Long-time readers of Abnormal Returns are by now familiar with the work of Wesley Gray of Alpha Architect. He is the co-author of Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors. Last year we published both an excerpt and a Q&A related to the book. In addition posts by his firm dissecting recent academic research are linked to frequently on this site.
What you may not know is that Wes’ firm last week launched its first ETF, the ValueShares U.S. Quantitative Value ETF ($QVAL). You can read more about the fund in its Fact Sheet. In addition there are plans to launch a non-US version of the strategy as well. With that in mind Wes was kind enough to answer some questions about the strategy behind the new fund and launching a new active equity ETF amidst recent market volatility. Our questions appear in bold, Wes’ answers follow.
Why get in the ETF business? Alpha Architect is not a huge money manager. The process of getting exemptive relief to launch your own fund is long, expensive and arduous. Why not partner with one of the existing players?
I’ll tackle your first question–Why get into the ETF business? It’s not immediately obvious why we should want to do this. To date, we have exclusively served family offices and high-net-worth clients and achieved almost $200mm under management. Our clients are sophisticated and have a deep understanding of our approach to investing. Business is great, and we could certainly go down the easy path of growing organically, and focus exclusively on finding additional like-minded clients. But as my old Marine range instructors used to tell me: “Make bold adjustments.”
We discovered that an ETF vehicle would help us pursue two significant opportunities:
- Serving investors with less than $1mm in assets.
- Book readers and blog fans continually ask us if they can invest $10k, $20k, etc. with us. Of course, we would love to help them, but the reality of servicing small accounts means we would have to charge excessively high fees, something we simply don’t believe in. With an active ETF, we can manage any account of any size, and at an affordable price.
- Capturing the tax advantages of ETFs and applying them to an active strategy.
- For our high net worth clients, we are constantly seeking new ways to minimize tax burdens. Although some strategies can be enhanced by more active management, and more frequent rebalancing, there are diminishing returns to such activity due to taxes. We quickly discovered that the ETF vehicle facilitates our ability to optimize our strategies, while minimizing tax liabilities, an issue that plagues “traditional” active managers, such as mutual funds.
Next, why not partner?
Our vision is simple as an investment advisory firm: deliver affordable, active, alpha. Keep costs affordable; Deliver transparent, high-conviction, high-tracking error portfolios (active), and build systems that we believe can systematically exploit behavioral bias (alpha).
Delivering active alpha is something we are comfortable with because we started as a research and development shop, have reviewed a huge number of strategies and approaches, and we are confident in our ability to identify market opportunities.
Delivering affordability is typically a challenge, but we are religious in our pursuit of minimizing our cost structure and passing savings on to our partners. Traditionally, an active manager can pay 50bps, 75bps, or more, in distribution fees, just to get their strategies sold. The 12b-1 fee is an example of this. Add management fees on top of that and you have a very expensive product. The only winner is the distribution channel. We believe this must change.
Our vision is to be a direct-to-consumer financial services company. The concept isn’t new: Vanguard did the same initially and is the gold-standard in circumventing distribution costs. So for example, you will not find a Vanguard fund with a 12b-1 fee. We see that as commendable, and we want to emulate this approach. Plus, in addition to minimizing distribution costs, we also focus on minimizing operational costs. To succeed, we follow a simple rule: Thou shalt understand ops. We do not outsource any activity until we know how it works and why someone else can do it cheaper. Then we ask a simple question: Does outsourcing this activity contribute to our ability to be a low-cost provider? Or does it detract from that ability? With this simple belief, we insource the cheap work and leave the professional operations pieces to the experts.
The new fund is a transparent, actively managed value strategy. Many of the big, legacy fund managers are trying to launch actively managed, primarily equity, ETFs with non-transparent structures. Aren’t you concerned with other market players cloning your strategy?
The SEC just came out with a ruling that they would not allow non-transparent ETFs to move forward because non-transparent ETFs are “not in the public interest.” We tend to agree. And while the fund managers you refer to will no doubt continue to try and play “hide the ball,” we believe in transparency, not black-boxes. We are happy to share our investment portfolios that traffic in large liquid securities. Taxable investors can clone these, but they are going to get killed on taxes, so what’s the point? And in the case of either taxable or tax-exempt investors are they really going to be able to do it at dramatically lower cost? We think it’s not obvious that they can.
Also, consider that our investment strategies are risky and require a long-horizon (5yrs+) to capture any of the expected benefits. This characteristic of our strategies means they are not exactly hospitable to would-be cloners. In the short-run, there is a high probability we will underperform standard benchmarks and/or lose money: Why would cloning make sense in that context? If you are cloning, it is probably likely that your investors have low tolerance for tracking error; perhaps that’s why they are hiring cloners in the first place? Investors running copycat versions of our portfolio have a good chance of losing their job if the capital they manage is benchmark sensitive and short-term oriented! And longer-term money is usually taxable, so cloning the strategy is fine, but paying 50%+ taxes to the government makes the fees associated with the tax-efficient ETF vehicle a lot less painful.
A recent study concludes that most of the factors researchers have identified have been a result of luck and/or data mining. How does your approach try to mitigate against this?
Although it is true that many factors are not robust and do not stand up to close scrutiny, we think that at least some factors do show promise. The real question is how can you reliably differentiate between what is signal and what is noise?
Taking a step back, it is behavioral finance that drives our research and development process. This provides a framework for addressing this challenging question of what is signal and what is noise. Recall that the two building blocks of behavioral finance–understanding bias and arbitrage restrictions–combine to create expected opportunities for savvy long-term investors. How can you apply this in practice? It means we look for situations in the market where irrational investors are influencing asset prices, and we can understand and articulate why this might be so. But that isn’t enough. We also need to understand why other smart investors aren’t exploiting these opportunities. Can we explain what factors are inhibiting arbitrageurs from jumping in with capital to arbitrage away the opportunity? Sustainable alpha requires both components: identify poor behavior and identify constraints on the competition’s ability to exploit poor behavior. If you have both these elements, you have what we believe is a sustainable alpha opportunity.
To examine how this might work in practice, consider value investing, which we think is not related to luck or data mining, since first, it has was worked reliably over long periods of time, and second, we think we understand why it works. Value-investing, which we loosely define as any strategy that buys the cheapest stocks in the market, works because investors overreact to poor performance and project it too far in the future (aka, LSV 1994 Journal of Finance). The available and noisy bad news overwhelms the fundamental signals, and the stock becomes too cheap. Sounds simple to exploit, right? Not quite. While value-investing is simple, it is not easy.
Cheap-stock strategies can underperform the broader market for 5+ years (e.g. internet bubble). The potential for long-term tracking error puts the fear of God into most investors (and their capital). Because of this capital constraint, value-investing, simply defined, will last as long as the majority of investors cannot tolerate relative under performance. There is a reason value has continued to outperform since the days of Ben Graham: people cannot stomach sustained underperformance, and they leave the strategy. So if you understand this aspect of value investing, and are psychologically prepared for the inevitable bouts of underperformance, then value investing may be right for you. So then a question becomes: how can you be a value investor in the most effective way possible, while simultaneously minimizing the risk that your approach is overly reliant on data mining or luck? Our quantitative value philosophy, which we discuss on our blog, is a framework for systematically buying the cheapest, highest-quality stocks in the market at any given point in time. This systematic process involves the use of carefully researched statistical and accounting-based tools, and in selecting these tools we have tried our best to identify the most robust ones available in academia and from our own research.
You’ve chosen to build portfolios that are fairly concentrated (i.e., <50 stocks). Does this eventually put some constraint on the strategy? Does excluding small caps help mitigate this?
We want to deliver truly active strategies, which means we are betting selectively and have to be concentrated in what we believe are the best investment opportunities. As Charlie Munger says, “The idea of excessive diversification is madness.” If you believe you have an edge, then you should bet on that edge, and not dilute the edge away. Of course, since we are concentrated, at some scale we run into constraints on our capacity. That said, we apply stringent liquidity screens and so our strategies are focused mostly on quite deep and liquid markets, and we estimate our capacity is in the $1-2B range. If we are ever blessed with the problem of “too much capital to manage” we can explore options at that point in time, and we do think we have some options and quantitative tools to address that issue.
There seems to be some disagreement in the data whether distress risk, per se, is priced. In your model is distress simply the flipside of quality or something different altogether?
We have investigated most of the forensic accounting models that identify distress risk and we have explored a number of internal ideas. The original mission for our research efforts on distress risk was to identify the “ultimate short book,” and we came to feel that running a short-only portfolio is often hazardous to one’s health and wealth. And so while being short these names and running a smart short book can be challenging, we certainly believe that you don’t want to be long any of these names! Being long these names just exposes you to tail risks that really are best avoided. We think systematic fraud, manipulation, or bankruptcy detection models can sometimes help us avoid various blowup situations, and related potential value traps.
Be sure to check in with us tomorrow for the second part of our Q&A with Wesley Gray of Alpha Architect.