Welcome to Bogleheads on Investing, episode number 9. In this episode, I'll be speaking with Dr. Wesley Gray, CEO of Alpha Architect, where he and his colleagues are breaking new ground. And the author of three books on quantitative investing. Hi, everyone. My name is Rick Ferry, and this is Bogleheads on Investing.

This episode is sponsored by the John C. Bogle Center for Financial Literacy, a 501(c)(3) corporation. Today, we're speaking with Dr. Wesley Gray. After serving in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago, where he studied under Nobel Prize winner Eugene Fama.

He then took a job in academia before starting his investment management company, where he is on the cutting edge of new insights into factor investing. With no further ado, let's bring in Dr. Wesley Gray. Welcome to the show. How are you today? I'm great, Rick. I appreciate you bringing me on.

You very much impressed me the very first time I learned about you and I talked with you. The stuff you're working on is cutting edge. I really believe that you are the new Jedi out there in the quant world. Before we get into what you're currently doing now, I want to start at the beginning.

Where did you go to your undergraduate degree? I went to undergrad at University of Pennsylvania at the Wharton School. I kind of started off with the Uber finance geek undergrad. And my first way I parlayed myself into academic research is I walked into this gentleman's office named Chris Gatesy, who now writes a lot of papers on the 200-year history of momentum or relative strength or value or what have you.

And I just said, I love this stuff. Can you teach me how to be a professor? And he basically said, hey, see that shelf right there? Grab these 10 books and read them and come back in two weeks and let's talk. That was my initial start into geeking out and getting into academic research and moving along my initial path, which was to be a finance professor.

But there was also another side to you. You had this idea that perhaps you could figure out ways of outperforming the market. Well, yeah, kind of. Simultaneous to the sign I want to be a finance professor, I was also trading my own money, doing a lot of investing. I was there from '98 to 2002, and so that was obviously during the internet bubble.

And so I had this exposure where I'd come off reading every book, everything I could get my hands on related to Ben Graham and Warren Buffett and the value investment philosophy. Pets.com's going up 1,000% a day. My dad's telling me to go buy the Janus Global Tech Fund. And I'm a value-by-nature person, and I'm watching these markets thinking they're crazy.

I'm obviously trading in value names, getting destroyed. But then on the other side of my life, I'm like, hey, I just intellectually like this. And I was like, hey, I want to stay this forever. So it was kind of a weird barbell in the sense that I was sitting there trading stocks, and then on the other hand, I was reading stochastic calculus books, just trying to get baseline, essentially to be a research assistant for Gatesy.

And so what happened is I kept doing all the investment stuff, kept doing my stock picking. And then I started-- essentially, I became, for the Wharton Finance Department, the-- I don't want to use the-- the computer monkey. I was like the data monkey. So if someone needed to have something coded up in MATLAB, that was my job.

So I kind of became like a little mini workhorse for the department. So fast forward a couple of years, and I was saying, all these guys are also, by the way, Chicago PhDs, because for whatever reason, Chicago tends to feed the Wharton faculty. And Chris Gatesy's like, hey, you're going to apply to Chicago.

And that's it. I was like, well, aren't there other schools? Should I consider other PhD programs? They're like, no, you've got to go to Chicago. They're like, we'll get you in. And I'm like, OK, how does that work? They're like, hey, take all your tests and do all your stuff, and we'll write your recommendations letters.

And so sure enough, I applied to the University of Chicago PhD program just straight out of undergrad, which is also not normal, because typically, you go get a master's or what have you. But I had a lot of kind of close holds in the department that were writing letters for me.

And PhD programs, they only accept a handful of people every year, so it's a much more kind of one-off deal. It's not like applying to an MBA program. Long story short, I got in. I was like, wow, I guess I'm going to actually do this. Since you entered the program in 2002, the Chicago school at the time-- and it still is to a certain extent-- it's just, we're going to take you in, and we're just going to beat you up.

You are going to get destroyed in problem sets, workload, and let's just see if you survive. And so the first two years are just-- literally, I was studying like 15 hours a day, seven days a week, just trying to stay above water. Because I came in, obviously, without having a lot of experience or grad score or what have you.

So it was actually, say, pretty difficult, but I made it. And so after the first two years there, I don't say I was burned out, but I was 24. I'd been slaving away doing quaint academic geek stuff forever. And I just thought, hey, I need to maybe take a break or do something else.

So you really did do something else. I would say that what you did was quite radical. And of course, I'm proud of you for it. So what I did is I decided I was going to join the Marine Corps, which you're an alumnus of. And it certainly seems radical.

But what was super interesting at the time is I would say a good 20% to 30% of the Chicago Finance PhD program were actually former military officers, a lot of them from Israel or Finland or what have you. So they were all like, oh, yeah, of course you should do that.

Whereas many people outside are like, you must be the first time anyone's ever done that. But what was super interesting is inside the program, my other fellow PhD mates were like, hey, that's pretty cool. And so, yeah, I went down to Professor Fama. And at the time, Professor Thaler, which is crazy, I had these two Nobel Prize winners, were actually-- it wasn't my dissertation, but my curriculum paper advisors.

And I just had to ask them permission to get a four-year sabbatical. And Professor Fama was actually super cool about it. He's just like, oh, that's awesome. Proud of you. Yeah, happy to sign. Didn't even think twice about it. And then your Professor Thaler, he was more curious. He was definitely like, you're going to do what?

But eventually, I got both those gentlemen to sign off and then submitted it to the PhD program coordinator and took a four-year sabbatical. That's amazing that you could actually do that, take four years off. Well, so you can't. You can take technically one year off. And so that's the reason I had to go and have them sign off on this special kind of extended sabbatical, because it was a unique circumstance where most people don't go on sabbatical to do service.

The PhD program director kind of agreed, like, hey, this is a unique circumstance. As long as you get your advisors to sign off on it, we're cool with it. And so I had to do a few extra hoops to jump through to actually make it happen. Well, that's great.

And then you went down to Quantico and went through Officer Candidate School? Yep, so then I went to OCS, which is Officer Candidate School, then went to TBS, the basic school. And then my MOS was a ground intelligence officer. You go through the infantry officer course. You kind of do everything that the infantry officers do.

And then they go pick up their platoons, whereas ground intelligence officers then go down to dam neck and do another six months of intelligence officer training. And then you go hit the fleet. So it's the longest pipeline besides, you know, Hilo and fixed wing people. But it's about a year and a half, almost two years, of training pipeline.

And from there, they shipped you off to Okinawa. I went right to Okinawa. And then right when I was in Okinawa, they sent me down to one of the islands in Japan and did a bunch of, like, joint training missions with them. Spent about a month there. And then I got sent directly down to the Philippines.

And at the time, this was, I think, was that 2004, 2005, there was a bunch of activity going on on this island called Holo, which is a bunch of Muslim extremists and what have you. But then there was this thing called the Leyte mudslide disaster and a coup. So I was in the Philippines, you know, going crazy for a couple months there.

And then right when I got back to Okinawa, which I was assigned there, but I rarely ever hung out there for, like, maybe a day or two, the colonel calls me in the office. And he basically says, hey, you're going to Hawaii. And I was like, all right, why am I going to Hawaii?

They're like, oh, you're on a MIT team, a military transition training team, and you're going to get deployed to Iraq. So then I went out to Hawaii, did a big work up. And then we deployed out. I was on one of the training teams where you're in bed with Iraqis and try to help them avoid shooting themselves in the foot.

In fact, you wrote an entire book about your experience working with the Iraqis. The name of the book was called Embedded. And it was a fascinating insight into what was going on. Yeah, so I kind of went in to the service. I didn't join the service because I wanted to go to war, per se.

I just wanted to do my time. But I was certainly under the belief when-- I don't know if you probably remember, but Colin Powell showed that little powder of-- that white powder and said, hey, we're all going to die. I kind of believed that. I was like, all right, we need to probably do something here.

Fast forward, now I'm actually deployed, living in an Iraqi battalion, training up these Iraqi soldiers to kind of take over their defense duties. And I really got an opportunity to actually live with these people, eat with these people, talk with these people, and kind of get a better insight to the culture and kind of how they operate.

And that experience, honestly, just floored me. And I took a whole 180, where I said, I don't know what we're doing here. This is crazy. Like, I was not expecting this. These people are tribal. They're totally different. Like, what we're trying to achieve here does just not jive at all with their society.

I need to tell the story, because there's probably a lot of guys like me that, rah, rah, let's go to war. And they don't realize it. So I just got inspired. I was like, I got to share the story. So I had to just write a whole book, basically, about my time being embedded with the Iraqis and just trying to explain their cultural nuance and why what we were trying to do, like bring freedom and democracy to their society, just seemed like maybe it wasn't a great idea.

That's pretty much what that book was about, just sharing my experiences there, which were highly enlightening to me. And I just wanted to make sure other people got to at least experience it through at least my book, even if they can't be there themselves. I understand that you speak Arabic and that you taught yourself.

I did. So I mean, I could probably converse in it if I got warmed up. But yeah, so I was the intelligence officer. And the more I read beforehand, because I knew we were going to war in these areas, speaking Arabic, the actual language there means a heck of a lot more because it's associated with the religion, because it's from Allah.

So it's kind of a big deal. So the more-- if you want to win in those sort of culture wars, you've got to really establish bonds with the people you're working with. And so learning the language, I thought, was a main effort. So yeah, I just put a ton of time up front to train extremely hard, both on learning how to kill people and everything, but also how to learn this language.

And then when I got there, I just forced myself to literally embed with the people and not use a terp. And then if you sit there long enough and get tired of using hand signals and not understand each other, eventually you can start maneuvering. So yeah, I got to a point where I actually served as a terp for our team.

And we would go out on convoys. And I would be the terp to interface between our team and the Iraqis. Yes, and I definitely highly recommend, if anyone has to do that mission ever again, to spend way more time learning the language and a lot less on tactics, per se.

Because it gives you a lot more, I'd say, what the Iraqis call wasta, kind of karma and the ability to interact with them and have them actually listen to you if you actually know their language. That's fascinating. Well, you did that. Did you stay for four years? Yep, did the four-year active duty.

And then after that, you went back to the University of Chicago? Got out when it was early 2008. And then my mind-- well, you know, being in the service, it's just obviously way different than being in a PhD program at University of Chicago. Just slightly. I got out-- yeah, yeah, kind of like 180.

And so literally for the first three months, I just had to relearn everything. Because my curriculum paper had a bunch of math in it. And honestly, I couldn't even read my own paper. I was like, well, I don't even know what this person's talking about. But it was me.

So I just put the basics on like, hey, here, I got to relearn calculus and all this stuff. And it is true that it is like riding a bike, where if you know how to do it, if you just get back into it, you do quickly learn. So yeah, reentered the program, moved back to Chicago.

And I was in much more like-- I was in discipline mode versus a lot of my comrades there at the PhD program who were students, because I'd kind of come out with a new look on life. So I was like, I'm getting out of here in two years. And because usually you don't get out of the PhD program in a collective four years.

Usually it's five, six years. But I just didn't want to mess around. So I spent three months relearning everything. And then I immediately went to work on dissertation. So yeah, because my goal was I need to get out of this place by 2010. Or my wife, she's not going to be happy living on a ramen noodle salary for longer than that.

And who was your mentor on your dissertation? So I went back to my old curriculum paper advisors. And it was Thaler and Fama were the top two. And then another gentleman, Andrea Frazzini, who's also famous now, but he actually left and went to AQR. So when I came back, basically Frazzini had already gone to go be a millionaire over at AQR.

Thaler had gotten too famous. So he obviously wasn't going to mess with PhD students anymore. So really who I was left with was Fama, because he was the only link in the chain that hadn't been broken. So I essentially went to him. And he was kind of like my core advisor.

And then another gentleman, Stavros Panagias, he helped me a lot because I had a theory paper as well as part of my dissertation. Pietro Viranesi was another one. So I had a handful of them. But I'd say the most influential and obviously the one that had the most experience in empirical asset pricing work was obviously Professor Fama.

So he was kind of the one that hazed me the most, I would say, in the dissertation writing stage. Your paper, if I'm not mistaken, was about active management. Yeah, so being a Marine and probably a little hardheaded, I came back. And I'd always been, like I was telling you before, a stock picker, specifically a big believer in value investing and value investing stock picking.

And so what I decided was I want to highlight to Professor Fama that active stock picking can add value, because this whole efficient market thing seems a little too crazy to me. So you're going to tell Eugene Fama, the future Nobel laureate, that he was wrong. At least that was my going in.

And so what I did is, well, how am I going to highlight this? Well, it turns out that there's this organization called Value Investors Club, where a bunch of super sophisticated stock pickers, a lot of them associated with hedge funds, they would submit huge theses on basically stock pitches.

So best buys undervalued. Here's my DCF. Here's the 100 reasons why. And so what I thought is like, hey, I've been following this club since 2000. I'm a member of this club. I think they add a lot of value. They seem to have really good ideas. I'm going to read every single one of these stock pitches, systematically enter them into a database, and do the quant analysis on it to then assess, hey, do these people actually add value or have, quote unquote, "alpha." Long story short, they do, at the margin.

And so I submitted this as part of my dissertation. And somehow, by the grace of God, Fama agreed with the analysis. He had some quibbles on takeaways. But at least at the margin, I highlighted that there is some segment of the market where active stock picking might work at the margin.

So that was a small victory for me. How did you meet up with Jack Vogel, who you ultimately became partners with at Alpha Architect? Sure, so what happened is when I graduated from the program there, I went on the academic professor market. And also, my wife was going on the academic market.

She's a PhD in history, which is a way less, I'd say, marketable profession than being a finance professor. So I went out to the market. And my wife's from Philly. And she needed a job as a history professor. And I ran into Drexel, who gave me what they call an exploding offer.

So they gave me this offer I couldn't refuse. They gave me three days to decide on it. They say, hey, come to Philly. Your wife's from here. We'll get her a job. And we'll give you the best gig ever. And we'll assign you a PhD student who will do all your dirty work.

So I was like, OK, well, sign me up. What are you going to do? How often do you got to twist my arm? And so I entered Drexel. And then part of my package was having a dedicated research assistant. And that happened to be Jack Vogel. So just by circumstance and a lot of great luck, I just had a gentleman who was insanely smart, extremely well-- extremely good at computer programming and doing all this data analysis.

And we just hit it off immediately. So we've been working ever since 2010 when I took that job. Well, the way I understood it was Jack had read your dissertation. And he said, yeah, all this is great. These people have alpha. They're outperforming the market. But I can replicate that using a computer.

So are they really outperforming the market? Can you tell me about that? Well, yeah. So that was an insight that actually I had before I met Jack. And kind of the takeaway from-- well, the interesting takeaway from the dissertation was I cataloged all this data on these individual stock pickers.

And sure enough, they had alpha relative to Pharma, French models, what have you. But essentially what they were doing for all intents and purposes was small cap value investing in a certain element of concentration because there's only so many ideas that they would produce. It's not like you go buy 500 names at a time.

So there would usually be like five or six ideas a month, sometimes 10. So on a rolling basis, this portfolio would have anywhere from 50 to 100 stocks. But essentially what they were doing from a quant perspective is buying smaller stocks that were super cheap, generally higher quality, and doing it in somewhat concentrated fashion.

And sure enough, you could also just have a computer essentially do the same idea, right? Concentrated, small, cheap quality. And lo and behold, it basically replicates what all these stock pickers were doing, which was certainly-- well, it was kind of disheartening because at the time I was still kind of believing in stock picking because I was still being a stock picker.

But that kind of analysis there proved to me why am I banging my head against the wall so hard to do these dissertations on these stocks when you can essentially replicate a lot of the core ideas with just using an algorithm. And so that was really kind of the straw that broke the camel's back, as they say, that moved me much more heavy into just pure quant and less into thinking I was going to be Warren Buffett.

I think the proof was in the numbers. And Jack Bogle, your research assistant, was doing a dissertation similar to that? So Jack's dissertation was a little bit different. So what he looked at is there's a huge argument over whether value investing, which in defining academic terms just means buying cheap stocks, right, on book to market or price earnings or what have you.

He was looking into the argument, is this a risk-based phenomenon, or is this a behavioral-based phenomenon? Just to explain the two ideas simply, the risk-based hypothesis essentially says that the reason cheap stocks earn higher returns is because cheapness is a proxy for fundamental risk. So the reason you're getting paid more on average is because these stocks are just fundamentally riskier.

The behavioral argument, which is on the other side of the coin, is like, no, it's not because these stocks are riskier. It's because the market generally throws the baby out with the bathwater. And that's more related to a mispricing story that sentiment throws these names out and beats them up too bad.

And so his dissertation was about, how do we empirically identify whether value is risk or mispricing? And the short story is that it seems like, if anything, it's more likely mispricing versus risk that explains the value premium. Obviously, this is highly debatable, but that's what his dissertation was all about.

And after all of that, you decided you were going to go out and create a company together. Well, kind of. Actually, all this happened simultaneously, and it's one of the crazier stories in our industry. So right when I actually got my job, it actually was during the time I was on the professor markets.

At the time, I was writing a blog, and obviously, my dissertation was out there. I got cold called by a very large real estate family in New York, and the son had been put in charge of essentially managing-- it was around $4 billion of their liquid wealth. And they were in the middle of just living through 2008, and they were big in hedge funds, big in active management, and they'd got smoked.

And they're like, we're firing every one of these people. We're going to take control of our wealth. We're going to do this in-house. We're going to do it with quant. We need someone to help us. And he had just been out there Googling around, and somebody found me. And he calls me up, and he's like, hey, can you help me manage this $4 billion?

We want to use computers. I really like your dissertation. How do we do this? So went up there, met him. Again, this is all at the same time I'm sitting here thinking I'm going to be a professor. I wasn't 100% sure if this would actually lead to anything, but it initially kind of led to a basic consulting gig where the gentleman said, help me for a couple of years.

If you guys do a great job, we'll cede your business on the asset management side. Because they had just gotten out of the whole asset management hedge fund world, and they're like, we're never going to cede or do that ever again. And then I was putting the ask on the table.

But they said, hey, give me two years. And so essentially, I kind of helped them initially. And then I got Jack involved immediately because it kept scaling up bigger and bigger. And then so after two years, in 2012, they essentially ceded $20 million in the quantitative value strategy, which we have a book about.

And then very quickly, they ramped it up to 50, and they put the other part in the international quantitative value. And this was all going on simultaneous to when I was being a professor as my day job. It just-- things kept happening in the background. So it was a very hectic time in my life, I would say.

And you were having children at the same time? Yeah. I was up to two, and we were working on three. And yeah, it was getting crazy. And then essentially, what happened is after-- I think it was around three years into it-- this was clearly becoming a real business because we were managing a $50 million managed account.

We've got a huge consulting contract. I'm also moonlighting now at this point basically as a finance professor. And I was just thinking, hey, I need to go one way or the other here. And so I talked to my boss, the head of the department. I just told him, I was like, listen, I think I need to resign, but I don't want to screw you over here because recruiting for professors is a total nightmare, at least a one-year cycle.

So he's like, hey, put in one more year so we can at least recruit for your position, and then you can go out into the sunset. So that's essentially what happened. After my third year being a prof, for all intents and purposes, I was all in on the business, but I was still technically professing until they could recruit for my position and then basically kick me out the door.

Another interesting thing along the way is through this whole time period, it wasn't just this large family office. For whatever reason, people like what we were putting out there. We were just being super transparent about putting our research, putting our ideas. So a bunch of random rich people would call us up and say, how do I do this?

And we'd say, well, we have a managed account. That's how you could do it. And so we kept building the business up. We would do tax-as-harvesting to try to minimize tax impact because everyone we were dealing with, it was taxable money. And another thing happened along this way. Another couple hundred million gentlemen out in the Midwest, we were working for them as well, and he had a tax problem.

And it was one of these situations where he had a low-basis stock that was going to get bought out by a large conglomerate for cash. And he was very afraid that he was going to have to incur a huge capital gain event. So he says, go figure this out.

And this is like one of these impossible things where like, hey, go figure out how to not pay tax. But if the rich guy says, jump, I say, how high? And so that's what I did. I went on this mission. How am I going to deal with this problem?

And I ran into a gal at a bank and structured product. And this is not something you could really do anymore. But it was all related to the ETF structure. And I started to learn about how the ETF structure essentially allows assets to come in at mark-to-market basis. The ETF can then dump any asset out, even if it has low basis, onto a market maker with no tax liability.

And it's essentially kind of a laundromat for capital gains liabilities. And a light went off in my head, like, holy cow, if I'm doing strategies that involve trading and turning over, and taxes are essentially Uncle Sam's 50% performance fee, this seems like a good idea. So long story short, in around 2014, we decided we're going to get into this ETF business because we thought it was a better structure to deliver these concentrated factor portfolios than doing them in SMA with tax-loss harvesting.

Just out of curiosity, all that work you did on the ETF structure of how it-- Yep. With the creation of the redemption, how you can push out any unrealized gains onto the authorized participants. You had that one client in the Midwest who had this big capital gain problem, and then you had this ETF over here.

I've always wondered, is there any kind of a structured product, or can there be a structured product where you could take people who have these stocks out there and put them all together, and bring it in, and just issue them shares of an ETF, and then take the stock then that they put in kind into the ETF, and then give it to an authorized participant to get rid of.

And now their cost basis is in the ETF. Yeah. It's diversified. Is that possible? Yes. Yes and no. The long story short is in the old days, yes. But what happened is all the big banks got smoked out on a bunch of tax things a few years ago, and they just cut off anything that could even be perceived as being on the edge because they didn't want to make Treasury angry.

So my understanding from the inside baseball of talking to people that deal in this world is in the old days, they would actually do stuff like that for super ultra high net worth clients and where they control the custody and clearing pipes. But my understanding is nowadays, that doesn't go on.

But I certainly feel like an enterprising entrepreneur that had the time and energy to try to figure that out, it could be possible. We've looked into it from like 50 different angles and haven't been able to figure it out. But yeah, there's certainly-- there's something there. I just haven't solved it.

I believe there's something there too. I believe that this thing called direct indexing where you can-- Yeah. --you buy 250 or 300 stocks, and then you individually sell off the ones that are at a loss and do a tax swap. And at the end, when that's all played out four or five years down the road, when there is no really longer any ability to do a lot of tax swapping, you've got this portfolio of 200, 300 stocks that have a low cost basis.

But that looks an awful lot like an index. So if you could just take that and just turn that into an ETF provider and get shares of a more diversified ETF where the cost basis of the ETF is the cost basis of all your stocks in aggregate, but it's a lot more easy to manage one security than 400.

Yeah. Yeah. I agree 100%. And I get in fights all the time with people arguing over, do you do the ETF structure or do you do the tax loss harvesting structures? And I still believe there's a marginal benefit. Even if you're doing pure passives, like say, for example, the parametric solution like S&P with tax loss harvesting or just go buy the Vanguard Fund, I still believe that the Vanguard Fund is better because a lot of people also forget, and to your point, that eventually you get basis and everything.

But the index changes. Like firms get bought out for cash. Guess what? You can deal with that problem in an ETF structure. You can't if you are in Social Security. Like if you have low basis and Joe Blow wants to buy the company out for cash, you're going to eat tax liability.

That's easy to cleanse in an ETF. And then there's the fee differential. Those tax loss harvesting solutions are 20, 30, 40 bps. An S&P 500 ETF is basically zero. So if you annuitize that cost differential over the life of the investment, the lump sum of that's maybe 2%, 3% of your wealth.

Does that make sense? Probably not. Is that the value of the tax loss shield you're going to get? I don't think so. So I think tax loss harvesting and direct indexing is total hype overblown versus just buying the passive index through an ETF structure for zero. That seems like a better long-term solution to me.

But reasonable people can disagree. Let's move on a little bit. So all of a sudden, you decide you're going to launch Alpha Architect. And you open up the world headquarters, which I've been to several times now. Yeah, for sure. So the original world headquarters was in a little house I had in New Jersey.

But that was five minutes from my mother-in-law. So both my wife and I agreed that, hey, we should probably move a little bit further away. So we moved over here to the Pennsylvania side. And I'd spent a year doing a commute from Baltimore to Philly when I was first year as a professor there, because we still had a place down there.

And I came out of the service. I'd swore off commuting, because I actually wanted to hang out with my kids. I like exercising. So I said, you know what? I'm going to set up a business in my house. And if people don't like it, that's fine. But it's good for my mental, physical health.

It's going to make me operate more efficiently. Why not? And so we bought this place out in Pennsylvania. It's kind of a compound of sorts. And now it's Alpha Architect Global Headquarters. But yeah, essentially, we just built an office inside this residence, got it zoned and everything. And we start off with, obviously, no AUM hardly at all.

And now we have almost a billion. But it functionally achieves the goal. It keeps our costs down low. And it keeps commuting time down. So we're kind of stuck with it. So it's a bit awkward. But in the world of 0% management fees, you've got to do weird things sometimes.

And I understand some interesting artifacts went along with that house. Yeah. So we got this place from a big game hunter, who was basically had-- it was a tragic situation. He had pancreatic cancer. And he was basically going to die in three months. So it was kind of a liquidation opportunity of some sort, both the house and our friends we have.

He was, like I said, a big game hunter. So we acquired a grizzly bear, a leopard, and a bunch of other really cool taxidermy mounts. And one of which we keep in the office, the grizzly bear, because we like to say that we try to kill bear markets. And we have evidence of it by having our grizzly bear here.

So it's definitely a unique experience visiting Alpha Architect Headquarters. It was for me, because when I first time I went to visit you, I'm driving down this residential street, and I'm saying, this can't be it. Yeah. We've had many of very, very wealthy people and a lot of famous folks roll through here with that exact same expression.

What in the world did this guy talk me into? Why am I hanging out in a residence in the suburbs of Philadelphia? Is this person crazy or what? So things have gone well. You've launched several ETFs. And the way in which you do ETF and factor investing, I find it to be kind of the right way of doing it.

It's almost like the next generation of factor investing, because it's so deep and so concentrated that if you want to do factor investing, that it seems to me you should be paying for as much exposure to these factors in a concentrated form as you can get. So it appealed to me right away when I found out how you were doing it.

Yeah. So essentially, the genesis of this idea is when we were working for the family office, they were going to do the typical thing, where they're like, let's go buy our cheap beta, but then we need to figure out how to replicate a lot of these different exposures that we used to get from these hedge fund people.

And hedge funds obviously aren't doing cheap beta stuff. They're usually doing concentrated bets and stock picking, but what's essentially is factors like small value quality. But they're doing it a much more focused way. So we naturally thought, well, if we want to replicate these more unique exposures out there, we need to replicate them how they need to be replicated.

And that means we're going to do maybe factors, but we're not going to hold 500 securities and focus so much on how close this tracks the index. We're going to do 50 stock portfolios and just tell people up front that this is not a closet index with a little tilt to the value factor.

This is pure value, where we're literally buying the cheapest 40 or 50 securities on a different metric. We use enterprise multiples, but keep it simple, like PE ratio. So yeah, and that's just what we did. And we just told people up front of the downside, which is, of course, the tracking error and the relative performance that this stuff can bounce around, both good and bad, over long time periods.

And you should just be prepared for that. It's not the Vanguard fund. And we just wanted to deliver it transparently, affordably, and be very up front about the potential pain associated with this style of investing. And I think that's all very interesting. Let's say that you want to have a slice of your portfolio to additional risk factors.

And the reason I use additional risk factors is because I actually interviewed Gene Fama one time. And I said, if beta is a factor, so what do you call these other things? Do you call them smart beta? Do you call them-- what do you call them? And his answer was, they are additional risk factors.

So they are additional betas. I said, OK, so let's say you wanted exposure to something other than beta. I guess you could do it by going long short, correct? But that would be expensive in many ways. So here you're going long only, but you're doing it very concentrated, and you're keeping the cost down.

Yes, that's right. So you got it. So the concept, to Professor Fama's point, and our portfolios are constructed in a way that is much more akin to how academics form portfolios. And that's what all the evidence shows. Look how great they are. The idea is, we're not going to go long short, to your point, because it's much more expensive to run, operate, and just access those exposures.

And so we're going to stick on the long side, but it's not going to be broad market beta exposure. It's going to be some beta, obviously, because it's long only. But we're going to focus as much as we can on capturing the value risk premia or the momentum risk premia.

And again, it's very important for us to communicate this element that this is a risk premia, and this is very different. Because frankly, the biggest issue with doing different risk is that they're different than what a lot of people see on the news channel, like on the S&P 500.

And if they're not mentally prepared for that, they're oftentimes going to be in at the wrong time, out at the wrong time, and ruin the whole reason for holding additional risk premia, which is to help your long, long-term performance and to diversify away from just owning generic beta. You and I went back and forth on Twitter a little bit about, what does the word "long-term holding" mean?

How long is long? And I think I said, a lifetime. And you said, no, it's only 20 years. And I said, OK, we'll compromise at 25 years. But this idea of holding these factors for a long, long time is really critical to the success of an investor. Yeah, the advice from Bogle is actually timeless, and it applies everywhere.

Like, when he talks about holding equity, he doesn't suggest you should go buy the S&P 500 fund, or VT, or VTI, and just trade it every year. He's like, no, this is basically your permanent holding, because you want to capture the equity risk premia. Well, same thing here. We're trying to capture some specific factor risk premia.

And the same advice applies. You're not going to capture it by trying to time it, day trade it, bounce around all over the place. You've got to hold the thing and actually earn the associated risk premia with it, which means you need to look at it more as a long-term strategic holding and not as a kind of a short-term trading vehicle, because that's not what it's really designed for.

So let's get down to the nitty-gritty then, the bottom line on all this. It's going to cost me more money to go after those additional betas, because I have to pay a fee every year. That's higher than the basically beta is free now. So anything other than beta, which is now free out there, I'm going to decide to add additional betas or additional factors to my portfolio using your funds.

But your funds are not free. Your funds have cost. So number one, I have to get over that hurdle rate of the cost. And there's this thing out there called-- where we talk about it as an alpha decay or a premium decay that's going on. As more and more people are doing what you're doing, there seems to be a decay going on as to the expected return from these additional factors.

Can you see that? Have you measured it? Are your funds going to produce-- because I have to take money out of beta to put it into the additional factors. It's long only, so I'm taking a slice of my total market index fund. And I'm going to allocate it to your fund.

And I'm going to pay you a higher fee. And I need to at least get beta, which I know I'm going to get in the market. I've got to get above and beyond that. Is it worth it? So yes, there's a lot of questions in there. And it's all about cost and benefit.

So in general, when you look at any of these factors, the cheaper you can get them, the better. And a lot of times, the price is going to be associated with the scarcity of said factor. If something has massive insane capacity, well, at the margin, that's something that Vanguard can deliver at scale.

An example of a factor like that might be market beta, right? That's obviously something that has trillions of dollars of capacity. You can jam tons of money into it. Not infinite amount of money, by the way. But in general, that would make sense. But then there's other sort of strategies where if you're actually going to do the actual factor, like for example, like what we do, 40 stocks, mid cap, a lot of times small cap weight, you just can't jam a trillion dollars into that strategy.

So there's going to be a natural limit on capacity, which means you can't just scale it to infinity, which means the cost can't be free because you've got to pay the fixed costs and the bills and the operational things for running this damn thing, right? So that's just kind of the economics of general capturing any exposure that doesn't have infinite scale.

The second question relates to, well, what do these premiums actually deliver? So for example, value, let's say. And you could do value investing, just generic. Let's just call it low PE investing. You could do it one of two ways. We'll just make up. One way is you could go buy a portfolio of, say, 40 stocks that have low PE.

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

So that's one element, like how is the thing constructed. But then the other important element is, is this premium going to pay off in the first place? Because let's just say value just doesn't work at all. Well, then if I have it in a concentrated format or have it in a diluted format, it's not going to do anything for me.

And that gets back to the question of, well, why does a factor pay off in the first place? And because it's an open secret, and because a lot of people know about it, and because a lot of people are perceived to be doing it, will that make it decay?

Well, we've got to step back and say, why did they pay off in historical sense? Well, value generally paid off, because to Fama's point, it's riskier. So unless you were to believe that risk preferences have changed, then one would probably want to believe that exposure to the value factor will probably pay off at some point in the future.

Clearly, it hasn't paid off very well in the last 5 or 10 years. But just like generic market beta doesn't pay off all the time, it's had 10, 20 year droughts as well, there's a reason to believe from economic perspective that value will pay off, just because a lot of times it's fundamentally riskier.

And then the second point is that if someone is going to do value, and you believe even in the mispricing component of value, like people throw the baby out the bathwater, there's this aspect of what they call career risk. So just because everyone knows about something doesn't mean they may go and do it, because if you go out and buy concentrated portfolios of value stocks, like right now, it's very likely that you have a high probability of getting fired, because these things can bounce all over the place.

You're going to get destroyed by the S&P 500 sometimes, and people think you're an idiot, and you get booted out of the job. So this creates its own what we call career risk premium. So to the extent that a lot of people are quote, unquote, "doing these things," but these strategies earn premiums for a reason, i.e., they're risky, and they stink to do, one would expect that over the long haul, they're probably going to earn some premium.

I don't know what that will be. Historically, like a concentrated value portfolio, like what we're doing, maybe 3% to 4% over a generic index, which is going to be being sourced from being smaller, being cheaper, for the most part. Let's say that cuts in half to 2%, because at the margin, it gets more efficient.

So you may earn this 2% premium, but this is not like an arbitrage. This means you're going to deal with probably more risk, probably more vol, probably-- well, definitely way more pain in English in a relative sense to common benchmarks. So you're probably going to earn this return. But then the question is, well, how much does it cost me to access this 2% premium?

Well, if it costs me 200 bps, that's probably a bad idea. If it costs me zero, that'd be a great idea. And then there's somewhere in between. So what we do is, on our stuff, for the domestics, we charge 49 basis points, so just under 50 bps, which is obviously way more expensive than zero.

I wouldn't call it outrageous, but the idea is the bet on our stuff would be, hey, over the next 20 years, do I believe that the excess return associated with the factor exposures that I'm getting here are in excess of 49 basis points? If not, then why would I do this?

If so, OK, I might want to do this. But then the second question would be, well, can someone else deliver it even cheaper? Because maybe Vanguard's got some concentrated value factor fund for 30 bps, right? And the process is very similar, and I like it. Well, OK, I think I project it's worth 1% over the long haul, or 2%.

It only cost me 30 bps. Here, I'll go do that one, right? So it comes down to the trade-off between, what do you expect this premium to pay off over the long haul? What do I got to pay for it? And obviously, you want to pay less and earn more as best you can, which is what I argue a lot of these people that do factor investing are doing today.

They're not buying and holding our fund for 20 years. They're day trading the iShares factor funds. That's not arbitraging factor premiums. That's, in the end, probably contributing to make them even higher in the future. But that's a different debate. Speed-dating factor funds rather than marrying one. Yeah, yeah, exactly.

The only way you can pull premium out of the market is you need to have massive amounts of permanent capital sticking in something, because it's kind of taking supply off the market. But if all you've got is more day traders throwing money around, sloshing around in factors, that's not arbitraging away the factor.

That's just money sloshing around, and it's adding volatility to the factor. But unless that money is like all mini Warren Buffetts holding for 20 years through thick and thin, it's not going to depress the risk premium associated with them, or it would be very unlikely to do so. And I frankly don't see that sort of mentality amongst factor investors in the marketplace.

Nor do I see that as an incentive for product manufacturers, because they're in the business of activity. So the more I can get you to like day trade them, do this, that, and the other thing, that's good for the business out there. So I think people have an incentive to promote activity in factors.

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

But-- Well, yeah, I would say it's just like on BogoHeads. You can go review the start here. Here's how it's done. And yeah, you can read it, and there's the cookbook. But at the right price, sometimes people will still be like, you know what? Thanks, I really appreciate the transparency.

I understand what you're going to do, but I have better uses for my time. I'd rather pay you to do this for me. But there are people that definitely are DIY, but there's certainly a lot of people, like my grandma, for example, where she's probably not well-suited to DIY, even if she read the book and thought it was cool because her grandson wrote it.

It's a bit of a misnomer on the title. We're coming up on the end of our time. I'd just like to switch gears here for one last second. Could you talk about your March for the Fallen and what that's all about? Yeah, so March for the Fallen is a 28-mile march held at the Pennsylvania National Guard training unit.

And the idea here is you're out there representing on behalf of those who lost loved ones in the military. So we're supporting Gold Star families and people who have lost people in war. And it's not a charity in the sense that you give money. It's a charity in the sense that people that have lost their loved ones like to know that other people are remembering and honoring the fallen.

So that's what you do. You're out there in your charities counting your blood, sweat, and tears to represent and let them know that we still appreciate sacrifices they gave as a family. And so you go out there and hang out. And it's a great cause. And you meet a lot of great people.

And I really enjoy promoting it and trying to encourage as many folks as possible to come out. And if somebody was interested in joining your group, you've got a pretty large group that you've put together. Yep, so you've got-- so last year we had around 150. This year, I imagine, we'll have probably 200 plus.

All you've got to do if you want to be on notifications, obviously, is reach out direct. Or just if you go to alpharchitect.com/mftf, there's a whole website about training plans, nutrition, how to sign up, and all these sort of other things. And all you've got to do is just show up.

We take care of lodging and chow. And I think it's like $35 you've got to pay to the National Guard. So it's very low cost, super efficient, great cause. You meet a bunch of great people. And I think everyone should at least do it one time in their life.

Thank you, Wes. It's been a great conversation. I really appreciate you joining us here on Bogleheads on Investing. You got it. It's been an honor. And keep doing what you guys do over at Bogleheads. I love the education and love the effort for DIY investors out there. This concludes the ninth episode of Bogleheads on Investing.

I'm your host, Rick Ferry. Join us each month to hear a new special guest. In the meantime, visit Bogleheads.org and the Bogleheads wiki. Participate in the forum and help others find the forum. Thanks for listening. (upbeat music)