Episode #4: “Even God Would Get Fired as an Active Investor”
Guest: Wes Gray, CEO/CIO of Alpha Architect. Wes was a Captain in the U.S. Marine Corps, holds a PhD, and was a finance professor at Drexel University. He has also published four books, multiple academic articles, and is a normal contributor to the Wall Street Journal, Forbes, and the CFA Institute.
Topics: What if you had perfect foresight and knew ahead of time which stocks would be the best performers? The reality is even if you knew this and invested accordingly, you’d still suffer gut-wrenching drawdowns along the way so painful (around 75%) that “even God would get fired as an active investor” if he was managing other peoples’ money. That’s the result of one of Wes’s studies which he and Meb discuss. By the way, with perfect foresight, you’d do about 28% a year, so what does that mean for those investment groups that want your business, claiming they do 35% or so a year? Then Wes says it’s not about volatility – it’s about protection against tail risk. That leads into a discussion on one of Meb’s favorite topics, managed futures, “one of the best diversifiers to a traditional portfolio.” There’s talk of Wes’s roboadvisor, timing factors, and Wes’s secret to getting the best prices on Amazon. All this and more on Episode #4.
Episode Sponsor: TheIdeaFarm.com
To listen to Episode #4 on iTunes, click here
To stream Episode #4, click here
Comments or suggestions? Email us [email protected]
Links from the Episode:
- Alpha Architect
- Alpha Architect’s new roboadvisor
- French Fama data
- Wes’s books
- Wes’s white papers
- “What the Marine Corps Taught Me About Investing” – Wes Gray
- “Even God Would Get Fired as an Active Investor” – Wes Gray
- “Want to Spot a True Value Investor? Look for Horrible Recent Performance” – Wes Gray
- “Contrarian Investment, Extrapolation, and Risk” – LSV
- “To Win with “Smart Beta” Ask if the Price is Right” – Rob Arnott
- “Why We Built an Active Roboadvisor and Why You Should Too” – Wes Gray
Running Segment: “Things I find beautiful, useful or downright magical”:
Transcript of Episode #4:
Welcome Message: Welcome to the Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management of its affiliates. For more information, visit cambriainvestments.com.
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Meb: Welcome to the Meb Faber Show. This is your host Meb Faber. Today we have an extra special guest, Professor Wes Gray. Wes, welcome to the show.
Wes: Hey, Meb, thanks for having me.
Meb: So Wes, super quick background. Like many of our guests, Wes has a pretty unique and varied background. He’s got a PhD in, I think, MBA from the University of Chicago, studied under Noble Laureate Fama, did undergrad at Penn. Is that right?
Wes: Yeah, that’s right.
Meb: Did you study business then, too, or something else?
Wes: Yes, unlike you I never branched out in world so I was a working undergrad and I just always did vocational schools my whole education time.
Meb: Well, then there was this stop for four years in between as a marine in Iraq, and also Wes now runs Alpha Architect, which is an institutional money manager. They also have four ETFs, and also launching it, or I believe launched a tactical roboadviser, which we’ll talk about at some point as well. Your second guest, we had Patrick O’Shaughnessy on in the office, and I’m kind of glad you’re remote. You’re in Pennsylvania right now, right?
Wes: Yeah, that’s right.
Meb: I’m glad you’re remote because when Patrick was here, I said, “Patrick, during this podcast we’re gonna do a beer tasting.” And I know you love beer too, but the problem was Patrick had to give a speech the next day, then this podcast went on for about an hour and a half. So Patrick had probably half of one beer and I had probably the other four. So the quality of my discussion went downhill quickly, but it probably made Patrick sound great. So good news is it’s also 9:00 a.m., so no beer drinking today.
Meb: You may be on your side but none over here. All right, so let’s get started. One of the things that I did in the first one is I looked up online and you can sort people’s Twitter stream, and Wes is a prolific tweeter, and you can sort them by their most popular post or most liked or most re-tweeted. So I figured that I would use some of those as a jumping off point for conversation. And one of the first ones, one of the most popular, and we’ll talk about a few, was an article you did in the Wall Street Journal almost a year ago called, “What the Marine Corps Taught Me About Investing.” And if you don’t remember this article, I’m sure you do, but there was a few takeaways, first one being, follow your model. Maybe you could talk about that real quick and kinda extrapolate any takeaways you had from your time in service.
Wes: You know, one of the things that you learn in being in battle is that basically the human element you can never take it away, and I think, which goes about the human element is that when humans are involved, humans make crazy decisions sometimes. And the only way you can get rid of making crazy decisions is to basically automate things and do standard operating procedures in… You know, that’s what you obviously do in the Marine Corps all the time is you train to a standard because you know that when the proverbial feces hits the fan, you’re always going to revert back to what your human nature wants you to do. Just like you think and how we think in investing, it’s the same problem. You can sit there and be in a 50% draw down in theory and be like, “Oh yeah, I’ll just buy and hold. No problem.” But we all know in reality is when your in a 50% draw down, you’re gonna sell everything and give up. So you want to kinda either follow a model or have some sort of process in place before you enter combat or before you enter the market just to kinda almost protect you on from your own, you know, behavioral bias and problems you might have.
Meb: And it’s interesting because you also talk about trusting evidence and evidence-based investing, and lastly you said, “Integrity is everything.” And this is an interesting comment because particularly in our business, which often a high compensation business, you see Forbes 500, plenty of hedge fund managers on there every year, but it also attracts kind of the bad actors. And I can’t tell you how many made offs we’ve seen, Gallions, F-Squared, all of these are just really bad actors. And I think that’s really an important point you make that’s often not talked about a whole lot is the integrity side.
Wes: Yeah, definitely. Probably the biggest issue with the financial markets is it’s a market where it’s really hard to learn effectively because the outcomes are realized way into the future, there’s tons of volatility, and it’s really complex to understand whether someone actually was doing the right thing or the wrong thing, which means in the end all you can really rely on is at some level trust in whoever you’re working with, and that’s a good thing in the sense that you wanna build trust, you know, so you can do the right thing and help people out. Also the problem with that is once you have someone’s trust, because it’s so hard to ascertain whether you’re basically full of shit or not, you know, in theory you could use it for a nefarious means, and that’s kinda why integrity is kind of a big deal in financial markets. You know, that Beaufort has that old saying where you can spend a lifetime building your integrity and your honor and all that stuff and, you know, five minutes you can blow the whole thing.
Meb: You see a lot of swindling going on with financial advisers that attract professional athletes. I mean, it’s almost everyday. I was ribbing a good buddy who is a Cowboys fan, where one of the Cowboys just came out and he said he lost millions of dollars by investing in a bitcoin mine. It is those sort of things, you know, people see, the old proverb, “Fish see the bait, not the hook.” Everyone dreams of about these returns and high returns. This is actually gonna leap perfect lead into one of your other most popular tweets and talking about what’s possible with returns and what’s possible in investing in general, and the title of this post you did, which is your most popular tweet was, “Even god would get fired as an active investor.” And I’m gonna read a whole paragraph, then let you run with this. But I thought this paragraph was so good it was gonna be a lead in.
So you said, “Empirical asset pricing research can sometimes get monotonous because you end up circling back relentlessly to the same conclusions, value works, momentum works, and yet markets are remarkably efficient. But sometimes research uncovers absolutely stunning and counterintuitive results, and that is where things get truly exciting. The study below is what we consider to be exciting research because the results are so profound, [inaudible 00:08:19] at least to us. Our bottom line result is that perfect foresight, crystal ball, that’s my words, has great returns, but gut-wrenching draw downs. In other words, an active manager who is clairvoyant and knew ahead of time exactly what stocks are gonna be in the long term winners and losers would likely get fired many times over if they were managing other people’s money.” Why don’t you tell us a little bit about that study, how you designed it, what it kinda means investors?
Wes: Sure, yeah. I wouldn’t even take full credit for inspiration. The way this happened is I was giving a talk at a thing called The Nantucket Project, which is…well, these mutual admiration societies, which are great. I was there but there’s a lot of rich people and famous people, and I gave my talk and I was at this bar. And this guys in the corner was like pretty wasted, and I was there with one of my business partners, David, and this guy starts walking towards us, and I’m like, “Oh, god.” Well, he sits down and he introduces himself. He’s like, “Yeah, I’m a Chicago Economics PhD from 1980,” and I was like, “Oh, god.” And he’s pretty wasted and he’s like, “I want you guys to do this general test,” where it wasn’t related to exactly what we did in this study, but he wanted to actually just examine how much look ahead bias actually can influence like back test whatever.
So we were kind of doing research along that line just to see like, “Hey, what is look ahead do? Like, how can that influence a back test?” And then we started thinking, “Wait a second, I’m just curious.” If you had the perfect look ahead, just what your performance would like, and of course, you know, the intuitive thing is that if you have perfect foresight and you know exactly the names that are gonna be the best performers over the next five years and the worst performers, you’re gonna have amazing returns.
Meb: I think you referred to it in your article is Biff from Back to the Future having the sports almanac.
Wes: That’s right, 100%. And obviously if you have that sports almanac, you do really well. And then just by pure serendipity, because we run these things in all our analytics tools, we start looking at the draw downs on what we call this god portfolio and we’re like, “Holy shykies.” You can actually get your face ripped off. Even if you’re god and you know exactly what the long, exactly what the short, it was just fascinating that even if you’re perfect, if your managing other people’s money, assuming that you couldn’t convince me you were actually god because that would probably be tough, they would probably pull their capital at certain time periods.
Meb: Let me get some statistics just for context for the listeners. Every five years they had re-balances portfolio, pick the top 50 stocks out of the S&P 500 all the way back to the 1920s. So if you were able to pick with perfect foresight, you would have done 28% a year, and this is verses about 10% for stocks. As you can imagine, people are out there, they’re trying to market 20, 30% returns. Just put that into context, you have to be perfect, zero mistakes to be able to get to 30%. But the big thing that Wes is…the bigger takeaway is not just, all right, there is a ceiling on what it is possible, but also the loss you would have experienced at one point with this portfolio or draw down, the way we call it, peak the trough, with 76%. So even if you were perfect, even if you were Ted Williams combined with Babe Ruth, combined with Barry, Bonds all of them, you still would have lost 75% at some point, and that’s really, really hard to live through. And then you actually kinda did the combination, too, where you said, “Perfect foresight on the best names,” but also if you shorted the worse names, and a lot of people would assume that all of a sudden you would have a really low vol, low draw down strategy, but that wasn’t the case, was it?
Wes: No, not at all. Basically when you do the long-short, because now you’re long the best names that you just mentioned, almost have 30 cagers [SP] and you’re short the worst names, and I don’t even remember, but they’re like terrible, like negative five cagers. With a portfolio that is gonna grind, you know, almost 50% cagers. So you obviously you’re gonna become a trillionare pretty quick. However, there’s also an episode where that portfolio has a 60% draw down. And what makes matters worse is over that same time period the market has a 100% gain. So you can imagine being a hedge fund guy and saying, Yeah, I’m god, I’m down 60,” and they’re like, “Well, the market is up a 100. You’re an idiot, you’re fired. Give me my money back.” Even though, you know, you would have stuck with that, you would obviously be a trillionaire, so it’s just unbelievable.
Meb: There’s a great quote, too, about being a professional investor, and this is Kyle Bass, and our buddy Morgan was tweeting it the other day, and he said, “It’s easy to maintain conviction, it’s harder to maintain investors.”
Wes: Hundred percent agree with that.
Meb: And that kinda goes along with some other ideas you were talking about recently, which is talking about being a value investor and said, “All right, if you want to spot a true value investor, look for a horrible performance.” would you want to talk about that post at all?
Wes: Yeah, yeah, sure. And you know, this is why anyone whose in the industry knows that you’re always waiting this trade off between, “I got to run a business and I want to maintain my assets base,” but at the same time you also want to actually generate performance for your clients. The problem is sometimes those two objectives are in conflict, because if I’m a large asset manager, you know, I don’t really have huge incentives to knock it, you know, knock the cover off the ball. Because if I out preform by a lot, whatever, I got my same assets, if I under perform by a little, no one’s gonna fire me because it’s kind of sticky. But if I get destroyed by the market in the year, I’m like done. Everyone is gonna rip their assets out. So what do people do? They cause an index.
What do a lot of people don’t do? They actually do the active strategies that generate the returns that are actually documented in academic research. And so value in 2015, as example, is a perfect example of this, where if you look at all “value funds” out there, they pretty much look like the S&P with a little bit of noise. Whereas if you just look like a generic top desk out cheap portfolio and book the market, grabbing data off Ken French’s website, that portfolio obviously got destroyed last year, likely driven a lot by energy, but that’s just the realty of it. If you’re actually doing active value, you should have got your head ripped off last year, and if not, you’re kinda faking it because you’re just the closet indexer. And so it’s really hard to, you know, for people to understand that you don’t want to be following the market if you’re trying to buy something that is supposedly different. You actually want it to under perform some of the time really bad and obviously out preform some of the time really well. But the last thing you want is to basically buy more of the same crap you already have because you can buy a Vanguard fund for free, so why would you want to double pay for that?
Meb: And you see that with a lot of funds. What looks like maybe a reasonable fee of half a percent or 60 basis points, if you look at the actual holdings and compare it to the active share, because it is a closet indexer, you’re not paying the five basis points you would have paid at Vanguard, but you’re really paying 1.5% on the active side. You’re just not that active and it’s mostly in S&P plus a little bit different. What do you see as kind of the right number of stocks for a public fund manager to hold? Because there’s got to be a blend between concentration but also getting enough diversification so that it accurately reflects the strategy? What’s the right number of stock for you?
Wes: You know, I think it depends on the psychology makeup of the individual that’s gonna use it. But for us we try to get it as extreme as possible within regulatory limits, so we try to get like equal way 40, 50 stocks. Because within, you know, like ETF structures or mutual fund complexes, there’s rules. You can’t just put all your money in one stock in whatever, that’s fine. But I think the result studies on correlations of random portfolios where one stock obviously is a bad idea, two stocks probably a bad idea, 10, it’s all right, 20, 30, getting better, 40, 50 great, and then there’s stream really between 50 stock portfolio, and like 5,000 is pretty much nothing. So we like to keep them 40 to 50, where a lot of what they call idiosyncratic risk or kinda random volatility that’s just associated with company-specific issues kinda washes out, and at the same time you can concentrate on whatever factor, characteristic that you’re going for. So we like 40 to 50, but reasonable people can disagree.
Meb: There’s a fund in Europe, I’m blanking on the name, that is a momentum fund that just owns these single best in their mind momentum asset. And I thought that was a pretty, pretty great balls of the wall portfolio, and it has a hundreds of millions of dollars in it. I can’t imagine they’re probably gonna stay in business forever, but I love the concept.
Wes: I mean, in theory, you know, you’d probably run it maybe, I don’t know, 20 to 30, and then you’d obviously wanna pull that with other exposures. You mentioned that trinity piece, like you wanna have value but you also want to have momentum. Because if you only do value, you’re gonna like wanna jump off a cliff many years, and you want to obviously pool with other things as well. But I think to get the concentrated effect, I think 30 is maybe…it’s 30 to 40 maybe the ultimate sweet spot, 40 to 50’s is basically the same thing.
Meb: And Wes is a quan that really, to give you some credit, leads with what we would call evidence-based investing, which means, I think, it was Fama that used to say, “If it’s in the data, just show me. “But you also did a post called, “The academic finance papers that changed my mind,” and we’re not gonna go down this rabbit hole because everyone will fall asleep while they’re driving their cars listening to this podcast and crash. But there was a general evolution in kinda your career of thinking about markets and thinking about the way things worked, where you talk about early days and value investing and then the PhD days where the tilts towards market efficiency and then kinda current thinking. Maybe let’s talk a little bit about what you were just mentioning that the ability to hold in your head two thoughts, which is something like value works and something like momentum works, where so many investors, they wanna say, “Hey, I’m a gold bug guy or I’m a stocks guy or I believe I’m a bogo head. I index and that’s that.” Summarize your evolution of thinking and how you think about markets today and how you guys manage money for your various strategies? Because you’re rare in that you do both value strategies and momentum strategies as well.
Wes: Yes, so I kind of start off I guess with a good start, reading Ben Graham, doing the whole value thing. I recommend everyone probably get started there because it’s a common sense approach that a lot of times will keep you out of trouble from doing crazy things like day trading or what have you. You start off there and become a value investor and you’re like, “Okay, this works because I buy cheap stuff.” And I was like, “Yeah, that makes sense, you buy cheap stuff that works.” But then you start doing it and then you I start asking, “Well, why do things work?” Because does it work just because stuff is cheap? No! Investing is all about essentially front running other people’s expectations. Because the only reason value investing works is because those cheap stocks, eventually someone else in the marketplace down the road says, “Oh, wow, this is not a total dire situation. It’s not as bad as we thought.” They reevaluate expectations and then you make a spread there. That’s why value works. And the core psychology is it’s basically an overreaction to crappy news. People throw the baby out the bath water on average and then what happens is expectations down the road change, they get reevaluated, you make money.
That’s why value works, not because you buy cheap stuff and because the market gods say you deserve to get paid. It works because it’s essentially cheapness is a proxy for a bias expectation that gets resolved down the road, and when it changes you make money. Once you start thinking in that context, the things work because you’ve basically front run other people’s expectations that you know will change in the future on average, now it opens up your whole world to not being sort of dogmatic that like, “We only buy value because that’s what Ben Graham said, and he says technicals are stupid.” Well what if technicals, what if you can find like momentum or like you always talk about like trend falling where you can actually say, “Wait a second, momentum, we can actually map that back and highlight that momentum is basically a proxy for under reaction to good news. And if we systematically buy these securities, it tends to be the case that there’s is an under reaction to the news that is being pushed into the price and it gets results down in the future and we’re gonna make money when people realize that. So it’s all about, again, front run expectations and finding signals that you know help you that in an effective manner basically.
Meb: And so thinking about that and thinking about what we call in our world factors, like value momentum, at some point, there’s been a lot of noise lately where a couple other big quans, Rob Arnott and Cliff Asness and others, have been talking about factor timing. Meaning, Rob was talking about, “Hey, there are some factors like low volatility worth high dividends, where over time they work great,” and you were talking about some of the Chicago guys talking about price the book, for example, but at times they go through long periods of out performance and under performance, but also you could possible take a step back and say there is a factor that maybe the stocks are now expensive in that factor and Rob was talking specifically about low volatility stocks, and then Cliff says, “No, you probably shouldn’t time these factors but just diversify across them.” What’s kind of your take on that space? Do you think it’s possible to time them? Do you think much about it? Are you guys doing any research there?
Wes: Yeah, of course. And unfortunately I’m bias towards Asness because he is a working undergrad, Chicago PhD, then became a professor. I have the same training so we’re obviously gonna think very similarly here. Maybe that’s just because it is what it is.
Meb: Well, perfect. I’ll take Rob’s side on this. So let’s hear what you have to say.
Wes: Our basic opinion is obviously gonna be prior related to Asness’ is that the… Let’s just take value momentum, for an example. So there’s clearly episodes where to Rob’s point, maybe the value stocks or even the cheapest value stocks on an absolute level are just not cheap. So maybe you could somehow time that exposure or whatever signal it is that you think there is a way to time between, and that’s fine. The problem is you get a bird in the hand effect of diversification when you combine value and momentum, because for whatever reason there they’re yin and yang, and I’m not really sure anyone understands exactly why, but empirically there is no doubting that that’s the case.
When you combine them in just a generic way, let’s just say you equate them or vol weigh them or whatever, you’re guaranteeing yourself the diversification benefit. The minute you step outside of that, you’re now in the bird in the bush fight. Yeah, we might be able to add marginal value by shifting from say value over to momentum or from momentum over to value, but now we are implicitly giving up the bird in the hand diversification benefit for the anticipated reward of that marginal extra benefit of being able to switch back and forth. I mean, we just can’t get comfortable that there is anything that’s as robust enough to overwhelm this bird in the hand diversification benefit. So that’s kind of our take on it.
Meb: Yeah, I want to believe that it is possible, but then again have we done this podcast in January, I would of said low vol stocks are expensive, high dividend yielders, you should run away from them. And of course what’s happened this year, utility stocks are just blowing it out of the water. So of course things can always move even further than you expect them to. We’re doing a lot of research there. I don’t have any simple answers and takeaways, but think it’s an interesting area, kind of under the same lines. We had a couple of Twitter questions I asked yesterday. I said, “Wes is coming on.” People can e-mail me questions, and for the show in general we always do feed back at the Meb Faber show. If you have Q and A, we’ll ask people some questions on the air. And one of the masters said, “Do you have a strategy that sorts cheapest stocks by value, then sorts by quality?” And they say, “What’s the benefit of doing that? Why just not pick value? Is there an added benefit for sorting for quality and what is it? Is it low volatility? Is it higher quality companies? What’s the reasoning for that process.”
Wes: So this is, the book “Quantitative Value” kind of maps through the logic behind that. I know ah Toby has a book “Deep Value” out there. So one case you could just buy say the cheapest 10% of names on some factor or some valuation metric. Pick your favorite, they’re all bout the same. An alternative hypothesis is that you can go play around in that bin of the cheapest names, and within those cheapest names, in order to capture the value normally, you have to be in the cheap. We think we can separate via looking at the fundamentals the good from the bad on average. And why do we do that just from a theoretical stand point, behavioral stand point? Well, one of the things we know that’s in the evidence and you can look at the old [inaudible 00:27:10] 94 paper. It’s all about over reaction to bad news. And the reason value works is because the is an expectation change in the future, people are like, “Oh my god, it wasn’t as bad as we thought,” that’s how you make money on average.
Now, it tends to be the case that those securities that are more likely to mean revert on their expectation or quality. Because some stocks are cheap for a reason, they’re pieces of crap, they’re bankrupt, they’re going…they’re done, they’re frauds, they’re manipulators like they’re falling knives, and that’s fine. And so what we’ve shown, I think, empirically, pretty clearly is that if you can buy cheap, you have to be there, then within that focus on quality so that you can at least fair it out potential permanent lost or capital situations, your risk adjusted value normally is gonna be better in our opinion, or at least based on our opinion what the evidence actually says.
Meb: There is a funny example a couple of years ago where Joel Greenblatt had started a website called Formula Investing or something like that. And it was basically a precursor to robos, where it would allow people to go in and they would manage separate accounts for you based on his quantum formula, or you could just sign up and and run the screens and run your own portfolios, and also I think it allowed you to exclude names for some reason if you just wanted to exclude names. And what they found was that the people who would exclude the names did far worse than the ones that just took the screen as is because they would introduce their bias and say, “My god, I can’t be buying XYZ. That’s a total piece of crap,” like you said, “There is no way we can invest in that.” And of course that would be the one that would end up doing the best. That’s the beauty of a quantitative process. I had a reporter who was like, “Can you tell us about some of your names?” I’m like, “Look, I’m happy to gossip but I don’t even know what’s in the fund. I couldn’t even tell you what the largest holdings are. Because if I I did start to mock around with it, it would probably hurt more than anything else.”
Wes: Yeah, totally agree with that, and there are certainly some element of just… Because obviously we all know that the core maximum here is cheap and have horizon, have the balls to hold onto this thing when inevitably under performs for three or five years. That’s 95% solution there. All we’re saying is with quality at the very margins we think there is a sustainable, robust benefit. But if a guy came to me and he said, “Hey, I’m just gonna buy cheap stocks. I’m actually gonna buy the lowest quality cheap stocks,” I’d say, “Hey, go for it. Maybe it’s not optimal but it’s not a terrible idea.” So quality is really just…it’s some level of red herring because it pulls the tension away from the core muscle movement, which is cheapness, which is critical, and then quality, we think, does matter, but it’s…I’m not gonna argue it’s like an end all, be all to save the world.
Meb: One of the things for the audience members, Wes manages private accounts for institutions, has a handful of ETFs. You can look them up online. I can’t talk about them on the show. But Wes also started a few months ago, I think it’s publicly available now, but why don’t you tell us a little bit about the technology space and another popular poster, which is called, “Why we build a active robo adviser and why you should too.”
Wes: One of the things that you do, Meb, and I’d say you’re probably like the the revolutionary on it, is this idea that products at some level should be bought not sold, where historically products are always sold, not bought. In this new age with blogs, media, putting yourself out there, being fully transparent about what you’re doing and why you do it, you get a lot of inbound traffic. The problem is, when you run an asset manager business, there’re obviously ideally or else equal, you get big millionaires that say, “Hey, I wanna open an account,” because that’s a lot easier. The problem is, it’s not really a problem, is that sometimes you get people that are really excited about what you are doing, they love it, they are like, “I’ve got 50 grand, can you manage a private account for me?” We got to say, “Well, listen, I love your enthusiasm. I would love to help you, but if you only have $50,000 in assets, from an economics perspective we have to charge you so much money, it’s gonna be a lose-lose proposition here.”
And so the robo aspect would now…technology and fintech and the ability to kind of automate things and make it where you can actually do with the 50k account, we saw it as like, “Well, listen. We got all this natural inbound flow where people want to work with us or we don’t have an economic easy way to do it and we got all these tech guys and programmers, let’s just build a robo.” Like, “Why not? So that’s what we did, and now we now we can take on smaller amounts of capital and deliver them as the best foot forward, and obviously there’s not gonna be tons of hand holding and daily conversations with us because that would make it not work anymore. But if you just need a basic portfolio, we can do that with technology.
Meb: And to talk a little about the investment approach of how you think about a portfolio, because it is quite a bit different than what most of the robo, and I call them robo allocators rather than robo advisers because most of them don’t actually come with an adviser. Most of them just give you a portfolio for a low cost, and for those that aren’t familiar, they’re shops like Vanguard and Schwab, Betterment and Wealthfront, and they all do it a bit differently. Vanguard actually comes with an adviser, but most of them do a buy and hold allocation, tends to be heavy in the US, but it does a risk scale of if you’re older and you have a little bit to retirement, you’re gonna end up 80, 100% in bonds. If you’re younger, you’re gonna have 100% stocks and something in between. But you guys do it a little bit different in the sense that you do have factor tilts, pretty concentrated factor tilts, and they also will be different and then you also added risk management overlay, right? Isn’t that right?
Wes: Yeah, yeah, you got it. Typical robo advisers just, “Let’s go buy and hold Vanguard funds,” and you got to ask like well, any idiot can go buy a Vanguard fund and a Schwab account, why do you need a robo to do it? So I’ve always kind of questioned that whole thesis at the outset. So our robo would… Again,ours is a robo from a technology standpoint but you always talk to someone, you can always give up a holler. So it does have a human element, but we are trying to do is really like back to your book, which I really like the Divey Portfolio originally, you kind of highlight, if you get big muscle movements on equities, bonds, commodities and some real estate, you’re gonna catch this global risk premiums at a real high level, and we say, “Let’s start with that. For equity let’s tilt towards value and momentum with high conviction and then let’s add trend falling over the top of it.” So it’s basically like that new trinity portfolio concept, where, “Let’s trying to globally diversify portfolio and fuse it with value momentum and then overlay trend to try to minimize massive face-ripping draw down problems.” And that’s what we’re doing. It’s basically global macro hedge fund that’s cheap. That’s the idea.
Meb: What Wes is referring to, a new white paper we’ve written called, “The Trinity Portfolio,” and technically isn’t out yet, but by the time that this podcast hit iTunes it will probably be out as well. But yeah, so unfortunately, this has been another conversation where we tend to agree more than disagree on things. Do you guys do…? Do you do any sort of top down thinking on valuation? I know you’ve written a lot on kind of cape ideas, written on… What else do you guys are working on these days as far as future research? Is there anything you got in the can that you can talk about or is it all…? Are you just ready to go, “Wes and I, we’re gonna go hiking in in Colorado this summer”? Ironically both of our families have land pretty close to each other but I can’t make it sadly and we’re gonna talk about all these brilliant new ideas. So maybe you’ll give up a preview of what you guys are working on right now.
Wes: You know, I would love nothing more than to find what we would consider like a robust effective kind of valuation based switching capability. And I think your approach with like cape is as probably as good as you can get. We just feel like it doesn’t have enough bang for the buck relative to just good old fashion long term trend type things. So we can be convinced obviously, and I’m always open to new ideas, but valuation-based timing we just haven’t got our heads around yet. The big thing we’ve been thinking about is, and I think you’ve been mentioning this maybe vaguely, is looking to match not doing what… A lot of guys are talking about risk parity, right? And what is risk parity? When you’re gonna take your volatility, your standard deviation, and try to make sure you kind of get the same amount from all your assets that are pulled together. But who really cares about volatility? What we all care about is tail risk parity. So we should be thinking about how do we manage the risk of the tails in a portfolio, which is all about understanding what assets go up during a 2008 crisis and what assets go down?
Well, here is a rude awakening. Most stuff, no matter what it’s called or how it sliced or how it’s baked, basically blows the hell up when 08 happens, right? Your corporate bonds, your high yield debt, your convertible ARB. Any of these things that sound cool and ulti [SP], their beta is won when the world blows up. So what a guy wants to do is you want to find, “Okay, what are the things that give me premiums, but we also know our short volatility and basically blow up. Okay, that’s equity, that’s always in our things. Let’s go find things to partner that with that actually go ripping whenever the world blows up.” And as you, I’m sure aware of, and I think you’ve talked about it, managed futures short term trend falling, managed futures are an incredible hidden put option on the equity market in our opinion, albeit noisy, and we find that those sort of asset classes and structures that basically give you insurance like benefits with potentially positive carry coupled with equity or whatever the heck people own, that leads to robust diversified portfolios, also a lot of career risk, which is why a lot of people don’t do it, but we think that’s a new horizon.
Meb: In managed future for the audience, if you are not familiar, because a lot of individuals but also institutions have very little to know allocation managed future, it’s nothing more than a trend falling approach to let’s call it 50 world markets, where you can go long or short based on a trend falling algorithm. And like Wes said, it’s one of the best diversifiers to a traditional portfolio. The thing that often keeps me up at night for a traditional portfolio is today, and you guys actually had a guess blog on this, I think yesterday, is that most people assume bonds will diversify stocks and in bad times. And while that is often the case, it is not always the case. And when you have a world where US bond yields on one and a half percent, foreign bonds yields are zero or negative, you know the next equity crisis, will bonds diversify that? I don’t think you can count on that.
And so managed future historically has been one of the best. There is a lot of insurance sort of option base tail funds that are expensive. You are paying an insurance but could protect you as well. We spend a lot of time thinking about both as well. I don’t have any easy answers but I often call managed future is my desert island strategy. Ironically, I used to own the domain riskparity.com. I sold it many years ago to a large institution annoyingly, and that’s kind of a funny story, we’ll save for another time, where I would have happily sold it for $500 but sold it for much more. Maybe I’ll tell you about that at your Freedom Festival. Are you guys doing that again this year?
Wes: We’re not doing Freedom in this year just because the logistics requirements are huge, and right now there is rapid or rabbit race to buy ammo stocks and AR-15, so I don’t…I don’t feel like fighting on the demand.
Meb: See? That’s a good idea for you. You should launch a ammo and guns ETF and then people… You can say, “Look, I’m agnostic.” You can either buy them or you can short them. You could work to both sides, to people that hate guns and people that love guns.
Wes: Yeah, that’s true. I notice, not to sound like a crazy weirdo, but you know I’m always buying ammo and guns or thing. And what you notice is the minute the world is like, “Oh my god, we’re gonna take this stuff off the market,” the great irony is all of a sudden people go buying this stuff, hand over fist, ammo stocks get down, the prices go shooting skyward, and what happens, the over supply happens, and then what happens there is a huge crash in those markets six months down the road. So it’s like one of these like super predictable kind of market things.
Meb: Rinse and repeat, my favorite example, is the the Cuban closing fund, which by the way doesn’t even own Cuban stocks but will trade at a 50% premium or discount based on whether people think Castro is gonna die or opening up trade to Cuba. That thing went to like 12 bucks and is now back down to six bucks because all these people buy it, thinking they are buying Cuban stocks, and of course what are they getting? A bunch of Florida cement makers and a 2% fee on top of it. Look, Wes, I know you have a call, so we’re gonna wind down here. We’ll get you back on the podcast six months, a year from now, and have you on for longer. We usually end our podcast with a question to the listeners, which is to name something, this is the only prepared question so hopefully you have something, if not, I’ll name two, something you find useful, beautiful or down right magical. Do you have something for the listeners?
Wes: It’s a…I bought it for my wife. She actually told me about it, but there’s this really cool website. It has a weird name. It’s camelcamelcamel.com, and what it is it’s like being travel or they they tell you when the flights, like the best prices, like when to buy and when not to buy. And a lot of people don’t know but like Amazon changes their prices all day long and for a bunch of different reasons, and Camelcamelcamel just allows you to basically identify kind of when you can bottom tick your purchase of whatever you want to buy on Amazon. It’s super cool. I recommend everyone check it out just to get ahead of the Amazon algos.
Meb: I feel like knowing you as a potential prankster. This would be like a really funny joke if that actually that wasn’t what is was, but it’s something like giant pop up, where someone was gonna be screaming on their other computer and is just gonna embarrass everyone when they open it. I hope so. I’ve never heard of this.
Wes: It’s totally legit, but that said, if you go to alpha-architect.com, don’t go there because it’s a spammer guy, and we can’t do anything about it, but yeah, people do crazy things, but this one is legit.
Meb: That’s really funny because when I did the ideafirm.com, someone else has Idea Farm, and if you go to that site, it’s altogether differentsite than a than a finance research portal. I’m not gonna tell anyone to go there but it is unique. All right, my thing I find beautiful, useful, magical, I’m gonna do two of them real quick. One, Nancy Silverton’s pizza recipe. This is the best pizza recipe I’ve cooked. A gazillion pizza doughs from whole foods and trader Joe’s and everybody else, and they always just end up kind of just meh. This pizza recipe from a famous LA chef, baker, it’s one of the best pizzas on the planet. The other one I’ll give you is a website called Charity Buzz, and this lets you go online and bid on various sort of events. Things like having lunch with a famous actor or sports figure, or tickets to Hamilton or a villa rental in Joshua Tree. And I kind of regret telling people this because it’s not a very efficient market yet, and so a lot of these experiences or services would go for pretty low cost, and the good news is that it all goes to charity. So a really cool website for some unique ideas. Wes, thank you so much for coming on. Where can people find you? Tell us to learn more about you other than alphanotdasharchitect.com?
Wes: Yeah, yeah, just alphaarchitect.com. Without the dash, you’re good to go. Yeah, don’t put the dash iunless you’re feeling frisky, I guess. But yeah, alphaarchitect.com is pretty much where we hang out.
Meb: And so Wes is also active on Twitter, as well as some of his co-workers and researchers. He has three books all highly recommended, “Embedded,” “Quantitative value,” “Do It Yourself Investor.” You have a fourth one on the way here soon?
Wes: We do. Jack and I are working on it. It’s “Quantitative Momentum,” and that should be out, I guess, I actually need to send the main script into Wiley here that’s [inaudible 00:44:46] as we speak, but it should be out like I imagine two or three months.
Meb: All right, excellent. Looking forward to that. And lastly Wes is a prolific academic writer. He’s got at least a dozen papers on the SSRN, some of which we’ve worked with him on, and I’m sure a lot more to come. You can always find show notes for this episode. We’ll link to all the papers we mentioned, websites etc. at mebfaber.com/podcast, and subscribe to the Meb Faber Show on iTunes. And if you liked the show or hated it, leave a review, we would appreciate it. Wes, again, thanks for coming today. Thanks for listening and good investing.