,

00:26:12.540 | and they put the other part in the international quantitative

00:26:15.060 | value.

00:26:16.060 | And this was all going on simultaneous

00:26:18.580 | to when I was being a professor as my day job.

00:26:22.580 | It just-- things kept happening in the background.

00:26:25.020 | So it was a very hectic time in my life, I would say.

00:26:29.540 | And you were having children at the same time?

00:26:31.460 | Yeah.

00:26:32.620 | I was up to two, and we were working on three.

00:26:35.580 | And yeah, it was getting crazy.

00:26:37.980 | And then essentially, what happened is after--

00:26:41.220 | I think it was around three years into it--

00:26:43.980 | this was clearly becoming a real business

00:26:46.260 | because we were managing a $50 million managed account.

00:26:49.500 | We've got a huge consulting contract.

00:26:52.220 | I'm also moonlighting now at this point

00:26:55.260 | basically as a finance professor.

00:26:57.300 | And I was just thinking, hey, I need

00:26:59.380 | to go one way or the other here.

00:27:01.820 | And so I talked to my boss, the head of the department.

00:27:05.660 | I just told him, I was like, listen,

00:27:07.540 | I think I need to resign, but I don't want to screw you over

00:27:12.100 | here because recruiting for professors

00:27:14.180 | is a total nightmare, at least a one-year cycle.

00:27:18.220 | So he's like, hey, put in one more year

00:27:20.220 | so we can at least recruit for your position,

00:27:22.180 | and then you can go out into the sunset.

00:27:25.100 | So that's essentially what happened.

00:27:27.260 | After my third year being a prof,

00:27:29.460 | for all intents and purposes, I was all in on the business,

00:27:32.180 | but I was still technically professing

00:27:36.100 | until they could recruit for my position

00:27:38.220 | and then basically kick me out the door.

00:27:41.860 | Another interesting thing along the way

00:27:43.900 | is through this whole time period,

00:27:45.860 | it wasn't just this large family office.

00:27:49.060 | For whatever reason, people like what we were putting out there.

00:27:51.980 | We were just being super transparent about putting

00:27:54.260 | our research, putting our ideas.

00:27:56.460 | So a bunch of random rich people would call us up and say,

00:28:00.020 | how do I do this?

00:28:01.260 | And we'd say, well, we have a managed account.

00:28:03.140 | That's how you could do it.

00:28:04.380 | And so we kept building the business up.

00:28:06.100 | We would do tax-as-harvesting to try to minimize tax impact

00:28:10.020 | because everyone we were dealing with, it was taxable money.

00:28:13.660 | And another thing happened along this way.

00:28:16.220 | Another couple hundred million gentlemen out in the Midwest,

00:28:19.820 | we were working for them as well, and he had a tax problem.

00:28:23.500 | And it was one of these situations

00:28:25.020 | where he had a low-basis stock that

00:28:27.860 | was going to get bought out by a large conglomerate for cash.

00:28:32.540 | And he was very afraid that he was

00:28:34.380 | going to have to incur a huge capital gain event.

00:28:37.580 | So he says, go figure this out.

00:28:39.700 | And this is like one of these impossible things where like,

00:28:42.460 | hey, go figure out how to not pay tax.

00:28:45.340 | But if the rich guy says, jump, I say, how high?

00:28:49.500 | And so that's what I did.

00:28:50.740 | I went on this mission.

00:28:51.740 | How am I going to deal with this problem?

00:28:53.980 | And I ran into a gal at a bank and structured product.

00:28:58.940 | And this is not something you could really do anymore.

00:29:01.220 | But it was all related to the ETF structure.

00:29:04.580 | And I started to learn about how the ETF structure essentially

00:29:07.860 | allows assets to come in at mark-to-market basis.

00:29:11.900 | The ETF can then dump any asset out,

00:29:15.460 | even if it has low basis, onto a market maker

00:29:18.780 | with no tax liability.

00:29:20.860 | And it's essentially kind of a laundromat for capital gains

00:29:23.940 | liabilities.

00:29:25.260 | And a light went off in my head, like, holy cow,

00:29:29.100 | if I'm doing strategies that involve trading and turning

00:29:32.540 | over, and taxes are essentially Uncle Sam's 50% performance

00:29:37.800 | fee, this seems like a good idea.

00:29:40.540 | So long story short, in around 2014,

00:29:44.060 | we decided we're going to get into this ETF business

00:29:46.660 | because we thought it was a better structure to deliver

00:29:49.680 | these concentrated factor portfolios than doing them

00:29:53.140 | in SMA with tax-loss harvesting.

00:29:55.940 | Just out of curiosity, all that work

00:29:57.780 | you did on the ETF structure of how it--

00:30:02.140 | Yep.

00:30:02.640 | With the creation of the redemption,

00:30:04.180 | how you can push out any unrealized gains

00:30:07.180 | onto the authorized participants.

00:30:09.240 | You had that one client in the Midwest

00:30:10.860 | who had this big capital gain problem,

00:30:12.440 | and then you had this ETF over here.

00:30:14.560 | I've always wondered, is there any kind of a structured

00:30:16.740 | product, or can there be a structured product where

00:30:19.380 | you could take people who have these stocks out there

00:30:22.700 | and put them all together, and bring it in,

00:30:25.620 | and just issue them shares of an ETF,

00:30:27.540 | and then take the stock then that they put in kind

00:30:30.780 | into the ETF, and then give it to an authorized participant

00:30:33.700 | to get rid of.

00:30:34.500 | And now their cost basis is in the ETF.

00:30:38.400 | Yeah.

00:30:38.900 | It's diversified.

00:30:39.780 | Is that possible?

00:30:41.380 | Yes.

00:30:42.180 | Yes and no.

00:30:43.140 | The long story short is in the old days, yes.

00:30:48.340 | But what happened is all the big banks

00:30:51.980 | got smoked out on a bunch of tax things a few years ago,

00:30:56.300 | and they just cut off anything that could even

00:30:59.260 | be perceived as being on the edge

00:31:03.140 | because they didn't want to make Treasury angry.

00:31:05.220 | So my understanding from the inside baseball

00:31:08.220 | of talking to people that deal in this world

00:31:11.060 | is in the old days, they would actually

00:31:13.020 | do stuff like that for super ultra high net worth clients

00:31:17.220 | and where they control the custody and clearing pipes.

00:31:21.460 | But my understanding is nowadays, that doesn't go on.

00:31:26.060 | But I certainly feel like an enterprising entrepreneur that

00:31:31.540 | had the time and energy to try to figure that out,

00:31:34.420 | it could be possible.

00:31:35.900 | We've looked into it from like 50 different angles

00:31:38.380 | and haven't been able to figure it out.

00:31:40.020 | But yeah, there's certainly--

00:31:42.660 | there's something there.

00:31:43.700 | I just haven't solved it.

00:31:45.620 | I believe there's something there too.

00:31:47.260 | I believe that this thing called direct indexing where you can--

00:31:51.340 | Yeah.

00:31:51.820 | --you buy 250 or 300 stocks, and then you individually

00:31:54.780 | sell off the ones that are at a loss and do a tax swap.

00:31:57.980 | And at the end, when that's all played out four or five years

00:32:00.520 | down the road, when there is no really longer any ability

00:32:03.400 | to do a lot of tax swapping, you've

00:32:06.300 | got this portfolio of 200, 300 stocks

00:32:09.500 | that have a low cost basis.

00:32:11.860 | But that looks an awful lot like an index.

00:32:14.780 | So if you could just take that and just turn that

00:32:17.420 | into an ETF provider and get shares of a more diversified

00:32:21.660 | ETF where the cost basis of the ETF

00:32:24.260 | is the cost basis of all your stocks in aggregate,

00:32:26.340 | but it's a lot more easy to manage one security than 400.

00:32:30.640 | Yeah.

00:32:31.560 | Yeah.

00:32:32.120 | I agree 100%.

00:32:34.960 | And I get in fights all the time with people arguing over,

00:32:39.240 | do you do the ETF structure or do you do the tax loss

00:32:43.080 | harvesting structures?

00:32:44.880 | And I still believe there's a marginal benefit.

00:32:49.160 | Even if you're doing pure passives,

00:32:51.400 | like say, for example, the parametric solution like S&P

00:32:54.660 | with tax loss harvesting or just go buy the Vanguard Fund,

00:32:58.720 | I still believe that the Vanguard Fund is better

00:33:01.720 | because a lot of people also forget, and to your point,

00:33:05.000 | that eventually you get basis and everything.

00:33:07.440 | But the index changes.

00:33:08.720 | Like firms get bought out for cash.

00:33:11.080 | Guess what?

00:33:11.760 | You can deal with that problem in an ETF structure.

00:33:14.700 | You can't if you are in Social Security.

00:33:17.800 | Like if you have low basis and Joe Blow

00:33:20.880 | wants to buy the company out for cash,

00:33:23.560 | you're going to eat tax liability.

00:33:25.240 | That's easy to cleanse in an ETF.

00:33:28.840 | And then there's the fee differential.

00:33:30.460 | Those tax loss harvesting solutions are 20, 30, 40 bps.

00:33:35.800 | An S&P 500 ETF is basically zero.

00:33:38.640 | So if you annuitize that cost differential

00:33:40.960 | over the life of the investment, the lump sum of that's maybe 2%,

00:33:45.600 | 3% of your wealth.

00:33:47.280 | Does that make sense?

00:33:48.560 | Probably not.

00:33:50.680 | Is that the value of the tax loss shield you're going to get?

00:33:53.880 | I don't think so.

00:33:54.640 | So I think tax loss harvesting and direct indexing

00:33:58.740 | is total hype overblown versus just buying the passive index

00:34:04.240 | through an ETF structure for zero.

00:34:07.080 | That seems like a better long-term solution to me.

00:34:09.480 | But reasonable people can disagree.

00:34:12.760 | Let's move on a little bit.

00:34:13.920 | So all of a sudden, you decide you're

00:34:16.080 | going to launch Alpha Architect.

00:34:17.960 | And you open up the world headquarters,

00:34:21.080 | which I've been to several times now.

00:34:23.680 | Yeah, for sure.

00:34:24.680 | So the original world headquarters

00:34:27.500 | was in a little house I had in New Jersey.

00:34:31.440 | But that was five minutes from my mother-in-law.

00:34:34.320 | So both my wife and I agreed that, hey, we should probably

00:34:37.120 | move a little bit further away.

00:34:38.560 | So we moved over here to the Pennsylvania side.

00:34:41.120 | And I'd spent a year doing a commute from Baltimore

00:34:45.480 | to Philly when I was first year as a professor there,

00:34:47.940 | because we still had a place down there.

00:34:49.720 | And I came out of the service.

00:34:51.440 | I'd swore off commuting, because I actually

00:34:53.880 | wanted to hang out with my kids.

00:34:55.280 | I like exercising.

00:34:56.880 | So I said, you know what?

00:34:58.480 | I'm going to set up a business in my house.

00:35:01.080 | And if people don't like it, that's fine.

00:35:04.160 | But it's good for my mental, physical health.

00:35:06.640 | It's going to make me operate more efficiently.

00:35:10.120 | Why not?

00:35:10.920 | And so we bought this place out in Pennsylvania.

00:35:13.720 | It's kind of a compound of sorts.

00:35:16.600 | And now it's Alpha Architect Global Headquarters.

00:35:19.720 | But yeah, essentially, we just built an office

00:35:22.400 | inside this residence, got it zoned and everything.

00:35:26.240 | And we start off with, obviously, no AUM hardly at all.

00:35:31.320 | And now we have almost a billion.

00:35:33.800 | But it functionally achieves the goal.

00:35:37.640 | It keeps our costs down low.

00:35:39.120 | And it keeps commuting time down.

00:35:41.200 | So we're kind of stuck with it.

00:35:43.840 | So it's a bit awkward.

00:35:44.760 | But in the world of 0% management fees,

00:35:48.640 | you've got to do weird things sometimes.

00:35:51.040 | And I understand some interesting artifacts

00:35:53.280 | went along with that house.

00:35:55.040 | Yeah.

00:35:55.560 | So we got this place from a big game hunter, who

00:35:59.000 | was basically had-- it was a tragic situation.

00:36:02.000 | He had pancreatic cancer.

00:36:03.640 | And he was basically going to die in three months.

00:36:05.800 | So it was kind of a liquidation opportunity of some sort,

00:36:09.600 | both the house and our friends we have.

00:36:13.760 | He was, like I said, a big game hunter.

00:36:16.360 | So we acquired a grizzly bear, a leopard,

00:36:19.120 | and a bunch of other really cool taxidermy mounts.

00:36:22.400 | And one of which we keep in the office, the grizzly bear,

00:36:26.000 | because we like to say that we try to kill bear markets.

00:36:29.880 | And we have evidence of it by having our grizzly bear here.

00:36:32.880 | So it's definitely a unique experience

00:36:35.640 | visiting Alpha Architect Headquarters.

00:36:38.080 | It was for me, because when I first time I went to visit you,

00:36:41.080 | I'm driving down this residential street,

00:36:42.840 | and I'm saying, this can't be it.

00:36:44.720 | Yeah.

00:36:45.220 | We've had many of very, very wealthy people

00:36:51.380 | and a lot of famous folks roll through here

00:36:54.200 | with that exact same expression.

00:36:56.680 | What in the world did this guy talk me into?

00:37:00.360 | Why am I hanging out in a residence

00:37:02.840 | in the suburbs of Philadelphia?

00:37:04.600 | Is this person crazy or what?

00:37:07.400 | So things have gone well.

00:37:08.960 | You've launched several ETFs.

00:37:11.600 | And the way in which you do ETF and factor investing,

00:37:18.160 | I find it to be kind of the right way of doing it.

00:37:20.960 | It's almost like the next generation of factor investing,

00:37:25.280 | because it's so deep and so concentrated

00:37:30.160 | that if you want to do factor investing, that it seems to me

00:37:35.040 | you should be paying for as much exposure

00:37:38.440 | to these factors in a concentrated form

00:37:41.360 | as you can get.

00:37:42.640 | So it appealed to me right away when I found out

00:37:45.920 | how you were doing it.

00:37:47.400 | Yeah.

00:37:47.900 | So essentially, the genesis of this idea

00:37:51.760 | is when we were working for the family office,

00:37:55.560 | they were going to do the typical thing, where they're

00:37:57.920 | like, let's go buy our cheap beta,

00:38:00.200 | but then we need to figure out how to replicate

00:38:02.440 | a lot of these different exposures

00:38:04.000 | that we used to get from these hedge fund people.

00:38:06.680 | And hedge funds obviously aren't doing cheap beta stuff.

00:38:10.720 | They're usually doing concentrated bets

00:38:13.520 | and stock picking, but what's essentially

00:38:16.880 | is factors like small value quality.

00:38:20.080 | But they're doing it a much more focused way.

00:38:23.960 | So we naturally thought, well, if we

00:38:26.160 | want to replicate these more unique exposures out there,

00:38:30.400 | we need to replicate them how they need to be replicated.

00:38:33.760 | And that means we're going to do maybe factors,

00:38:36.080 | but we're not going to hold 500 securities

00:38:38.960 | and focus so much on how close this tracks the index.

00:38:43.760 | We're going to do 50 stock portfolios

00:38:46.560 | and just tell people up front that this is not a closet

00:38:50.400 | index with a little tilt to the value factor.

00:38:54.240 | This is pure value, where we're literally

00:38:57.920 | buying the cheapest 40 or 50 securities

00:39:01.080 | on a different metric.

00:39:03.960 | We use enterprise multiples, but keep it simple, like PE ratio.

00:39:08.440 | So yeah, and that's just what we did.

00:39:10.680 | And we just told people up front of the downside, which

00:39:14.240 | is, of course, the tracking error

00:39:16.080 | and the relative performance that this stuff can bounce

00:39:19.400 | around, both good and bad, over long time periods.

00:39:23.400 | And you should just be prepared for that.

00:39:25.160 | It's not the Vanguard fund.

00:39:26.880 | And we just wanted to deliver it transparently, affordably,

00:39:30.800 | and be very up front about the potential pain associated

00:39:35.040 | with this style of investing.

00:39:37.880 | And I think that's all very interesting.

00:39:39.800 | Let's say that you want to have a slice of your portfolio

00:39:44.200 | to additional risk factors.

00:39:48.300 | And the reason I use additional risk factors

00:39:50.420 | is because I actually interviewed Gene Fama one time.

00:39:54.240 | And I said, if beta is a factor, so what

00:39:57.360 | do you call these other things?

00:39:58.640 | Do you call them smart beta?

00:40:01.560 | Do you call them--

00:40:03.000 | what do you call them?

00:40:03.880 | And his answer was, they are additional risk factors.

00:40:07.040 | So they are additional betas.

00:40:09.600 | I said, OK, so let's say you wanted exposure

00:40:11.680 | to something other than beta.

00:40:13.280 | I guess you could do it by going long short, correct?

00:40:16.240 | But that would be expensive in many ways.

00:40:19.000 | So here you're going long only, but you're

00:40:21.800 | doing it very concentrated, and you're keeping the cost down.

00:40:26.280 | Yes, that's right.

00:40:27.700 | So you got it.

00:40:28.960 | So the concept, to Professor Fama's point,

00:40:32.320 | and our portfolios are constructed

00:40:35.360 | in a way that is much more akin to how academics

00:40:39.600 | form portfolios.

00:40:40.600 | And that's what all the evidence shows.

00:40:42.400 | Look how great they are.

00:40:44.120 | The idea is, we're not going to go long short, to your point,

00:40:47.320 | because it's much more expensive to run, operate, and just

00:40:52.160 | access those exposures.

00:40:54.120 | And so we're going to stick on the long side,

00:40:57.160 | but it's not going to be broad market beta exposure.

00:41:01.180 | It's going to be some beta, obviously,

00:41:03.300 | because it's long only.

00:41:04.860 | But we're going to focus as much as we

00:41:06.980 | can on capturing the value risk premia or the momentum risk

00:41:12.340 | premia.

00:41:13.300 | And again, it's very important for us

00:41:15.620 | to communicate this element that this is a risk premia,

00:41:19.260 | and this is very different.

00:41:20.740 | Because frankly, the biggest issue

00:41:23.380 | with doing different risk is that they're

00:41:26.020 | different than what a lot of people

00:41:28.180 | see on the news channel, like on the S&P 500.

00:41:32.020 | And if they're not mentally prepared for that,

00:41:34.680 | they're oftentimes going to be in at the wrong time,

00:41:37.400 | out at the wrong time, and ruin the whole reason

00:41:41.020 | for holding additional risk premia, which

00:41:42.920 | is to help your long, long-term performance

00:41:46.180 | and to diversify away from just owning generic beta.

00:41:50.700 | You and I went back and forth on Twitter a little bit about,

00:41:53.380 | what does the word "long-term holding" mean?

00:41:56.900 | How long is long?

00:41:59.140 | And I think I said, a lifetime.

00:42:01.100 | And you said, no, it's only 20 years.

00:42:04.020 | And I said, OK, we'll compromise at 25 years.

00:42:06.860 | But this idea of holding these factors for a long, long time

00:42:13.380 | is really critical to the success of an investor.

00:42:16.860 | Yeah, the advice from Bogle is actually timeless,

00:42:21.700 | and it applies everywhere.

00:42:23.060 | Like, when he talks about holding equity,

00:42:26.180 | he doesn't suggest you should go buy the S&P 500 fund, or VT,

00:42:30.380 | or VTI, and just trade it every year.

00:42:33.380 | He's like, no, this is basically your permanent holding,

00:42:36.380 | because you want to capture the equity risk premia.

00:42:40.380 | Well, same thing here.

00:42:41.540 | We're trying to capture some specific factor risk premia.

00:42:46.500 | And the same advice applies.

00:42:48.180 | You're not going to capture it by trying to time it,

00:42:51.180 | day trade it, bounce around all over the place.

00:42:54.860 | You've got to hold the thing and actually earn the associated

00:42:58.980 | risk premia with it, which means you

00:43:01.100 | need to look at it more as a long-term strategic holding

00:43:05.100 | and not as a kind of a short-term trading vehicle,

00:43:09.700 | because that's not what it's really designed for.

00:43:12.900 | So let's get down to the nitty-gritty then,

00:43:14.700 | the bottom line on all this.

00:43:15.820 | It's going to cost me more money to go

00:43:18.340 | after those additional betas, because I have to pay a fee

00:43:20.940 | every year.

00:43:22.540 | That's higher than the basically beta is free now.

00:43:26.700 | So anything other than beta, which is now free out there,

00:43:31.300 | I'm going to decide to add additional betas

00:43:34.180 | or additional factors to my portfolio using your funds.

00:43:38.900 | But your funds are not free.

00:43:40.740 | Your funds have cost.

00:43:42.780 | So number one, I have to get over

00:43:44.460 | that hurdle rate of the cost.

00:43:47.220 | And there's this thing out there called--

00:43:50.260 | where we talk about it as an alpha decay or a premium

00:43:54.500 | decay that's going on.

00:43:55.540 | As more and more people are doing what you're doing,

00:43:58.620 | there seems to be a decay going on as to the expected return

00:44:04.580 | from these additional factors.

00:44:07.540 | Can you see that?

00:44:09.940 | Have you measured it?

00:44:11.460 | Are your funds going to produce--

00:44:16.060 | because I have to take money out of beta

00:44:17.720 | to put it into the additional factors.

00:44:21.460 | It's long only, so I'm taking a slice of my total market index

00:44:25.020 | fund.

00:44:25.540 | And I'm going to allocate it to your fund.

00:44:27.820 | And I'm going to pay you a higher fee.

00:44:30.340 | And I need to at least get beta, which I know

00:44:33.500 | I'm going to get in the market.

00:44:35.620 | I've got to get above and beyond that.

00:44:37.820 | Is it worth it?

00:44:40.580 | So yes, there's a lot of questions in there.

00:44:44.020 | And it's all about cost and benefit.

00:44:46.580 | So in general, when you look at any of these factors,

00:44:53.020 | the cheaper you can get them, the better.

00:44:55.940 | And a lot of times, the price is going

00:44:58.140 | to be associated with the scarcity of said factor.

00:45:02.460 | If something has massive insane capacity, well, at the margin,

00:45:08.300 | that's something that Vanguard can deliver at scale.

00:45:11.620 | An example of a factor like that might

00:45:13.780 | be market beta, right?

00:45:15.620 | That's obviously something that has

00:45:17.580 | trillions of dollars of capacity.

00:45:19.780 | You can jam tons of money into it.

00:45:21.700 | Not infinite amount of money, by the way.

00:45:24.460 | But in general, that would make sense.

00:45:26.420 | But then there's other sort of strategies

00:45:28.860 | where if you're actually going to do the actual factor,

00:45:32.340 | like for example, like what we do,

00:45:34.300 | 40 stocks, mid cap, a lot of times small cap weight,

00:45:39.220 | you just can't jam a trillion dollars into that strategy.

00:45:42.820 | So there's going to be a natural limit on capacity, which

00:45:46.500 | means you can't just scale it to infinity, which

00:45:49.460 | means the cost can't be free because you've

00:45:52.420 | got to pay the fixed costs and the bills

00:45:54.300 | and the operational things for running this damn thing, right?

00:45:57.740 | So that's just kind of the economics

00:45:59.580 | of general capturing any exposure that

00:46:02.500 | doesn't have infinite scale.

00:46:04.380 | The second question relates to, well,

00:46:06.620 | what do these premiums actually deliver?

00:46:10.380 | So for example, value, let's say.

00:46:13.100 | And you could do value investing, just generic.

00:46:16.500 | Let's just call it low PE investing.

00:46:18.580 | You could do it one of two ways.

00:46:20.340 | We'll just make up.

00:46:21.140 | One way is you could go buy a portfolio of, say,

00:46:24.700 | 40 stocks that have low PE.

00:46:27.060 | Another way is you could go and weight.

00:46:29.660 | You could go take the S&P 500 stocks

00:46:31.700 | and kind of tilt more weight towards the low PE,

00:46:35.460 | less weight to the high PE.

00:46:37.700 | But on net, you're basically not really doing much.

00:46:40.900 | You're kind of tilting one way or the other.

00:46:43.060 | So clearly, the potential value add

00:46:46.100 | from the so-called value factor is

00:46:49.100 | going to be a lot higher in the concentrated one

00:46:52.620 | than in the diluted one.

00:46:54.220 | So that's one element, like how is the thing constructed.

00:46:57.140 | But then the other important element is,

00:46:59.020 | is this premium going to pay off in the first place?

00:47:02.340 | Because let's just say value just doesn't work at all.

00:47:06.100 | Well, then if I have it in a concentrated format

00:47:09.140 | or have it in a diluted format, it's

00:47:11.260 | not going to do anything for me.

00:47:12.940 | And that gets back to the question of, well, why does

00:47:15.340 | a factor pay off in the first place?

00:47:18.060 | And because it's an open secret, and because a lot of people

00:47:21.740 | know about it, and because a lot of people

00:47:24.180 | are perceived to be doing it, will that make it decay?

00:47:28.220 | Well, we've got to step back and say,

00:47:32.380 | why did they pay off in historical sense?

00:47:35.580 | Well, value generally paid off, because to Fama's point,

00:47:40.300 | it's riskier.

00:47:42.060 | So unless you were to believe that risk preferences have

00:47:45.980 | changed, then one would probably want

00:47:48.900 | to believe that exposure to the value factor

00:47:52.580 | will probably pay off at some point in the future.

00:47:55.980 | Clearly, it hasn't paid off very well in the last 5 or 10 years.

00:48:00.380 | But just like generic market beta

00:48:02.380 | doesn't pay off all the time, it's

00:48:04.740 | had 10, 20 year droughts as well,

00:48:07.260 | there's a reason to believe from economic perspective

00:48:09.500 | that value will pay off, just because a lot of times

00:48:14.060 | it's fundamentally riskier.

00:48:15.900 | And then the second point is that if someone

00:48:18.820 | is going to do value, and you believe even

00:48:22.180 | in the mispricing component of value,

00:48:24.660 | like people throw the baby out the bathwater,

00:48:27.300 | there's this aspect of what they call career risk.

00:48:30.300 | So just because everyone knows about something

00:48:33.420 | doesn't mean they may go and do it,

00:48:35.740 | because if you go out and buy concentrated portfolios

00:48:39.380 | of value stocks, like right now, it's

00:48:42.180 | very likely that you have a high probability of getting fired,

00:48:46.140 | because these things can bounce all over the place.

00:48:49.260 | You're going to get destroyed by the S&P 500 sometimes,

00:48:52.540 | and people think you're an idiot,

00:48:54.100 | and you get booted out of the job.

00:48:57.180 | So this creates its own what we call career risk premium.

00:49:00.980 | So to the extent that a lot of people

00:49:04.140 | are quote, unquote, "doing these things,"

00:49:06.540 | but these strategies earn premiums for a reason,

00:49:10.100 | i.e., they're risky, and they stink to do,

00:49:14.140 | one would expect that over the long haul,

00:49:16.460 | they're probably going to earn some premium.

00:49:20.540 | I don't know what that will be.

00:49:23.180 | Historically, like a concentrated value portfolio,

00:49:25.940 | like what we're doing, maybe 3% to 4%

00:49:30.340 | over a generic index, which is going

00:49:33.380 | to be being sourced from being smaller, being cheaper,

00:49:37.620 | for the most part.

00:49:38.700 | Let's say that cuts in half to 2%,

00:49:41.500 | because at the margin, it gets more efficient.

00:49:45.300 | So you may earn this 2% premium, but this is not

00:49:49.940 | like an arbitrage.

00:49:51.220 | This means you're going to deal with probably more risk,

00:49:54.340 | probably more vol, probably-- well,

00:49:56.700 | definitely way more pain in English in a relative sense

00:50:01.220 | to common benchmarks.

00:50:03.060 | So you're probably going to earn this return.

00:50:05.940 | But then the question is, well, how much does it

00:50:07.940 | cost me to access this 2% premium?

00:50:11.580 | Well, if it costs me 200 bps, that's probably a bad idea.

00:50:16.660 | If it costs me zero, that'd be a great idea.

00:50:21.780 | And then there's somewhere in between.

00:50:23.580 | So what we do is, on our stuff, for the domestics,

00:50:28.060 | we charge 49 basis points, so just

00:50:30.820 | under 50 bps, which is obviously way more expensive than zero.

00:50:35.700 | I wouldn't call it outrageous, but the idea

00:50:38.300 | is the bet on our stuff would be, hey, over the next 20

00:50:42.340 | years, do I believe that the excess return associated

00:50:47.860 | with the factor exposures that I'm getting here

00:50:51.140 | are in excess of 49 basis points?

00:50:54.300 | If not, then why would I do this?

00:50:57.900 | If so, OK, I might want to do this.

00:51:00.220 | But then the second question would be, well,

00:51:02.420 | can someone else deliver it even cheaper?

00:51:04.860 | Because maybe Vanguard's got some concentrated value factor

00:51:08.860 | fund for 30 bps, right?

00:51:10.980 | And the process is very similar, and I like it.

00:51:13.580 | Well, OK, I think I project it's worth 1% over the long haul,

00:51:18.220 | or 2%.

00:51:19.500 | It only cost me 30 bps.

00:51:21.100 | Here, I'll go do that one, right?

00:51:22.540 | So it comes down to the trade-off between,

00:51:25.660 | what do you expect this premium to pay off over the long haul?

00:51:29.220 | What do I got to pay for it?

00:51:30.860 | And obviously, you want to pay less and earn more

00:51:34.540 | as best you can, which is what I argue

00:51:37.540 | a lot of these people that do factor investing

00:51:39.860 | are doing today.

00:51:41.060 | They're not buying and holding our fund for 20 years.

00:51:44.900 | They're day trading the iShares factor funds.

00:51:48.580 | That's not arbitraging factor premiums.

00:51:52.580 | That's, in the end, probably contributing

00:51:55.620 | to make them even higher in the future.

00:51:57.740 | But that's a different debate.

00:52:00.140 | Speed-dating factor funds rather than marrying one.

00:52:03.620 | Yeah, yeah, exactly.

00:52:04.940 | The only way you can pull premium out of the market

00:52:08.260 | is you need to have massive amounts of permanent capital

00:52:11.780 | sticking in something, because it's kind of taking supply

00:52:14.620 | off the market.

00:52:15.660 | But if all you've got is more day traders throwing money

00:52:20.340 | around, sloshing around in factors,

00:52:23.340 | that's not arbitraging away the factor.

00:52:26.060 | That's just money sloshing around,

00:52:28.140 | and it's adding volatility to the factor.

00:52:30.940 | But unless that money is like all mini Warren Buffetts holding

00:52:35.140 | for 20 years through thick and thin,

00:52:37.660 | it's not going to depress the risk premium associated

00:52:40.620 | with them, or it would be very unlikely to do so.

00:52:43.380 | And I frankly don't see that sort of mentality

00:52:46.340 | amongst factor investors in the marketplace.

00:52:50.180 | Nor do I see that as an incentive for product

00:52:53.380 | manufacturers, because they're in the business of activity.

00:52:57.820 | So the more I can get you to like day trade them,

00:53:00.060 | do this, that, and the other thing,

00:53:02.180 | that's good for the business out there.

00:53:04.860 | So I think people have an incentive

00:53:07.140 | to promote activity in factors.

00:53:10.100 | And you've written a lot about this.

00:53:11.620 | You've got three books out there, numerous papers.

00:53:15.740 | The books are Quantitative Value, Quantitative Momentum,

00:53:19.860 | and then DIY, Do-It-Yourself Financial Advisor.

00:53:24.460 | I've read the book, and it's not as easy as--

00:53:27.660 | I think you make it out to be in that book,

00:53:29.460 | how you can do all of this as a do-it-yourself investor.

00:53:31.860 | But--

00:53:34.060 | Well, yeah, I would say it's just like on BogoHeads.

00:53:38.100 | You can go review the start here.

00:53:39.820 | Here's how it's done.

00:53:41.220 | And yeah, you can read it, and there's the cookbook.

00:53:43.300 | But at the right price, sometimes people will still

00:53:46.580 | be like, you know what?

00:53:48.020 | Thanks, I really appreciate the transparency.

00:53:49.940 | I understand what you're going to do,

00:53:51.440 | but I have better uses for my time.

00:53:53.580 | I'd rather pay you to do this for me.

00:53:56.020 | But there are people that definitely are DIY,

00:53:59.140 | but there's certainly a lot of people,

00:54:01.060 | like my grandma, for example, where she's probably not

00:54:06.940 | well-suited to DIY, even if she read the book

00:54:09.540 | and thought it was cool because her grandson wrote it.

00:54:12.180 | It's a bit of a misnomer on the title.

00:54:14.900 | We're coming up on the end of our time.

00:54:16.900 | I'd just like to switch gears here for one last second.

00:54:19.820 | Could you talk about your March for the Fallen

00:54:23.340 | and what that's all about?

00:54:24.700 | Yeah, so March for the Fallen is a 28-mile march

00:54:29.220 | held at the Pennsylvania National Guard training unit.

00:54:33.060 | And the idea here is you're out there representing

00:54:37.500 | on behalf of those who lost loved ones in the military.

00:54:41.820 | So we're supporting Gold Star families and people

00:54:45.260 | who have lost people in war.

00:54:47.100 | And it's not a charity in the sense that you give money.

00:54:50.260 | It's a charity in the sense that people

00:54:52.740 | that have lost their loved ones like

00:54:55.020 | to know that other people are remembering and honoring

00:54:58.180 | the fallen.

00:54:58.940 | So that's what you do.

00:54:59.860 | You're out there in your charities

00:55:01.260 | counting your blood, sweat, and tears

00:55:03.100 | to represent and let them know that we still appreciate

00:55:08.100 | sacrifices they gave as a family.

00:55:10.220 | And so you go out there and hang out.

00:55:12.460 | And it's a great cause.

00:55:13.820 | And you meet a lot of great people.

00:55:15.300 | And I really enjoy promoting it and trying

00:55:18.220 | to encourage as many folks as possible to come out.

00:55:21.500 | And if somebody was interested in joining your group,

00:55:24.140 | you've got a pretty large group that you've put together.

00:55:27.460 | Yep, so you've got-- so last year we had around 150.

00:55:31.860 | This year, I imagine, we'll have probably 200 plus.

00:55:35.340 | All you've got to do if you want to be on notifications,

00:55:38.140 | obviously, is reach out direct.

00:55:39.460 | Or just if you go to alpharchitect.com/mftf,

00:55:44.140 | there's a whole website about training plans, nutrition,

00:55:48.100 | how to sign up, and all these sort of other things.

00:55:51.380 | And all you've got to do is just show up.

00:55:53.820 | We take care of lodging and chow.

00:55:56.220 | And I think it's like $35 you've got

00:55:58.500 | to pay to the National Guard.

00:56:00.300 | So it's very low cost, super efficient, great cause.

00:56:04.340 | You meet a bunch of great people.

00:56:06.220 | And I think everyone should at least do it

00:56:08.580 | one time in their life.

00:56:10.180 | Thank you, Wes.

00:56:10.780 | It's been a great conversation.

00:56:12.340 | I really appreciate you joining us here

00:56:13.940 | on Bogleheads on Investing.

00:56:15.880 | You got it.

00:56:16.380 | It's been an honor.

00:56:17.140 | And keep doing what you guys do over at Bogleheads.

00:56:19.620 | I love the education and love the effort for DIY investors

00:56:24.340 | out there.

00:56:25.300 | This concludes the ninth episode of Bogleheads on Investing.

00:56:29.380 | I'm your host, Rick Ferry.

00:56:31.660 | Join us each month to hear a new special guest.

00:56:35.020 | In the meantime, visit Bogleheads.org

00:56:38.380 | and the Bogleheads wiki.

00:56:40.140 | Participate in the forum and help others find the forum.

00:56:44.380 | Thanks for listening.

00:56:46.580 | [MUSIC PLAYING]

00:56:49.940 | [MUSIC PLAYING]

00:56:53.300 | (upbeat music)

Bogleheads® on Investing Podcast 009 – Dr. Wesley Gray, host Rick Ferri (audio only)

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