Wesley Gray: Perspectives on Market Efficiency, Investor Behavior, and ETFs

Our guest this week is Wes Gray. Wes is the CEO, chief investment officer, and founder of Alpha Architect, a Registered Investment Advisor that offers ETFs and works with other RIAs to launch their own ETFs. An accomplished researcher and writer, Wes has authored numerous books on investing and financial topics, including Quantitative Value and Quantitative Momentum. Before founding Alpha Architect, Wes worked in academia and consulted for a family office. Wes’ path into finance began at the University of Chicago, where he earned his MBA and Ph.D. and studied under Nobel Prize winner Eugene Fama. Prior to that, Wes served as a captain in the United States Marine Corps. In addition to his MBA and Ph.D., Wes also earned a bachelor’s degree in economics from The Wharton School.

Background

Bio

Twitter handle: @alphaarchitect

Alpha Architect

Quantitative Momentum: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System, by Wesley Gray, Ph.D., and Jack Vogel, Ph.D.

Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, by Wesley Gray, Ph.D., and Tobias Carlisle, LLB

Active Investing

“Even God Would Get Fired as an Active Investor,” by Wesley Gray, alphaarchitect.com, Feb. 2, 2016.

“Has the Stock Market Systematically Changed?” by Wesley Gray, alphaarchitect.com, Sept. 20, 2022.

“The Cross Section of Stock Returns Pre-CRSP Data: Value and Momentum Are Confirmed as Robust Anomalies,” by Elisabetta Basilico, Ph.D., CFA, alphaarchitect.com, Nov. 7, 2022.

Stock Market/Trend-Following

“How I Invest My Own Money: Robust to Chaos,” by Wesley Gray, alphaarchitect.com, June 24, 2022.

“Trend Following: The Epitome of No Pain, No Gain,” by Wesley Gray, alphaarchitect.com, June 26, 2019.

“Trend-Following: A Deep Dive Into a Unique Risk Premium,” by Wesley Gray, alphaarchitect.com, Oct. 18, 2017.

“Does Emerging Markets Investing Make Sense?” by Wesley Gray, alphaarchitect.com, June 17, 2022.

Value Investing

“Value Investing Live Recap: Wesley Gray,” by Graham Griffin, gurufocus.com, Aug. 25, 2021.

“Value Investing: Headwinds, Tailwinds, and Variables,” by Ryan Kirlin, alphaarchitect.com, May 20, 2022.

“Value Investing: What History Says About Five-Year Periods After Valuation Peaks,” by Jack Vogel, Ph.D., alphaarchitect.com, Dec. 21, 2021.

Behavioral Investing

“Terry Odean: Who’s on the Other Side of the Trade?” The Long View podcast, Morningstar.com, May 14, 2022.

“Behavioral Finance Warning: Humans Love Complexity,” by Wesley Gray, alphaarchitect.com, Aug. 3, 2021.

“Individual Investor Behavior: What Does the Research Say?” by Wesley Gray, alphaarchitect.com, July 22, 2022.

“Momentum Investing, Like Value Investing, Is Simple, but Not Easy,” by Wesley Gray, alphaarchitect.com, Sept. 18, 2018.

Bonds and ETF Investing

“Treasury Bonds: Buy and Hold, or Trend Follow?” by Wesley Gray, alphaarchitect.com, Aug. 10, 2022.

“Why Advisors (and Family Offices) Should Consider Creating Their Own ETFs,” by Pat Cleary, alphaarchitect.com, Nov. 4, 2022.

“ETF Tax Efficiency Isn’t Always Efficient,” by Sean Hegarty, alpharchitect.com, Feb. 25, 2022.

Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning at Morningstar.

Ptak: Our guest this week is Wes Gray. Wes is the CEO, chief investment officer, and founder of Alpha Architect, a Registered Investment Advisor that offers ETFs and works with other RIAs to launch their own ETFs. An accomplished researcher and writer, Wes has authored numerous books on investing and financial topics, including Quantitative Value and Quantitative Momentum. Before founding Alpha Architect, Wes worked in academia and consulted for a family office. Wes’ path into finance began at the University of Chicago, where he earned his MBA and Ph.D. and studied under Nobel Prize winner Gene Fama. Prior to that, Wes served as a captain in the United States Marine Corps. In addition to his MBA and Ph.D., Wes also earned a bachelor’s degree in economics from The Wharton School.

Wes, welcome to The Long View.

Wes Gray: Thanks for having me. Appreciate it.

Ptak: It’s our pleasure. Thank you so much for joining us. I wanted to start out with a piece that you wrote. It’s ostensibly about active investing. You wrote it in 2016. It was very popular. It was called “Even God Would Get Fired as an Active Investor.” Can you talk about that study and what you found?

Gray: It was a serendipitous thing why we started this study. The idea was we’re going to go basically figure out what is the way where we can look ahead. We know the database, so we know who won after the fact. And we’re going to create a portfolio that cheats, where today I know in the next five years the winners. I’m actually going to create a factor where I just buy the 10% winners every five years, but ahead of time. And the original intent of that piece is we were going to try to reverse engineer and identify what are the factors or what are the contributions to why these names do so well. And turns out there’s no pattern. There’s no factor analysis or anything interesting there. But what was really interesting, and the obvious result, is that if you do a portfolio that cheats because you have the future machine, obviously, it does very well. The stock market gains 10% a year. This God portfolio earns 30% per year, so 3 times the compounded annual returns. But what was just a serendipitous finding is we were looking at the drawdown profile, the relative performance, we did a bunch of long-short analysis, and even this perfect long-term investing portfolio has plenty of opportunities where if you were actually God and you had perfect foresight, you’re going to look like an idiot many times throughout the market cycle. So, we thought that was a very interesting finding, because one would expect that if you had perfect stock-picking ability, everyone would want to hire you every single year, but that’s actually not the case at all. There’s lots of opportunities to get egg on your face.

Benz: You wrote another piece earlier this fall addressing the question of whether the stock market has fundamentally changed and is much more volatile now than before. What did you find?

Gray: This is another thing where, probably like you guys, we get questions from investors all the time. They always have their new theories about how the world works, and they always suggest that the stock market seems way more volatile than normal. And then, there’s a bunch of narratives about why that might be the case. And obviously, a lot of the narratives are pretty compelling. But luckily, we can go back and actually do research and assess, how’s the market fundamentally change?

So, what we end up doing is, is you can actually get daily stock return data for the U.S. market; obviously, the S&P didn’t exist back in 1800s. But a variety of researchers have done this, the painstaking work of actually creating these returns. And so, we spliced together a database—I think we went back to 1885. I think you could go back even further. And we just literally looked at the time series history of daily market returns from the beginning of when we got data all the way up to today. And then, we did a bunch of first-half samples, second-half samples to just try to empirically address this question of is the market crazier in the sense that it’s more volatile than it used to be. And the answer is no. And the most simple test we did is, is what is the distribution of daily returns on the first half of the sample, and then, we mapped the distribution of returns on the second half of the sample. And literally, they looked like an overlay chart. You have to really try hard to visually see any differences in the returns. Even though you can go quant, and we did that, I like to just look at the picture because a lot of times a picture will tell a thousand words. And it doesn’t seem like the market is that much different than it has been historically. It’s just always crazy essentially.

Ptak: Wanted to ask you another question. It doesn’t necessarily relate to the stock market, but it’s somewhat timely given what we’re seeing happen in the crypto market. And the question is, what you think is the best model or a framework for attempting to estimate the value of an asset that generates no cash flows. Or maybe in the case of hyper-growth stocks where the cash flows are too distant to be modeled with any accuracy. How do you think someone should approach something like that?

Gray: In general, I’d give them the Warren Buffett advice and stay away. So, anything that’s just very speculative and doesn’t have cash flows, it’s hyped up. Those are usually bad ideas after the fact. And obviously, a lot of the crypto people are learning that the hard way right now. That said, all those assets, I would obviously not apply a valuation or a fundamental framework, because how the heck are you supposed to value something that doesn’t even have free cash flow or at least that free cash flow is so far in the future, it’s hard to estimate. So, these assets, they’re traded assets, and I would say sentiment momentum, because that’s like the human reaction that’s going on in those markets. So, if I were to invest in, say, crypto, if someone were to say, “Wes, would you ever be a buy-and-hold crypto investor?” I would say “No way, you’re insane.” But I would be a trend-follower. I don’t ever invest in crypto because there’s too much compliance and I just don’t want to deal with it. But to the extent that I were, I’d run trend-following models or sentiment-based models on those, but I definitely won’t be a buy-and-hold or be running the DCF on those sorts of things just because it’s not plausible.

Ptak: Must as a follow-up, we’re going to talk a bit more about trend-following in a moment. But applying trend-following to something like crypto, or I suppose it could be something like precious metals, it doesn’t throw off any kind of cash flows—the question would be, what is the theoretical basis for trend-following, working on an asset like that? And then, maybe to widen out, why does trend-following work even with respect to other types of assets that do generate cash flow?

Gray: We could have a long discussion on that, but I’ll step back. So, the first thing is on trend-following, and you guys are probably aware, but we’ve done… I used to not be a trend-follower. I’ve obviously come out of the Chicago school. Eugene Fama was one of my advisors. So, I was highly brainwashed into just thinking that anything like that is heresy. Like the idea that you could use momentum or trend to help you is just insane. And before that, even I was a Warren Buffett aficionado. Same thing, like, this is total black magic. This changed for me about 12, 13 years ago when we got seated by this huge family office and they’d been investors for a good 30, 40 years, and he started talking about this whole trend-following thing. And of course, my initial reaction, which is more religious-based, not evidence-based, is you guys are insane. This is crazy. Haven’t you ever read the academic journal?

So, just to give you a backdrop, I wasn’t a natural trend-follower. It came to me over time and through a lot of data work and a lot of looking in the mirror, thinking about why the heck does this work? And so, what I’ve come to is, there’s really two things to be aware of the trend-following. The first thing is that trend-following, like pretty much all investment strategies that actually work over the long haul and that I would expect to work out a sample, is they create massive and incredible career risk. What does that mean? That means that if you were to do these strategies and you’re heavily benchmarked or you have institutional mandate, it’s basically career suicide. We already know after the fact that if you engage in a trend strategy like a simple, buy the S&P above 200 moving-day average, go flat otherwise. Well, you’re going to look like an idiot for the last 10 years, save the last year, because most of the time you’re going to be underperforming the buy-and-hold benchmark. And you can only do that for so long before people just give up. And so, that’s just not an S&P. That’s literally in every data sample, every asset class you can imagine.

The pain and anguish if you thought about this, could be compared relative to buy and hold is astronomical. So, that’s one good thing, I guess, in the sense that if you want to believe in the long-term viability of anything, you usually want to look for why does this suck? You’re not trying to always look for why is this going to beat the market every day? Because obviously, if it’s going to beat the market every day, it will probably be gone pretty quickly.

Stepping back, what is the theory of why the heck does trend-following work? And so, I’ll just throw out something that I’ve thought about. And this is going to be a little bit convoluted, but I’ll try to go slow. In general, let’s just take the S&P 500. It’s already a puzzle to academics of why the stock market can plausibly go down 50%, because we already know the history of dividends. And theoretically, the stock market is supposed to be representative of the discounted cash flow of all the future cash flows, and if we have a general sense for dividend growth, dividend dynamics, we can always model what the stock market is supposed to do. And this relates back to Schiller’s original work where he basically highlighted that wait a second, the stock market is way too volatile given what we know about actual free cash flow.

And so, stepping back to trend-following—well, if you look at trend-following, and you look back at the stock market and trying to understand, well, why is it, first off, puzzling that the market can drop 50%? Well, the reason it’s puzzling is, as the stock market is dropping, the expected returns are shooting up, and in general, volatility is pretty stable. Everyone believes that over long-haul volatility is around 15%, 20% a year on the stocks. But if the prices start going down, expected returns start shooting up. So, if they knew the history of the market, well, if the stocks go down maybe because of some shock, they should go down a little bit, but as the expected returns go up, people should be there to buffer it.

Why can they possibly then go down 50%? Well, there’s also this component of what they call risk aversion, where how the market participants trade off risk and return. And historically, and from a rational framework, it’s always thought that risk aversion is static. You’re endowed with some sort of risk aversion. So, you look at a bet today and you give me a risk/return. You look at a bet tomorrow; you give me a risk/return. It’s always going to be constant. Also, it’s assumed that if the regime shifts—so, right now, the stock market is up 20%. Great. You give me a bet. I got a risk/return and I make a decision. Tomorrow, the stock market is down 50%. Great. You give me the risk/return. I make a decision. And it’s assumed that risk aversion is constant. Well, most of us, if we’ve hung around people and if you read the literature on the neurons in our brains, that’s actually exactly not what people do. And again, I’m going to tie this back to trend-following here. You just got to bear with me a little bit.

What do humans actually do? Well, humans have, what they call, dynamic risk aversion, where in normal times, like when the world is seemingly great, there’s no issues, everyone is feeling happy, you have one set of risk/return trade-offs. And in general, people are willing to take some risk for returns. However, if you shock people and they’re in a regime of fear and it’s a new world like oh my God, the world is blowing up—not only does your risk aversion shoot up, people do not want any risk. It goes to zero. So, you could offer someone a guaranteed 100% return, but there’s a nuclear bomb coming toward your house. People just don’t care. They’re like, nope, I’m going to put all my money under a mattress. And this is something that’s been shown in like the labs and everything.

So, stepping back to trend-following and stepping back to dynamics of charts. If you look at any charts, bull markets generally, they climb a wall of worry. Bull markets in most asset classes, it’s like these long-trending, slow-grinding worlds. Bear markets are usually fast and furious. They don’t happen immediately. They’re going to happen over two, three, four months. And the reason behind that, I believe, it goes back to dynamic risk aversion. We’re in generally a bullish scenario where markets are doing pretty well. That psychology is in a situation where people still accept risk and reward trade-offs, all good. But there’s something in monkey brain across the systems where at some point—and this usually happens in a market where you’re under a long-term trend—something breaks and our brains trigger into survival mode, and no amount of expected return is going to solve that. You’re going to just puke out everything. And once you get into that psychology, that’s where you get the dynamics of a bear market, where the reason bear markets don’t fall slow and steadily over time, and they fall off a cliff is because of this dynamic risk aversion, everyone just pukes everything out.

So, again, going back to monkey brain, in normal times, people accept normal risk/return and it climbs this wall of worries, so things grind up high and slow. When things crash, because the brain triggers to safety, everything blows up. Well, to the extent you believe that generally describes risk asset classes, and if you look at all of them over time, outside of a few exceptions, that’s how it is. Well, any sort of trend model that keeps you invested when things are trending and psychology is good, you’re going to be participating. However, when things get really bad, like when they’re in regimes of below some sort of long-term trend, that’s where the risk of this, let’s just puke everything up, is high, and that’s also the risk of big bear markets. And so, naturally, a long-term trend rule will avoid that just mathematically, and you get to capture most of the upside of the equity risk premium in any sort of risk asset class, but you’re protected from some of the details in that regime of, oh my God, we might die. So, again, it’s not perfect, and it loses 80% of the time; but again, that 20% of the time that it helps, that obviously saves your bacon. That’s a long story, and it’s actually much more common with that, but that’s the general idea theory of why I believe that long-term trend-following has worked historically and will probably work for as long as humans are involved in the stock market.

Benz: Sticking with that, your trend-following model recently recommended full exposure to commodities and nothing else. And a lot of advisors might be squeamish about allocating assets that way as it could get them fired if it goes wrong, and you referenced that career risk earlier. So, why does your firm recommend such a position?

Gray: Stepping back to our firm, our firm’s mission is to empower investors to education in order to make sustainable investors. And we have four core beliefs: transparency, evidence-based, systematic, and win-win. So, everything we do—and again, this starts with my history where I was never actually in the business. I was PhD, and I just wanted to make products for my own money that just made sense. And so, we were never exposed to this whole career risk, worried about what the other people are doing. Our firm was always founded on just, we’re going to do what the evidence says, what we’d want to put on our own money, and we just don’t care what other people think. And that’s just the foundation of our firm.

So, we’ve always been like that. Our role has always been to say we’re going to inform you and educate you on the data, on the theory, on the first principles of the how and why of our strategies. And if you want to buy them, great. If you’re an intermediary and our stuff is like playing with poison, rat poison effectively, well, you probably want to not do 100% Alpha Architect products, and you probably want to size these inappropriate ways such that you might get some benefits tied to these, but you’re not going to die. And so, when we work with intermediaries, unlike with our own personal capital, where I’m obviously all in on trend-following and all the things we do, that’s just not appropriate for someone who’s in that intermediary seat, and we’re just going to recommend that they size that and use our products in a way that keeps them from their clients’ wrath of getting fired. But if they size it correctly and they inform people about how it works, they might be able to get some benefits by minimizing the career risk aspect.

Ptak: And one thing I would jump in to point out, I think you’ve been pretty clear in the past saying that if you don’t think you have what it takes to court that kind of career risk or for your personal portfolio to stick with this strategy, go with buy and hold, right?

Gray: Yeah. Trend-following is not a panacea. And because we’re all about transparency and education, our blog posts that we put out there, they don’t say trend-following is the best thing in the world, here’s all the reasons why you do it. The vast majority of what we put out there is like, trend-following is interesting, but here’s why it’s probably the most painful, onerous thing you could possibly do. Because again, we want people to go in with eyes wide open. And one of the things in particular about trend-following—and this is just the stats—is we know it “works” at least historically, and I can tell a lot of reasons why I think it will work out of sample. But we also know historically that usually trend-following, the downside is you get out and then the market goes higher, and you got to get back in. It’s called a whipsaw. Well, we already know that that happens 80% of the time depending on what the range is. But let’s say around 80% of the time. So, 80% of the time you look like an idiot. Who wants to do any strategy where 80% of the time you look like an idiot. That’s just crazy.

And so, it’s not recommended. There’s also you could get a tax hit if you don’t manage that. Where buy and hold for most people, if they’re not willing to invest the time to really understand the upside and the downside of things, buying a Vanguard product, where at least you don’t screw it up and keep your costs down, your tax down, that’s a pretty good solution for most people, and these more advanced strategies necessarily, they’re not a free lunch. You just got to make sure you understand what you’re getting into before you buy them.

Ptak: I wanted to go back to the relationship between risk and return. I think that you pointed out that much is maybe someone might be tempted to think of it as a linear relationship. It can be anything but in certain instances. Sort of in that vein, I think your firm did research looking into whether it’s worth it to allocate to emerging-markets stocks in a diversified portfolio, or on the other hand, whether investors can live without it. What did you all find and what do you think the implications are for somebody that’s thinking about including EM in a diversified portfolio?

Gray: Some of our basic philosophical principles are keeping costs down, keeping taxes down, and keeping things simple. So, all else equal, if I have something that’s low fee, low tax, and simple, even if something has a “benefit,” the bar for that has to be really high because we have this Occam’s razor of these core principles. And nothing we do is black and white. I will never say, EM, you should never do. But in general, if you look at EM over as long as possible, it looks a lot like a lottery stock or like growth investing where the expected return is very similar to domestic or more developed markets, but you get a lot more volatility and it’s unclear to me do you get huge diversification benefits at the margin in a portfolio that already has global equities, stocks, bonds, commodities, and what have you. So, to me, emerging markets just adds a lot of tax risk, frictional cost for a limited benefit.

That said, the other problem with EM is property rights. A lot of emerging markets, they just don’t have any foundation for property rights. And so, you always have this tail risk where EM might be great, maybe has a little bit of excess return. Yes, it’s higher taxes; yes, it’s higher frictional cost. But I could wake up tomorrow and it could be gone. And so, I’m not going to mention it, because I don’t want to talk or book. But there’s products out there where I think, in emerging markets specifically, they try to focus on, let’s do EM, but let’s at least try to keep the cost down, keep the taxes good, and make sure that there’s property rights, or at least they’re moving in the right direction. Because the worst thing you could do is like an FTX situation, where, this looks kind of interesting, crypto is diversifying my portfolio, but oh my God, I could wake up and I have negative 100%. And that’s just something that I think EM, if you’re going to go down that path, which I think could be reasonable for some folks, you just want to make sure you manage that tail risk of lack of property rights, and then maybe I could be persuaded. But for me personally, I don’t do any of it. I focus developed, U.S. That’s all I do. That’s good enough for me. But again, just because it’s good enough for me, it doesn’t mean that I couldn’t be sold that it’s a good idea under certain circumstances.

Benz: We want to switch over to discuss some of the factors, and that’s where a lot of your research has centered. Starting with the value factor, value stocks were in a huge slump until recently. Why did that slump happen and what might it portend for those who are considering allocating to value after its recent strong run, or its relatively strong run, I should say?

Gray: As you guys are aware, there’s thousands of research papers talking about why value exists in the first place, or the value premium, which is just simply buying cheap stocks over the long haul tends to outperform the market and expensive stocks. And two theories boil down to, this cheapness proxies for higher risk, and in general, higher risk should lead to higher return. And I’m a partial buyer of that. But there’s also this idea of just bad behavior. People throw the baby out with the bathwater. So, if you’re buying these cheap companies that no one likes, well, they probably have terrible stories, they’ve probably got terrible short-term narratives in performance. And what happens is, the market throws the baby out with the bathwater, and eventually, there’s a sentiment shift somewhere, someway along the way where they’re like, wait a second, these stocks shouldn’t be 5 P/E, they should be 10 P/E. And when you get that expectation shift due to this behavioral mispricing, that’s where value a lot of times goes on its big runs. And so, that’s just the theoretical foundations for why does value exist in the first place—mispricing due to sentiment issues and then arguably, some element of risk. We’re not going to talk about risk because it just is what it is. If things are riskier, they should get higher expected returns if you believe in the efficient-market hypothesis at all.

I personally believe that this recent issue we’ve had with value stocks, and now, we’re obviously seeing this thing turn is it was just the classic sentiment problem. Winding back the tape about a year, year-and-a-half from now, obviously people always have a hard time remembering this. But if you could wind the tape back a year, year-and-half from now, everyone said value is dead, why would you want to own energy, why would you want to own any of this stuff? These are fuddy-duddy, loser companies. It was literally a broken record from the exact same stories I used to hear back in ‘99—internet has taken over everything, tech is everything, and so on. And what happens is, even if value companies, which at that time and as we’re seeing right now, are coming out with better and expected earnings, better fundamentals, you’d expect a shift in valuation—you didn’t. The way it would happen is, Zillow would come out with worse earnings, worse revenue, and it would just go up higher. And I can’t explain that except with sentiment. And I don’t know when or how sentiment shifts occur. I think that’s an interesting question. But now that all of a sudden sentiment has shifted and everyone is like, wait a second, actually, let’s do focus on cash flow, let’s do focus on fundamentals, let’s focus on gravity—it matters. Now, all of a sudden, people are like, oh, these value stocks are actually making money. They’re real businesses. They actually send out dividends. We should probably boost their valuations a little bit and let’s go bomb out all these “Ponzi schemes” we’re buying where they say that we’re going to have revenue, they say we’re going to have earnings 30 years from now. But really, what they do is they just lose money all the time. And I think you’ve seen that shift. And that’s why I think you’ve seen this break where all of a sudden growth is down 70%, 80% and how value is starting to move in the right direction. So, I think it’s nothing new under the sun. If you have horizon, you know this research, it’s just welcome to the value trade. It’s finally, the sentiment is here and now you’re starting to get the relative outperformance.

Ptak: Do you think value stocks are still cheap enough compared with other types of stocks to confer access returns? I think that you all have done research in this area, AQR as well. What does it look like?

Gray: Yes. It’s counterintuitive to a lot of people that obviously they haven’t studied this their whole lives, they don’t look at the time series on it. Just because something all of a sudden starts working a little bit, it doesn’t mean it’s dead. So, value in particular right now, obviously, it’s had strong relative performance compared with overpriced, no-earning-type companies. So, obviously, the fundamentals are moving even faster and stronger than the prices, you can have relative outperformance, so the value stock was a P/E of 5 and now maybe it’s a P/E of 6, but that earnings has raised so much faster even than the P that you could still have this relativeness where the relative cheapness of value stocks versus growth stocks is still huge. And that’s exactly what we find, where right now, even though value has “crushed” growth, because they’ve fundamentally been doing so much better, so their earnings or however you want to assess their fundamentals versus the growth stocks, it’s been growing faster than the growth, the relative spread or the relative cheapness of value versus the rest of the market is still at nosebleed 90%-plus type ratios. And again, when you say “historically,” you always want to take it with a grain of salt. But anytime you have a spread that’s in the 90-percentile range, which you have right now, so the valuation on cheap loser stocks versus the broad market or the fancy growth stocks is at 90%-plus levels, that’s an edged bet. So, I don’t know if it’s going to happen next year, or next three years, or next five years, or next 10 years. But in general, when you have an edged bet and something is at the extremes of the spread, that’s usually a good long-term place to shift your capital, because they win. Lower price is usually the higher expected returns. But timing is everything. And I’m not going to tell you that now is the time because it could be five years from now where it flips. But it’s definitely elevated in the spread.

Benz: You’ve also spent a lot of time examining the research on the way individual investors behave, drawing on the research that people like Terry Odean and Brad Barber have conducted on the topic. We had Terry Odean on the podcast earlier this year. So, it’s not a pretty picture when we look at investor behavior. But do you think net-net investors are less prone to misbehave now than before? And if so, what are the implications for professional investors?

Gray: I have a counterintuitive thing for you. A lot of people say, wow, there’s all this data access. There’s all this new transparency. Anyone with a computer now can almost effectively equate to have the same data as a Bloomberg at this point. So, all this data, all this transparency, free trading. There’s basically zero frictional costs. How can it possibly be the case that markets aren’t really, really efficient, and how that makes sense? Well, I would suggest to you—and this is not a new idea—this is something Jack Bogle talked about for God’s sake. What you’ve done is you’ve unleashed the opportunity for the worst behavior in mankind’s history. I can now allow people to have a ton of information, so they can get way overconfident in their own ideas. They can trade with basically what looks like zero cost, even though it’s not actually zero cost, because your order flow gets sold to Citadel or what have you. And all this ability to take action for everyday investors, in my opinion, is making the opportunity for behavioral errors probably the largest it’s ever been in the history of the marketplace.

Ironically, I don’t actually think the market is skewed to become more efficient over time. I actually think that behavior is actually making it worse. And then, well, you might say, well, the institutions aren’t dumb. And, actually, the institutional imperative or this need to be how do you perform relative to the benchmark every day, every quarter, every year—I think those incentives have actually only gotten worse. This idea that you can go allocate to someone and say, I actually have a 10-year horizon. I don’t really care what—nothing against Morningstar—but I don’t care what my Morningstar stars say right now. I think that incentive is actually even worse. I think, actually markets, at least from a behavioral lens and an institutional imperative incentive lens, might arguably be set up to be less efficient on a go-forward basis. Again, that’s what I think. I actually see it all going the opposite of what efficient market says, because all the behavior and all the incentives of the marketplace are actually warped to allow people to make terrible decisions at zero cost these days. And I just don’t see human nature changing. That’s the number one thing that’s always going to lock is human stupidity. I’m very bullish on that on a go-forward basis.

Ptak: To follow up on that, if we suppose, as you are, that frictions have gone away or been lessened, and that’s led to misbehavior amongst retail or individual investors, but also, we’ve seen incentives squeeze institutions in ways that are unhealthy for them. So, you’ve got both of those important cohorts misbehaving and perhaps not performing optimally. If we assume the markets as zero sum, who is the offset to that? Is it the market maker?

Gray: Market makers, and the sharp critique in that math I think is a little bit off, because the issue is, everyone eventually has to access the market for liquidity and buy and sell at some price. And the people that do that, you can call him a market maker, but it’s also active market participants. Because passive owners, it’s just flows-based. You click the button, you buy; you click the button, you sell. You’re not looking at fundamentals. You’re not saying, I’m going to sell at this price or buy at this price. So, anytime anyone has to interact with the marketplace, they’re going to be offset with someone who’s an active participant to provide liquidity on that trade. That’s just the reality of it.

All of the excess will go to whoever has got that long-term capital who can buy at the right prices and sell at the right prices, which is effectively active management or liquidity providers. And I guess, through the sharp critique lens you could call him a market maker, but there’s market makers at the micro level and there’s also market makers at the macro level. And a good example of this, which I think is obvious, would be private equity. So, private equity is like a slow-motion train wreck. And if you look at private equity, you say, why did that perform so well? Well, in the old days, you could buy companies in private equity at a 50% discount on enterprise multiple basis to public markets. And, to the extent that everyone is like, whoa, this private equity thing is amazing and I don’t have to mark to market, so I can get rid of my institutional imperative problem and I could mark to fake, and I could tell my clients I’m making all this money, unlike this DCF that doesn’t exist. Why is that awesome? Well, it’s awesome because as I’m going through that cycle, the valuations were 50% of public, and now they’ve moved to parity with public. And so, all of a sudden, I have this massive world of private equity providers who everyone and their mother wants to allocate to, because on the back-test it looks like they have amazing realized returns, which is actually true, but they’re failing to account for the fact that they also have like a 50% valuation boost along the way, which is arguably one time. It’s not like when you bought at total enterprise value of 5 times, now you do 10. It’s not like it’s going to go to 20 where you’re going to get that excess return boost.

So, this is a situation where, who’s providing that? Well, all the capital providers, the CalPERS and anyone who is allocating to this. Even if they do it passively, they’re over here now paying off the croupiers in the form of private equity firms. And who’s the seller there? Well, it’s the private business owners who are probably selling their companies at way higher valuations than they should be. And who’s the loser? Well, it’s the “passive” gobs of capital that just keep clicking the private equity buy button. So, you can see there’s a natural winner and loser in that market. The natural winners are obviously the sellers of private equity, the institutions in the middle; also the private business owners who are probably selling to the public at way too high a price. But then, you also have another dynamic. These capital owners, these massive capital owners, a lot of times they’re passive in nature, they’re also having to do something with their public assets. What are they doing? Well, they’re like, let’s click the button sell VWAP across the board on this capital. Someone is got to be right on liquidity there. I don’t know if it’s Vanguard, I don’t know who it is, but arguably some active investor that’s got to be taking that on. And then, when they sell that, that capital then gets dished over to private equity.

So, you can see at the micro level and then all the way rolling up to the macro level, this idea of passive investment is ludicrous to me. What it is, is there’s this huge fund flows that shift around all the different marketplaces out there, and they’re getting clipped on the croupiers, what Munger calls the middle people, they’re always going to win, like the casino. And then, also, just whoever is on the other side of these trades that has a discipline and capacity to either buy at the dear prices and sell at the high prices, they’re going to be the winners. And passive is obviously going to earn whatever return they’re going to earn. But I’d argue, step back two years ago, if you just thought an S&P 500 investor was passive and you showed me the valuation, well, I’m going to tell you what the expected return is. It’s going to be terrible. Right now, it might be better. But right now, if you look at the “passive” private equity investor, you look at the fees, the taxes, and the current valuations, I can predict—I’m not going to say 100%—but if you were to say, “Wes, 10 years from now, what is the expected return on private equity given valuations and given fees and taxes?” I can tell you with very high certainty it sucks. I can also tell you with very high certainty that if you buy a portfolio of stocks that are selling at 5 times P/E right now, 10 years from now, they’re going to crush the stock market in the form of the S&P 500. That’s just, I feel, is math. It’s the math of valuations paid in the marketplace. That has nothing to do with passive and the Sharpe critique. It just has to do with the fact that everyone is active in the marketplace and even an S&P 500 is basically a mega-cap beta fund that’s slightly overpriced. Well, what is the expected return on that factor versus other things? It sucks. So, I’m not a buyer of the whole Sharpe equilibrium thing, because the reality is you don’t not have to interact with the active marketplace ever. You always have to interact with them.

Ptak: I wanted to ask you, maybe to stick to this theme of behavior. I think you’ve got a pretty interesting take on how to incorporate strategies like value, momentum, trend, all of which we’ve discussed to this point in the conversation. You feel like they ought to be split out, if I understand you, because if they’re combined, maybe it’s harder for investors to look through and understand why the combined strategy is performing as it is. I guess that I’ve tended to think of it in a slightly different way, which is that people, when these things are split out and they see the way they behave in isolation, they might behave even more rationally. But you’ve come to a different conclusion. So, based on your experience and research, how have you come to conclude that they’re better off left split out so people can look through them?

Gray: I wouldn’t say it’s better off. It’s just we have our core beliefs and our mission and how we go about business, and then other people have their ways about going about business, and I could be convinced either way. And I know all the arguments for either side of this. Let me just explain why we do what we do, and I could argue for the other side, too.

So, in general, empirically, in my opinion—let’s just take the very simple thing. We could do pure value. We could do pure momentum. And we could do 50-50. We could also say, no, I’m not going to do that. Let’s go look at value and momentum simultaneously and get the best combo of those. And so, these are two ways you could go about it. And you can argue about, well, one is more efficient, one is less efficient and what have you. Empirically, at least in the context of what we do, which is, concentrated investing. We’re going to hold 50, 100-stock portfolios. They’re all the same. It’s six of one, half dozen of the other. I feel like it’s not even worth arguing about the 50 basis points plus or minus, because as you guys know, that’s nothing in the grand scheme of a back-test. It’s all noise. I think they’re the same, whether you do 50-50, pure value, pure momentum, or you do a mix, you’re going to get the same spot. If you’re running closet index portfolios, where you’re benchmark-hugging, have low tracking error, I think the arguments for actually mixing is better, where you focus on value and movement at the same time.

But for what we do, empirically, I don’t care. They’re the same. Why do I like the pureplay? Well, the reason I like the pureplay is I like education and I like our core belief of transparency. And in my experience, it’s much easier ex ante or before the thing happens, to explain to someone, this is a value program, here’s my exact details of our process. We have no black box; 100% transparency. This is what it does. This is how it works. After the fact, we say, this is what we do, this is how it works, this is what it did. The client can look at that and be like, makes sense. This thing got destroyed. I don’t care, because this is the process. This is what it is, this is what it does, this is the outcome. Same thing on momentum.

The problem when you start mixing things is it’s extraordinarily difficult after the fact to explain to people what happened. Because now we got to have this mix of what percentage of momentum was it, what percentage of value was it? And trying to disentangle the attribution of a totally integrated factor portfolio is very challenging. And I think Cliff Asness, I think he was talking at Morningstar probably five, six years ago in the depths of the hell of factor investing that we’ve all lived through. And so, for me, in our setup, it was much easier where I can say, our value strategy, it sucks. And everyone was like, well, yeah it sucks because it’s a value strategy. All good. Momentum strategy—holy cow, our systematic momentum strategy is like an ARK fund. This is awesome. Well, should I get excited? No. It’s because it does price momentum during a price momentum market. Great. Everyone gets it. But meanwhile, Asness and AQR, they do the hodgepodge factor approach. Their stuff just looked generally bad, and they’re trying to explain that’s because it’s partial momentum, partial value, partial quality, partial low beta. And everyone is just like, Cliff, dude, whatever man, I’m moving on. So, because that’s a lived experience now and we’ve just seen it firsthand, I’m just a huge believer that the only thing that stops people from good investing is being highly informed and educated and have a lot of transparency into what they do ahead of time and after the fact. Otherwise, they’re never going to stick with it. And so, that’s a long-winded way of saying that empirically I don’t think there’s any difference in these methodologies, personally. But behaviorally, I think there’s a lot of differences in the sense that you can attribute the process directly to the outcome—much cleaner when it’s siloed effectively.

Benz: Wanted to get your opinion on bonds, specifically corporate bonds. You’re not a fan of them, especially in taxable accounts. Can you walk us through that?

Gray: Anytime I say I’m not a fan of something, I could be convinced of anything. There’s always costs and benefits. If you showed me a corporate bond with a 50% yield, well, what I’m about to say is kind of out the window. So, I’m just going to talk meta. In general, the problem with corporate bonds is they are, one, tax-inefficient because they have a huge income component, and income comes out as income, where all else equal, I’d like to have capital gains, because especially if it’s in an ETF wrapper, I can defer forever, but even in an ETF, if I get income, I’m screwed. I got to pay the tax bill. So, corporate bonds are just tax-inefficient generally. And I don’t know why people have to always keep relearning this lesson. I think it’s because they use the efficient frontier, where they’re like, corporate bonds are interesting because most of the time, in normal times, they are uncorrelated with equity. And that’s true. Corporate bonds aren’t super correlated with equity in 90% of the states of the world. The problem is that in the one state of the world where equity blows up, corporate bonds turn into equity. So, they’re like merger arb where in good, normal times, they have low beta, they look magnificent in your portfolio optimization thing where you’re like, oh great, I should probably do 10% in corporate bonds. But the problem with all those kinds of systems is the whole point of diversification is not really to be diversified when things are going well; it’s to protect your bacon when the world blows up. And so, why would I want to own an asset that has crappiest returns versus equity in normal times and is tax-inefficient all the time? And then, when the world blows up, it turns into equity. And I’m like, my diversifier didn’t even help me. That is corporate bonds basically in a nutshell. And so, to me, unless you can get the right price, good price, good valuation could solve all problems. I just find as an asset class, corporate bonds to be insane to me. And so, that’s why, in general, I have a negative feeling about them because I feel like there’s not enough juice in them to overcome these overarching hurdles.

Ptak: Wanted to ask you about the business of Alpha Architect and things that your team works on. I think your team recently put out a piece arguing that advisors should create their own ETF, and I think you’ve alluded to the fact that one of the lines of business in which you’re engaged is supporting RIAs and doing that sort of thing, launching ETFs and then basically supporting them on an ongoing basis. Why do you think advisors should consider doing this?

Gray: If you were to ask me about a year or two ago, I would have told them they should never consider this because obviously the big issue with setting up an ETF is the cost. It’s extremely costly. You have to run a registered fund and the compliance is varsity level where you’re running an SEC-registered RIA, there’s a little bit of brain damage there. But it’s not like running a registered 40 Act fund. And so, what we’ve focused on over the past few years is how the heck do we rip the cost out of this ETF wrapper so it’s more accessible to the broader public? Because as you guys are well aware of, it’s a magical investment vehicle. If I can run an investment strategy in an ETF because of the in-kind custom-created redemption, I basically created a huge deferral instrument forever. I run my strategy in an ETF, I never have to kick out capital gains. I own ETF, I die, I get a step up in basis, my kids now own the ETF, they get to continue to defer forever. If you really think about it, the ETF is the ultimate way to invest in most cases. And that’s awesome.

The problem, though, historically is accessing that thing is only for the iShares or the Vanguard of the world or ETF entrepreneurs that go raise capital. But if you really think about the broad investment public, most of the assets are, frankly, controlled by intermediaries in the form of RIAs. RIAs control the assets. They’re doing all these strategies where they’re swapping around different ETFs, or maybe they’re buying some ETFs and they have a siloed strategy that owns individual securities, or maybe they’re doing these tax-loss harvesting programs, what have you. And just imagine if I could go to an advisor and say, I have figured out how to, one, allow you to transfer assets with basis into an ETF tax-free; two, once you’re in that vehicle, you can now manage these assets without tax consequence; and three, you can skinny down your operations a lot, because remember, all that crazy train execution, all the 1,000-page 1099 you have, all of that brain damage is gone. It goes back to Vanguard. You just own a ticker that does everything, and you just allocate to that, and you tell us what to do. Done.

And so, the reason that we—to summarize here—that I think advisors and even high-net-worth family offices, and this what we’re trying to do is, as we lower the costs and lower the barrier to entry to the ETF wrapper, it all of a sudden becomes the tax efficiency and the operational efficiency of the wrapper become accessible to an entire blue ocean of people that wouldn’t have been able to do it. It used to be 300K if you run the things. Then it was 250. Now, we’re getting it down to like 200K range. And if we can keep whittling away, maybe we get even lower than that. And so, as we lower that barrier to entry, this is a tool that should be available to a lot more people. And RIAs, obviously, control a lot of the capital, and we just feel like this could be something that could be high benefit to their clients essentially.

Benz: You’ve served in the Marines, and you’ve come to experience risk and loss in vivid and personal ways that many of us, most of us, have not. As you reflect on that, how do you think it has influenced choices you’ve made in your career and in the way you invest and how you advise others to invest?

Gray: This is kind of sick, but one of the things you do in the service—and I can only speak to the Marine Corps—but you have to become unemotional about everything. Because if you allow, let’s say, your friend gets killed or something, obviously you’re going to be sad. But you can’t let that affect your decision-making, because in the end, you could get other people killed by being an idiot and letting these things seep into your System 1, which, as you guys know, is like a common diverse key reference. System 1 is your monkey behavior and then System 2 is like your rational brain. And so, in the service what you learn is how to operate under stress and high emotional states with pure rationality. Obviously, at some point, you’re going to have to decompress or you’re going to have issues, and there’s a whole edifice in the service to deal with these kind of issues. But when you’re in an operating role, and you’re in the military, obviously you’re leading other people’s kids. So, there’s a high thing there to care about. And in investing, even though it’s not that high a bar, you are worrying about people’s money, and that’s another important thing to a lot of folks.

I think it’s really important that in investing, just like when you’re in the service, that you have to always focus on this from a pure rational standpoint. And either if it’s your own capital, if it’s you’re an intermediary, or you’re an asset manager or something like us, it’s just really important to always have systems in place and in our opinion at least, follow systems to the grave. Because the minute you move from a system or you move from a process, especially if it’s during a time of stress, that’s exactly the time when you say, this time is different, let’s forget these systems we built because they were built in blood and tears; let’s do it our new way. The problem with that is that’s probably because you’re in System 1 mode, and you think that you’re going to do something that’s going to add value. But the reality is, you’re reacting to some sort of deep emotional problem. This can end up screwing things up in the future.

So, that’s a long way of saying that in the service you learn how to control your behavior so you can make rational decisions on behalf of your constituents. And I think that’s a valuable skillset, because that’s also in the context of financial markets—you as a fiduciary, you as someone who is in charge of helping people out—you want to try to minimize your human baggage as much as possible because you’re trying to help other people and you’re taking care of an important asset: their money and their life savings. And so, yeah, I think that core principle of being systematic and rational despite your feelings is a good thing to have in service and obviously, in investment context as well.

Ptak: Well, Wes, we salute your service and the work you continue to do for veteran causes. We could have asked you questions for hours, but we’ve learned a lot in the time we had. Thanks so much for being our guest and sharing your insights with us.

Gray: You got it. Appreciate the time.

Benz: Thank you so much, Wes.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)