Wes Gray runs his boutique investment firm Alpha Architect with the determination you'd expect of a former US Marine. In a competitive industry dominated by big names, his small team of 'quant ninjas' are endeavouring to make themselves unkillable.
They're doing it by bringing factor strategies and quant investing to regular investors. There's no black box or secret sauce, and there's no flashy office. Instead, they're leading on education - with blogs, books and research - to show how factor premiums can deliver long-term outperformance - even though they'll make your life hell at times (at least on a relative performance basis).
Alpha Architect is based at Wes's home on the outskirts of Philadelphia. Standing among the desks and monitors in the kitchen is an eight-foot stuffed grizzly bear. Walk through to the back and it opens into a huge space, with more large stuffed animals - including a leopard. The house was once owned by a game hunter but Gray (typical for a classic value investor) bought it in a distressed sale - and the stuffed animals came for free. Now it's a symbol of his efforts to offer transparent, marketing-free, win-win 'affordable alpha' with strategies that most investors can't stomach on their own or can't find anywhere else.
Wes and his team currently manage just over a billion dollars of client money, roughly half of which is spread across their 5 exchange-traded funds. They include US and international versions of Quantitative Value and Quantitative Momentum plus a crossover Global Value Momentum Trend strategy that was launched in 2017. The ETFs are concentrated and regularly refreshed to keep them as closely aligned to the value and momentum factors they aim to profit from.
I went to visit Wes and his team and spent three hours talking about football, finance and the epic battle they are preparing for in their mission to take more concentrated factor portfolios to the masses...
Wes, tell me about how you got into investing and your journey from being a value stock picker to a quant-driven factor junkie?
Ben Graham was my first intro to investing. I grew up on a ranch in Colorado and I came into a little money early on when I sold my 4-H steer at the county fair. My grandmother was an old-school value stock-picker and she was the only one in the family who even knew what investing was. So when we started asking about finance, my dad was always like: "Go talk to Grandma Ginny."
She literally sent me that damn book; I got Buffettology and I got Intelligent Investor. I thought it was an interesting idea that when you buy stocks you're buying a business. You want to buy it cheap, you want to buy it with a margin of safety and you want to be rational about it. Price shouldn't matter, momentum shouldn't matter; it's all about the fundamentals and figuring out what something's worth and buying it for less than that.
For a lot of people, that's not intuitive for some reason. But for other people, whether it's to do with culture or genes or something, it just clicks.
For me it seemed so obvious, but I was like the typical young value investor: You go from reading the Intelligent Investor, and then you find this Warren Buffett guy, and he's doing what Ben Graham did, so you try to learn some of his lessons. But for some reason the Warren Buffett thing didn't click with me. Ben Graham is all about buying cheap sh**. But Buffett's about: "Hey, cheap is good but focus on quality, it's all about the integration." But for me, Ben Graham's classic net-net strategy is symbolic of what I want to do: buy the cheapest things you can find (often distressed turds).
So I was just a stock picker trying to be a hero, and I was doing that right around the internet bubble. In 1998, we were going into the teeth of all this chaos and I just got lucky; I didn't get caught in the tech stuff. I was so in tune with value that I was focused on the cheap stuff that everyone hates.
At the time, I was a Wharton undergrad and we'd have all these speakers come in. They were like: "Well, if you actually figure out the present value of all the internet stocks, and you map out how many sales they have to achieve to justify those valuations, it's more than 100 percent. So, clearly this is a f***ing bubble."
Obviously, the Internet bubble blew up a few years later and I missed it completely, and then after that we had the small cap value rebound. Anyone with half a brain who bought any stock that was small and cheap was a "genius" and if you didn't make 50 percent-plus returns, you were probably an idiot.
A lot of people made careers in hedge funds post the bubble - so-called 'geniuses' - because they just happened to be value investors, which tend to be small value guys. But it wasn't because they were smart, it's because they were in the most epic bull ever in those factors. I happened to be in that crowd too. I rode it all the way towards the end before I started getting my ass handed to me towards the '08 crisis.
Another good luck event was being in a PhD program and getting exposed to quantitative, systematic strategies. I eventually realised: "Oh, I can just go buy all small value names, and I get the same return I did when I was beating my head against a wall. This seems like a smarter way of going about it."
So I had all these different events happen. Having done the stock picking thing, it's insane and you get emotionally involved. I just naturally gravitated towards the quant stuff, doing stock picking ideas, systematically. That's what started Quant Value, which is really a system of what was in my stock-picking head. Then eventually we branched into momentum, and ideas that were "off-religion" at the time. Everyone has their religion in investing, and then you've got to move off that somehow and expand your mind… but it's hard - especially for hardcore value investors!
You've done the in depth research, studied and tested all the data and read every academic paper on what works in the stock market over time. That's put you in a group of investors who pretty much agree on which factors drive returns, right?
I think if you set out to find the intellectual truth and to really understand what works and why - which is the culture of academic and quant research - in the end, we all agree on the same stuff. So in a way it's boring. You talk to Cliff Asness and he says, "value and momentum". You talk to James O'Shaughnessy and he says, "value and momentum". You talk to anyone who's been doing this for too damn long, and unless they've got a bias, that's what they say.
Value and momentum are the big kahunas of factor investing, and they have always been. But now we have the issue of the factor zoo, which is perfectly correlated with computing power. I can go get a machine and look at a million strategies in five minutes, and I can tell you which one is going to backtest the best. But unless you understand: "Do we do out-of-sample? Do we try different countries? Do we try to understand the economics of how or why this works in the first place?" it quickly gets boiled down to what we call the "open secrets" such as value and momentum.
Then we're just arguing about our algorithm versus O'Shaughnessy's algorithm versus Joe Blow's algorithm. The reality is that they're all probably going to be around the same in the end. Someone gets lucky, someone gets unlucky, but ex-ante, the distribution of value and momentum portfolios is probably about the same.
The other big fight here is about how concentrated you are in your portfolio. Some factor people are like: "Oh you want to run a thousand stocks, and just slightly tilt away to get a little bit of value and a little bit of momentum." So you never deviate too far from the index, but you may have a good shot at beating it in some designated time. Whereas we're like: "F*** that, we just want to make money. I don't want to be beholden to benchmark hugging because I may make suboptimal decisions. But if I want to just compound wealth, the best odds over the long haul - and the data is pretty clear on this - is if the factor works then it's going to work when it's more concentrated. It makes sense that the pure version of it should work even better. But the downside of it is you're going to get more whipping around the index. O'Shaughnessy and our firm are in total agreement on that, but most people in the industry are not like that.
In your research of the value and momentum premiums, what did you conclude about why those factors are so powerful and predictable?
With any of these really good premiums, they are going to be a proxy for risk at some level. So you've got to ask questions like: "Why is the other guy at the table giving me extra returns?" That's the equilibrium way of thinking about factors or quant or any investing. In the end, if I'm going to make extra money, I've got to understand one of two things: Am I eating more risk? Probably, because the market is pretty damn efficient. And, if I'm exploiting mispricing, because I think I know more than the other guy, I'd better damn well understand why the other smart guys haven't already done it.
You've got to have a reason why other smart people - the hedge fund and high-frequency guys - aren't already doing this. Because if I've accounted for extra risk and I see mispricing, I'm thinking this is free money. But both of those are fake. They're gone or they're fleeing. Structural excess return is going to come from real risk - i.e., because it has risk to it - and if there's mispricing that sucks to exploit, like value. Just because you know value works, that doesn't mean prop shops do value investing, because it could take you five years and you could burn out before you win.
So why does value work? Well, typically, if you buy cheap sh** it's because it's got extra risk. Right now, you buy things that are in Amazon's (NASDAQ:AMZN) path. There's a real risk, even with the margin of safety, that things will blow up, because you're buying f***ing Best Buy (NYSE:BBY), and Amazon is probably going to eat their lunch. But at a certain price, even that could still be good value, but there's risk.
The second part is the value premium associated with what I call "throw the baby out with the bathwater." Obviously value investing is risky, obviously it sucks, obviously it's not the best business in the world. But, if it's priced so low, it could still be a good investment. So the investing public threw the baby out with the bathwater. Obviously it's bad, but they're pricing it too bad, and that's the mispricing component.
So you know there is extra risk and you know there is this mispricing component that Graham talks about. You know it's hard to exploit, because it's not just like buying cheap stocks is an easy life. You know there's a reason that the mispricing is there, and there's a reason that mispricing is not being exploited by every hedge fund guy that charges two and twenty, because it sucks to hold stocks that don't track the market and are harder to hedge.
So value makes a ton of sense; but then we think about momentum. With momentum, the risk-based explanation is a bit harder to understand, because frankly it doesn't exist in spades like it does in value.
In momentum, it's a little bit harder to identify true, systematic macro risk that's associated with that premium. You can do it a little bit, because it has skewness to it. With momentum names in general, when sh** hits the fan they really hit the fan. They've got a high beta component to them, so arguably there is some risk element there. But the big one with momentum is obviously the behavioural component.
There's tons of mispricing there arguably, but it's also mispricing that's really, really hard to exploit. To do momentum right requires high-frequency turnover, and a ton of trading, so you've got to make sure you can do that in a way that's not going to destroy you. And when you look at real momentum strategies done the way that gives you those historical premiums, those portfolios are f***ing hair-raising. They've got like 25 percent volatility, they don't hug the index at all, they're totally insane. They're basically just a great way to say, 'I'm fired'.
It's like what Greenblatt always talked about: the career risk component. He talked about it in the context of value, but in momentum, it's arguably three times worse.
So in all these things, the question is where's the risk and where's the mispricing that's hard to exploit? In value, you can argue it's more even-keeled; there is a lot of risk and a lot of mispricing that's hard to exploit. In momentum, there is a little fundamental risk, but tons of this idiosyncratic behavioural risk that's just hard to exploit. It will still be there forever, because it's really hard to hold momentum portfolios frankly. And again, it's not like prop traders and two-and-twenty guys are going to fall out of their chairs to do momentum strategies.
So in my mind, momentum falls into the same framework of risk and hard-to-exploit mispricing. With pretty much every strategy we do, if I can fit it to that framework, and know why I'm earning some premium or some benefit, it makes sense because I'm doing stuff that sucks. And I should be getting paid for that. That's what gives me confidence that certain things will probably work in the future.
What I'm talking about is not pure quant. Pure quant is like: "Let's get our machine learning algorithm and pump 10,000 variables through it and just try to outsmart the other computers." But then there are also fundamental, common sense people that use quant to pull away the human problems. We're still fundamentally thinking about equilibrium in a market with other humans. So I guess the term would be 'common sense quant'.
Having done all this research, are you still as curious about other potential factors and anomalies?
We started Quantitative Value on live money about six years ago and we haven't changed any of our algorithms since. But we're always looking for new ideas and testing new concepts and our clients are usually our best brains because most of them are pretty sophisticated. They're like: "Hey, why don't you try this?" or "Joe Blow said this; why don't you take a look at that?" But we've honestly never found anything that has enough robustness, given what we've already got.
The marginal bar to change something at this point has got to be super, super high because we've also got to discount away data mining and optimisation bias. We've just never found anything, and it makes sense because we spent so much time thinking about this up-front. The idea that we could somehow magically uncover some rock we didn't think about is pretty low. I'm not saying it's not there, but we just haven't found it.
The only thing that's changed is that we've embraced ideas that we used to think were bullsh**. We had a long-time client who said: "Hey, why don't you guys look at managed futures?"
Now, I'm a Fama school guy, so I was brainwashed in efficient markets. Momentum is bad enough but now you're telling me that there is something in trend following and all this market timing crap? It's just not what we're predisposed to. But, he was like: "You guys are killing it. I'm not smart enough to study this, but you guy have all the capability. There's something here, I'm telling you!"
So we finally got past our own religion problems and started studying it. Now we've embraced it - trend following in managed futures is a great idea for a lot of the same reasons that value and momentum were great ideas in stock picking. So we've made changes in expanding our horizons to try to understand good ideas that maybe we would never really have considered, but now we do.
What about the pain that comes with these strategies? What kind of misery do investors have to face and how do you deal with that as a firm?
The good thing about value investors is that they've got a religion. I'm kind of weird since I can go across religions pretty easily. I understand the religion because I used to be in that religion, so I know how they think. But I also know about this other stuff like momentum, so I can go between the worlds. It's easy to offend them, but the one thing I like about value investors is they do have a humility culture. You have to have humility to be any good at it - because you're used to getting your ass handed to you.
With value investors or momentum investors or any of these people, you're always dealing with pain and anguish. Once you start thinking about it through that lens, these "simple" ideas start making a lot of sense because they're simple but they're not easy.
You're always in pain situations, and most people would be willing to give up a few percent to not have to deal with this all the time. It's just the plight of investing; stuff works for a reason. It's not because you're so smart, it's usually because you're doing stuff that sucks but you just haven't realised it yet. So that's the message that you want to bring to people. Firms like us are just making it transparent now.
Our mission, and our whole business model, revolves around this idea of saying: "Hey, nobody has a magic wand, but what we're going to do is inform you about the facts of why this works and how it works, and be upfront with you about why it's going to suck." But, to the extent that you understand that, you're going to be a better investor, and you're going to actually be able to exploit this stuff. This is why our mission is not: "We're PhDs, we're smarter than you, and hire us because we're alpha generators." Our mission is: "We're going to make you smart in order to make sure you can actually stick to the strategy we're about to tell you, because it's going to work. It's going to work on paper, but when you actually have to live through what we're delivering, you're going to hate us."
That's why investors have got to know what they're getting into. Everything we do revolves around our beliefs: we're transparent, we're not black box. In the old days, it was always about selling black box, how smart you are and how awesome your research is. If you do well and have a good run you'll raise a ton of money. But the reality is if you were winning it's not because you were that smart, it's because you were probably taking some unique risk, or you were exploiting the mispricing which sucks to exploit. Eventually it stops working, and all those clients you told that you had a secret sauce are like: "Wait a second...", and they're out.
That's great for product hawkers but we've moved past that. That was old-school Wall Street. New-school Wall Street is the internet, it's transparency, it's education. We're going to do the same that the hedge fund guys did, but we're going to tell you what we're doing and why.
Right now, three out of our four funds are like number one in the universe over the past 12 months. We're like: "Listen, you know if you've been hanging around long enough that the year prior they were 99th percentile. So don't get excited about any of this. Understand the process, and how and why it works. And when the thing kicks ass a lot, you shouldn't feel any different than when the thing gets its ass kicked a lot. You're just following a process that exploits these hard-to-arbitrage risk premiums. Stick to the process, don't worry about the returns."
So we're transparent, evidence-based and we're not going to sell stories. We're going to make systems, and it's not going to be how Wes feels today about the markets. It's going to be about what the f***ing computer says do, because it's a lot smarter than we are.
Finally, to what extent does your approach reflect the view that finance and investing needs to do more to serve the customer, not just the money managers? And how do you set yourselves up to compete in such a ruthless industry?
We're not a marketing shop, we're an inbound shop. For us, our products are only bought, not sold. We run all our own money on our own stuff, so our incentive is to think: "Hey, what would I want to do if I were an actual investor?" We don't think about targeting advisors and minimising tracking error, we don't do anything traditional like that.
It might take us forever to build this business but doing it this way gives us structural edge. We don't have sales people, we've cut them out of the equation. We're running over a billion dollars and it's all inbound. We fulfil our mission with the website; we go out there and educate and write blogs and, lo and behold, people like transparency, integrity and authenticity. And there are like, eight of us.
I think the world will be a lot better in terms of financial advice and products in 10 years, but it's rough right now. Who knows? It'll be an exciting world and we feel like we're on the trend.
As you get bigger and better, everyone knows who you are. Like the US military, everyone knows they're going to kick your ass, and so they're all going to be ready for you. So you've always got to be tough to kill and figure out how to do more with less. We've got a balance sheet that is like iron and I don't ever want to get a real job ever again. So I will live on ramen noodles and go pitch a tent out here if I have to; they ain't killing us.
The big issue in asset management is that it's such a high operating leverage business. People get blown out because there's huge competitive pressure. They get monster fixed costs and they create a hedge fund culture with fancy offices. Then when something bad happens, they're stuck at a high operating leverage, they die and someone comes in and sucks them up. We want to be the opposite; like, when things get crazy, we're going to buy you, because we're ready for World War 10.
Wes, thank so much for your time.