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.
ETF.com: Let's talk about the ValueShares U.S. Quantitative Value ETF (QVAL | C-58). Would you say that the ETF is meant for the long-term investor who believes markets are inefficient?
Gray: Yes. The base requirement is that you have to believe in the value anomaly. You have to believe it is driven by some element of market inefficiency, which is a combination of bad market behavior on behalf of participants, and also an inability for a large pool of capital to exploit it. If you believe in that, if you believe in value investing, we think that that vehicle is great for a longtime horizon investor. You need time to be successful.
If you're day-trading the ETF, you're going to get killed on taxes and fees. Also, you’re almost inevitably going to buy it when it's doing well, and you're going to be getting out at the wrong time. It’s a buy-and-hold, Warren Buffett-style, long-term, compound, tax-deferred, don't-worry-about-the short-term-vol-relative-to-an-index ETF, and you would buy it if you believe in the value anomaly.
ETF.com: How does QVAL compare with a passive competitor such as the iShares Core U.S. Value ETF (IUSV | A-93)? IUSV has almost $1 billion in assets and costs 9 basis points, when QVAL costs 79 basis points. Is the active management worth the cost difference?
Gray: Our answer to that is, it depends on what you believe as far as what is actually active and what it isn't. When you look at pretty much all iShares products, they're built for capacity and scale, and they're essentially closet indexing products. That's great, but what you're really buying when you engineer out the exposures is 95 percent S&P exposure, and then maybe 5 percent of actual value investing anomaly.
What we tell people is that these closet-indexing strategies are not capturing the actual value anomaly, which is the spread that has historically been identified of around 5-6 percent between expensive stocks and cheap stocks. If you look at what exposure you're buying through iShares or Vanguard, or any of these ETFs, you're not exploiting the anomaly. You're essentially going to track the S&P 500 with a little noise.
That’s fine, because it's tax efficient; it's cheap. And I love passive investing more than anyone—I think it's a great thing, on average. However, for people who want to bet on actual active value exposure, you need to either do it via a concentrated mutual fund, which is going to be twice as expensive and tax inefficient, or you have to move into the private space and deal with hedge fund guys.
So yes, we do think it's worth it. But it really boils down to whether or not you believe in active investing.
ETF.com: How do you discern between value opportunities that have moved beyond fundamentals, and value traps?
Gray: There're five steps to that process. First, you have to identify a liquid universe you can actually trade. Then you have to do a lot of forensic accounting analysis. The idea is that when you're value-investing, you don't want to just buy cheap stocks, because cheap stocks can get a lot cheaper. You want to somehow screen-out with some reliability firms that could be permanent loss of capital—i.e., they're going bankrupt, or it's a fraud.
Once we're within cheap stocks, we focus on a whole suite of quality metrics. But in the end, all we're looking for is evidence—at least historically—for economic moat. We’re looking for the ability a firm has to generate returns on capital, and return on assets that are in excess of what we think they're discounted. We’re looking for “fair market rate” of capital return.
As long as you're systematically going after cheap, high-quality firms where we've tried our best to forensically eliminate those that are likely falling knives, we think we can eliminate a lot of the value-trap problems.
ETF.com: So today in QVAL, I think about a third of the portfolio's in consumer discretionary, and then a quarter of it is in energy stocks. Are those the sectors you see the most value opportunity in today?
Gray: Yes, that's where it is. And we don't do any sector neutrality. We just go wherever the cheapest, highest-quality stocks are, period. Right now, that is in consumer discretionary, and oil services and oil companies.
ETF.com: On a more personal note, if I may, I'm curious about your stint in the military. You took a four-year sabbatical to become a Marine and go fight in Iraq. How has that experience impacted how you go about investing today?
Gray: A lot of ways, actually. I would say it was pretty profound for a lot of reasons. Over time, I became a huge fan of psychology, and a huge fan of understanding overconfidence.
I joined the service because I decided it was a good thing to do. I was paying my respects to the Man. But the first thing I learned from being in the military was about being humble.
Even though you may have a lot of skill, and a lot of credentials, being humble at the outset solves a lot of problems in the world. Whether it involves going to war or investing—where you've got to be pretty confident to believe that you can beat the market—you better have a lot of humility about how you go about thinking you're smarter than everyone else.
I also learned about the importance of really thinking hard and strategically before you make decisions. I'm a big fan of systematic decision-making. In the military, you’re often having to make decisions when you're getting shot at. If you haven't trained and you haven't thought through how you're going to react in that situation, in the emotional state of affairs, you're going to do stuff that you're probably not supposed to do.
Sometimes your intuition in a stressful situation is the exact wrong intuition, and you need to have a process to make sure you do the right thing. In investing, when you see oil prices collapse and stocks get super cheap, you are inclined to say sell, sell, sell.
In the military context or in an investing context, where there's a lot of stress and emotions involved, systematic processes eliminate a lot problems.
Finally, I’d say that in the military, you hear a lot of stories. We’ve all seen a lot of movies. But they often don't rely on actual evidence. Over time, you realize they are great stories, but we want to make decisions based on evidence and on what actually works.
That’s very important in a military context, where you could die if you just made decisions based on great stories. I think the equivalent of dying in financial markets is losing money, or paying some idiot to do something that they sold you on because it's a great story, but there's no actual evidence that it works.