Wesley Gray is an interesting man. He is a die-hard active manager who has come to be a huge believer in the ETF structure as a way to manage the tax burden that comes with tracking errors. He is also an avid value investor, looking for the most-beaten-down stocks in a world of proverbial “falling knives.”
The founder and executive manager of Alpha Architect—an asset management firm without about $230 million in assets under management—shared with ETF.com why true active value investing works. He also explained how his time spent in Iraq while in the military affects everything he does in investing today.
ETF.com: You began your career as a stock picker, and you studied under Eugene Fama. Today you not only use ETFs, but you’re behind two of them. How did you come to use ETFs?
Wesley Gray: I grew up during the whole value stock-picking, Ben Graham/Warren Buffett era. I did fundamental value investing for a long time, pretty much since I could trade.
I had been studying a lot on value investing, and when I came out of my Ph.D. in Chicago, I started getting much more familiar with quantitative tools, and then I got into psychology. To me, value investing made sense, but I quickly realized that it had to be done systematically or I would screw it up. Over time, as I was working for high net worth individuals, we started learning about ETFs, mainly for things like tax advantages.
We’re not smart-beta people, we do actual active investing, so we can have significant tracking error in our portfolios due to active management, and that brings massive potential tax problems. The ETF for us offered a solution to minimize a lot of that. That’s a pretty compelling value proposition.
That's why we basically burned through $1 million or so setting up an ETF structure. For our clientele, it made a lot of sense. It's a completely transparent, custodied, tax-efficient way to deliver truly active exposures. It's ideal for our situation.
ETF.com: Is active management necessary for the best value investing outcome?
Gray: When we study the value anomaly, we do everything through the lens of what we call behavioral finance. And there are really two legs associated with this approach: One, you need to identify poor investor psychology; and two, you need to understand why large institutions aren’t exploiting this “alpha opportunity.”
When you look at value, there's a few ways you could run it. You could do it the “smart beta” way, holding 500 stocks and tilting it toward value. There’s very little active management involved.
But if you think about how the value anomaly works, it's driven by what psychologists call “representative bias.” Essentially, people throw the baby out with the bathwater and overreact to crappy fundamentals. We're talking about the extreme values, the cheapest of the cheap.
In our particular case, we only focus on the top decile—the 10 percent cheapest stocks that everyone hates. Why would you ever want to own those? Because those are the stocks most likely to be suffering from this psychology problem that drives these stocks beyond fundamentals.
But there’s a lot of career risk involved in true value investing in the form of tracking error. So what we do is not meant for retail investors who chase performance.
We do true active investing that exploits anomalies in the marketplace, and that’s not a free lunch. It’s meant for clients who really understand that if you're going to have a real opportunity, there's got to be a catch.
And the catch is, you need true long-term time horizon, and you need to be different than, say, a RAFI fundamentally weighted product, or a Vanguard value-tilted product. If you don’t have tracking error relative to the passive index, you’re not exploiting the value anomaly, you're closet-indexing.