Episode #61: Jack Vogel, Alpha Architect, “(Factor Timing?) It’s Next To Near Impossible”
Guest: Jack Vogel is the CFO/CIO of Alpha Architect. He conducts research in empirical asset pricing and behavioral finance. He is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth and QUANTITATIVE MOMENTUM: A Practitioner’s Guide to Building a Momentum-Based Stock Selection System.
Date Recorded: 7/6/17 | Run-Time: 1:00:52
Summary: After Jack tells us a bit about his background and how he came to be at Alpha Architect, Meb jumps in, starting with “factors” – specifically, the value factor. Meb asks about Jack’s value philosophy in general, and how he creates a value portfolio.
What follows is a great look at how a professional portfolio manager/asset allocator creates a portfolio. Using quantitative tools, Jack starts by constructing the universe of potential assets to include, keeping in mind scale. Next, Jack applies some forensic accounting in order to exclude certain toxic assets that one wouldn’t want in a portfolio. Then, he screens for value. Jack likes using enterprise multiples. Finally, he looks for “quality.” These are things like free cash flow, margin growth and marketing stability.
Meb then points the conversation toward momentum investing. Jack offers us a general overview first, noting how momentum investing can be really beneficial for value investors. He also makes the point how it’s definitely different than growth investing.
In discussing creating a momentum portfolio, Jack discusses adding seasonality (which means addressing when to rebalance) and quality. On the topic of quality, Jack gives us a great example of what it means in the context of earnings; it involves two stocks, one of which is flat for an extended period, but then explodes in value in a short amount of time, versus the other that experiences the same growth, but gradually and consistently over the entire period. Which earnings are more “quality”? Jack gives us his thoughts.
Next up is Alpha Architect’s great tool, Visual Active Share. It’s a wonderful way for investors to compare the holdings of an ETF to its benchmark index. Investors can use this to see just how “different” the ETF in question truly is. After all, you don’t want to be paying too much in fees for an ETF that’s really just a closet index fund. The guys discuss whether there’s a particular number for what “good” active share is, as well as the challenge of tracking error as you grow more “different.”
As usual, there’s a great deal more in this episode: Alpha Architect’s new value, momentum, trend ETF… A discussion of the state of robos… What new tools Jack and his crew at Alpha Architect are working on now in order to help investors pull back the curtain on various funds… And of course, Jack’s most memorable trade – it was the last individual stock he owned, which he now refers to as “The Titanic.”
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Links from the Episode:
- Alpha Architect website
- White Papers on Alpha Architect
- On the Performance of Cyclically Adjusted Valuation Measures
- Enhancing the Investment Performance of Yield-Based Strategies
- Using Maximum Drawdowns to Capture Tail Risk
- Does Complexity Imply Value? AAII Value Strategies from 1963 to 2013
- Why Do Enterprise Multiples Predict Expected Stock Returns?
- 6:34 – Quantitative Value (Book) and Quantitative Momentum (Book)
- 6:46 – Our Quantitative Value Philosophy
- 13:43 – Analyzing Valuation Measures: A performance Horse Race over the Past 40 years – Vogel, Gray
- 25:31 – “Frog in the Pan” – Vogel, Gray
- 31:33 – activeshare.info
- 39:07 – The Value and Momentum Trend Philosophy
- 43:29 – DIY Financial Advisor (Book)
- 58:53 – AlphaArchitect.com
Transcript of Episode 61:
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 or its affiliates. For more information, visit cambriainvestments.com.
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Meb: Happy post-July 4th podcast listeners. Super excited today to have a good friend on the show. We’re bringing on a partner of one of our very first guests. If you remember one of the first episodes, was Wes Gray, we’re bringing on his partner and Alpha Architect, the CFO/CIO of Alpha Architect, Jack Vogel, welcome to the show.
Jack: Hey, Meb. Thanks for having me on.
Meb: I’m having trouble spitting my words out after this long five-day weekend. But the last time I saw Jack was in a karaoke bar down in Dana Point. And, Jack, I don’t think you got up on stage, did you?
Jack: No. I was, probably for everyone’s benefit, just staying in the crowd, enjoying everyone else’s singing experience.
Meb: Well, I wasn’t planning on getting on the stage, but Tom Lydon, our good friend from ETF Trends, was doing a brutally bad, just massacring “Baby Got Back” by Sir Mix-a-Lot. So I had to go steal the mic and take over for him. But he had a beautiful voice and did many other great songs, and was a gracious host so we had a lot of fun.
And we were just down at the Ritholtz IMN Evidence-Based Conference where we were both speaking, and where Meb and Jeff were…they tried to not let us into the happy-hour golf party, but eventually did.
Anyway, let’s get cranking today. So, Jack, why don’t you give us a little bit of origin story. I’ve known you for years now, but give the listeners a little…What was the path progression that eventually spat you out at Alpha Architects? Did you always wanna grow up to be a quant finance researcher?
Jack: I don’t know if that was necessarily the case, but it evolved, and I love what I do. So, good question. Basically, I graduated undergrad as a math education major. So I’m technically certified in PA as a high school math teacher. And I was in a PhD math program, and during my second year, I kind of realized I did not wanna do perpetual research on matrices and linear algebra in math, or nor did I really wanna go work for, you know, the NSA or something, like, that.
So I became interested in finance. And I switched to the PhD in finance program at Drexel. And that’s kind of where I met Wes. So Wes had graduated from Chicago and was placed and hired as a professor at Drexel. And in PhD programs in general, you end up working kind of closely with a professor. And I just got assigned to Wes, and, kind of like, the business side as well as the research side of finance as opposed to doing, like, academic, pure academic research. And that’s how I’ve kind of got into working with Wes at Alpha Architect.
And Meb, I know I’ve been working with you. I think it was back in, was it 2011 or whatever? Whenever you did your “Shareholder Yield Book.” I was kind of helping Wes out with you, and figuring out some…
Meb: Intimately involved. Well, I mean, you know, had you never met Wes, you would probably still have an ACL? I mean, I remember you just…Wes’ goofy basketball playing, I think, caused you to blow out your knee. But you’re fully recovered at this point, or close, right?
Jack: Yeah, pretty close. Yeah. Basketball in the driveway at someone’s house, Wes’ house can be very dangerous to your ACLs. That is a true statement. But, yeah, I’m pretty much…
Meb: Wes’ house also known as Alpha Architect’s global headquarters. I also don’t have an ACL in one of my knees from playing hoops. So I think I retired after doing that. Anyway, let’s get back to the topic on hand.
So, Jack’s written, like, a dozen white papers. You can find them on SSRN with all sorts of names like, “Using Maximum Drawdown to Capture Tail Risk” “Does Complexity Imply Value,” which is one of my favorite papers, by the way. We’re not gonna talk about today, but it looks at all the AAII American Association of Individual Investor value strategies all the way back to 1963. That is probably…that may be my favorite paper to read, over all, but it’s one of the least read.
We’ll put show notes up for all those. You’ve done three books, like, a gazillion white papers, but I figured we’d kind of go through the flow a little bit and see how long, first of all, we can go without saying the term “smart beta.”
I feel, like, the first person to say it has to owe a [SP] happy hour in this podcast. But let’s talk about factors. It’s an area you guys work a ton on. You’ve written two books, co-authored books with Wes on this topic. One called “Quantitative Value,” one called “Quantitative Momentum,” so I wanna talk about each. And in particular, you’ve actually distilled them into some really beautiful white papers.
Let’s start with value. And you guys got a nice white paper called “Our Quantitative Value Philosophy.” You wanna give us a quick overview? Actually, I wanted to read a quote that’ll lead in, and then I’ll just let you run from there. It says, “‘Quantitative’ is often considered to be an opaque mathematical black art, only practiced by Ivory Tower academics, and practitioners with their heads in the clouds. Nothing could be further from the truth. Quantitative, or systematic, processes are merely tools that value investors can use to minimize their unavoidable instincts. Quantitative tools serve two purposes. Protect us from our own behavioral errors. And two, to exploit the behavioral errors of others.”
So why don’t you talk to us a little bit about the value philosophy in general, and we can get into the nitty-gritty of the steps you guys take to forming a portfolio.
Jack: Sure. Yes, so, I, like, the quote you started with there. You know, and basically, the whole idea, in part, of that quote is to understand that, you know, quantitative can have weird, can cause weird reactions for people. Some people think, “Oh, you’re a quant. You’re just,” you know, “looking to optimize data and run regressions to figure out what was the best way in the past to invest, and that may not necessarily be true in the future.” And the whole idea behind, I guess, all our processes is we just use tools, quantitative, i.e. a computer, to do a lot of the heavy lifting that a security analyst, especially for value., like, a fundamental security analyst would end up doing themselves. We just use the computer to kind of sort through and sift through all the data because computers are just a lot quicker than humans are.
And then, as far as values goes, I’ll start with that before we get into details. You know, value investing has been around forever. Just to be clear, Wes wrote quant value with Toby. I helped do all the data on there, though, so I kind of know implicitly all the nuances of that process.
But on value investing, what is it? Essentially, you know, just buying cheap stuff. And the whole outline in the process of the quant value philosophy is basically to try to say, “What would be,” you know, “the best way to use a computer, in our opinion, to be a value investor?”
Meb: So you list five steps in the paper. And we could talk about each of them at length, or I’ll let you talk about them. But there are, you start with the universe, you then move to forensic accounting screens, valuation screens, quality screens, and investing with conviction. So why don’t you take us a little bit through that process, starting at how you really kinda, construct a portfolio based on the universe of stocks [SP]?
Jack: Sure. Yes, so the first step is, you know, constructing the universe, right? And the whole idea there is you wanna make sure when you’re building portfolios, especially that have any types of scale, that one can actually invest in them, right? So, you know, something in the academic databases, like, Fama has a good paper called “Dissecting Anomalies” where he highlights that within the databases, you know, 60% of the firms in there are what would be considered micro-cap stocks. And they only account for 2% of the market value of the U.S. investable universe. So you wouldn’t, like, kick them out. So I guess that’s the first step, is kind of look at mid-, large-cap stocks that are investable.
Then the second step is forensic accounting. And for value investing, as many people know, one of the issues is you don’t wanna be caught catching the following knife, right? You don’t wanna catch stocks that maybe doing some, they may be cheap for a reason. And so this is one way at the outset where we use a couple of forensic accounting screens such as high accrual firms, firms with higher probability of financial distress, and high probability of bankruptcy, and we use them to just eliminate, you know, around 5% to 10% of the universe.
To be clear, that step, what that will do is you’re gonna have a ton of false positives where you kick out a firm, and they, you know, they don’t go bankrupt or they don’t have financial distress. But on average, if you look and just say, “Hey, we’re gonna take the universe of 1,000 stocks, kick out 5% or 10%.” In the past, that was actually, like, a good bet. That was just, you know, that added some value, had, you know, slightly better summary stats.
Meb: I think it has a derivative benefit, which is, if you’re, like, you’re, kind of like, skimming the scum off the top of a pond. And if it keeps you from owning some really terrible name that goes bankrupt into zero, regardless of whether it’s a compound or return portfolio, a statistic benefit, there’s the benefit of not owning that turd, right? Like, you feel better about not owning some bankrupt stock and question your process.
Jack: Yeah, exactly. And it’s just one way, especially when you’re doing it…And I think this goes back to kind of that quote you’re talking about, like, the quantitative. And we always get people that ask, “Hey, what about a quantum mental approach when you kind of look at the stock names and add that human element that you’re gonna say, ‘Hey, we’re gonna screen out this name or that name.’?” I think it, kinda, maybe just makes you sleep better at night. As you, kinda, mention because, if you’re not gonna be screening the names at the end from a human aspect, you know, having a screen, like, that can be beneficial.
Meb: All right. So you get rid of the junk, and then next, how do you guys approach value? A lot of different investors use different value factors or have a different approach to value. What’s y’all’s?
Jack: Yeah, so we’re kind of big fans of enterprise multiples, which is, you know, you can measure by EBIT or EBITDA over total enterprise value.
Jack: Yeah. So basically, it’s, you know, taking earnings, and what total enterprise value is…It’s basically, if one had to buy the firm, how much would it cost to buy the entire firm? So you basically add a market capitalization, plus all the debt, plus, you know, maybe minority interest or preferred stock. So anything you would need to do. You need to buy out all the equity holders and all the debt holders. And then you subtract off cash, right?
So if you look at Apple, you know, Apple quotas clues that around, like, $200 billion or I forget what the number is now, but they have a ton of cash, so you get to subtract that off of the total enterprise value for Apple. And so that’s one way to measure it.
And how do we settle on such a measure? Well, Wes and I actually have a paper. It’s in “The Journal of Portfolio Management.” And we wrote this back in 2011 or 2012, I forget now. And we basically said, “Hey, we’re just gonna do a performance horse race across different value multiples.”
So we looked at book to market, P/E ratios, free cash flow to total enterprise value, enterprise multiples, and we even looked at analyst, forward analyst estimates. And we said, “Hey, we’re just gonna look at the spread between value and growth.” And what we found was enterprise multiples in the past did the best at predicting the so-called value premium in U.S. stocks. And also, in the international stocks, there’s another paper. There’s other academic papers have found that this is a decent value measure. And so, we looked at that and said, “Hey, we, like, enterprise multiples.”
We, it because, another just theory as to why it may work well is, you know, a lot of enterprise multiples have some private equity investors would value a firm, right? They’d say, “Okay, it’s earning this much. To buy the whole company is, you gotta look at the total enterprise value.” That’s the multiple that we chose.
You could use, you know, a couple different multiples if you wanted to, but we just, like, to keep it simple. So we basically take, like, getting back to our screen, if we start with 1,000 stocks, step two, we take out 10% for using math. So you’re down to 900. And then in step three, which really is the most important step, we kick out, we go directly to the top 10% cheapest firms so you’re down to 90 stocks.
Meb: Okay. And then the final…I think it’s the final step, which is quality. Explain what you mean by that.
Jack: Yeah, so quality can mean a lot of things, can be measured a million ways. The way we think of quality is, we look at it through, like, the lens, we, kinda, think of it as, like, a table, right? So for a table to stand up, you, kinda, need to have a /couple legs. So two of the legs we think of are, like, long-term for our U.S. screen. We look at long-term measures of quality. And what we look at is free cash flow over assets, over, you know, an eight-year period.
Another measure is, we look at a combination, and we take the percentile ranks on both margin growth and margin stability, so, clearly, you may not be able to, like, great firms may not be able to have high margin growth, but they may have super stable margins, right? So Procter & Gamble’s 50% or 55% percent margin stability, we kind of make, like, a Sharpe ratio out of, like, you know, your margin divided by the standard deviation of your margins over eight years. And we also look at other measures such as, like, return of return on capital and return on assets over eight years. So 50% of our quality score is, like, a long-term quality score.
And then the other, you know, two legs of our table, are what we call the, it’s, like, a pre-flight checklist where we look at the current financial strength of the firm. And what that is it’s basically, like, 10 year-over-year measures just to make sure that the firm that we’re buying isn’t gonna go bankrupt next year, or isn’t in current financial distress. It’s doing pretty well from a year-over-year basis.
Meb: And so, you come down to a pretty concentrated list. What is it? Down to a final 50 names?
Jack: Yes. So for the value portfolios, we go down to the top 40, 45 names, around there.
Meb: I tossed that you were coming on the podcast to Twitter, one of the questions was, you know, what does Jack and the crew estimate as, kind of, capacity? You mentioned that you’re focusing mainly on large-cap stocks when, you know, a fund crushes it, you guys do amazing. Where do you see, start to, like, you start to turn the dials a little bit when you get to a certain size? Is it, like, $5 billion, $10 billion? Where do you think the, if you have any thoughts on that in general?
Jack: Yeah, so that’s a great question. I saw that question on Twitter there. And some, Wes and I have thought about. So probably for value, the way it’s currently constructed where it’s, like, 40, 45 stocks equal weighted, and they’re mid to large cap, you can probably go up to around $1 billion without doing any tweaks, right? Around that time…And again, this is assuming you’re running the portfolio at the same time, right? So…
Jack: You know. If you’re rebalancing it at different times, you may be able to, at capacity. But let’s assume you wanted to run it as one bucket. And on, you know, one day, you wanna rebalance the whole thing.
But then, after that, you know, you can still make minor tweaks and probably get a lot more capacity in the fund, but you definitely would have to, probably, change that in portfolio construction where in step five right now, it’s like, “Hey, we go to 40 to 45 names and equal weight.” You know, maybe it’s, you add a couple more names or you do some sort of screen where maybe larger caps get a slightly higher weight. But that’s a great question.
Meb: Right. And there’s a lot of things you can do. I mean, Jack mentions rolling rebalances, which is certainly one, as well as many others. It’ll be a good problem to have when you guys hit that $5 billion, $10 billion capacity. Happy hour on you.
Well, let’s flip to a totally different…for many people, a lot of podcast listeners will hear this. And, you know, so many people are, you know, self-described value guys or buy-and-hold guys or whatever it may be, whatever your investment approach, dividend income guys. You know, almost a totally opposite left-brain/right-brain sort of approach, is momentum investing.
So you had a cool quote at the beginning of this one too. So I’ll read that it said, “Why might momentum be an interesting stock-selection tool?: It says, “First, Eugene Fama, the 2014 co-recipient of the Nobel Prize in Economics and father of the efficient market hypothesis has summarized the academic research on momentum as follows. ‘The premium anomaly is momentum.’ When the father of efficient markets suggests momentum is a leading anomaly, we take note.”
So talk to us a little bit about momentum because you guys have written what I would consider to be the most comprehensive, well-researched summary of the momentum literature. So give us a little overview, and then we’ll break it out into the similar five steps.
Jack: Yeah. So, yes. Wes and I, I guess year and a half ago wrote “Quantitative Momentum,” which was just a compilation of a lot of posts and papers and research that we had, kinda, gone through over the years. But really, the goal of that book was to, kind of, outline for investors why momentum investing, and momentum investing may be beneficial to your portfolio.
And, you know, this comes from the lens of, like, Wes and myself. We both kind of grew up is, like, value investing, you know, disciples, right? You know, you read Intelligent Investor. You see Warren Buffett. You’re like, “Oh, I’m gonna be a value investor.” And then what you come to realize is that momentum investing can be beneficial to your portfolio, and as I mentioned earlier, it’s really beneficial for a value investor. So we wanted to outline in that book, kinda, try to…The first couple chapters, we really tried to highlight how it’s beneficial, and also how it is definitely different than growth investing because a lot of times, what happens is for value investors, they just know “buy value, don’t buy growth,” right?, like, that’s kind of the gospel. And it’s important, I think, to differentiate the two, and highlight, “Hey, you know, momentum stocks are not necessarily growth stocks.” And so that’s, kinda, what we did…
Meb: Can you explain what you mean by it. So for listeners, like, growth stock, when you’re talking about growth, explain the difference just real quick, and then we’ll keep drilling down on momentum.
Jack: Yeah, so momentum, though, in the way we measure it, is we used was simple, called price momentum, i.e. You look at the total return of a stock over the past year. So if you had 1,000 stocks, you know, you’ll buy the top decile or 20%, right? Whereas a growth portfolio is if you had 1,000 stocks, you would rank all the firms on, let’s say, P/E ratios and a growth investor would buy those with the highest P/E ratio. And a value investor would buy those with the lowest P/E ratio.
So, you know, the overlap, historically, I think, in our book was, like, 27%, around there of the top decile of growth stocks, a top decile of momentum stocks. So they’re definitely not the same thing in our…according to the data.
Meb: Okay, so back to the momentum screen. So you do the first step, which is similar to the value, so you’re only looking at mid, large cap, exchange traded stocks. Second, you just mentioned the momentum screen, which is the past 12 months ignoring the first month. And this is where you kind of start to depart a little bit from what a lot of, just very basic, traditional momentum is. You add a little quality and then seasonality. You wanna talk a little bit about that?
Jack: Yeah. So, and real quick, just to highlight, in step two, momentum is actually a weird thing where if you look at short, like, i.e. month over month and long, like, three to five years, stock returns historically actually reverse. So in step two, you wanna look at, like, what’s called intermediate term momentum, which is anywhere from like, you know, 6 to 15 months.
But then, as you mentioned, step three, so if we start with 1,000 stocks in step one, step two, we go down to the top 100 stocks based on their past one-year return excluding last month. And then, step three, you’re right, we definitely do something different where…and we call it the quality of momentum, not necessarily quality. And what we’re looking for here is, the question is, and I like to give this example when people ask, “What is this step supposed to do?”
So imagine you have two high-momentum stocks that are both up 100%. So stock A we’ll call, you know, Exciting Biotech, which was just kind of bobbing around 0%, you know, jumping all over the place. And then, you know, three months ago, an FDA approval came out, and there was up 100%, right? And then it was 0% thereafter. So stock A is up 100% because it had a one-day jump due to an FDA approval.
Stock B, I’m gonna call Boring Big Box, right? And ,x has just returned 50 basis points for the past, you know, 250 days, right? Or let’s say 200 days. So stock B, Boring Big Box it is also up 100%. A question that one could ask is, well, you know, in this example, which type of momentum stock would you wanna own?
And there’s a cool paper that we kind of leverage. The title of paper is called “Frog in the Pan,” right? Continuous information and momentum. And what it asks, is essentially, you know, which type of stocks would you wanna own? And what they find is you wanna own those stocks that people tend to overlook, those that have more continuous good information. So in my simple example, it would be the Boring Big Box store. And the Exciting Biotech firm, you would actually wanna exclude them.
Meb: And part of that reason, you know, we talk about a lot of people, momentum is because of that predictable under reaction to fundamentals. And so a lot of the steady Eddie, you know, people may be under reacting to that change whereas, and vice-versa in the opposite. Okay. Next, you mentioned seasonality. What does that mean?
Jack: Yes. So seasonality is just the question of, you know, when does one rebalance the portfolio? And actually, this is a slightly interesting story. So when I was a PhD student, Wes and I were talking and, kinda, had an idea to examine the seasonality momentum because we, kinda, just had this thought, we were like, “Hey. Now it could be the case that in quarter-ending months, momentum may do really well due to people and, you know, such as mutual funds and institutions, where they have to disclose their holdings every quarter,” right? And so by construction, if you wanna make your portfolio look good on paper, right? Where you only have to close once a quarter. What would you do?
The natural idea would be, you would have to buy the high momentum stocks in the quarter-ending month, and you’d have this sell or get rid of all your crappy losing stocks, i.e. low momentum, right? And so, we had this idea, found the results, which were, kinda, what we thought, which is that momentum premium looks great and works, kinda, the best in quarter-ending months.
And, you know, as a PhD student, you just wanna get papers published so you can graduate. And, you know, looked at all the big journals and found no-one had published, thought we were great, and then, you know, we find out it was in, you know, a practitioner journal. Someone had already found this result, you know, in 2008.
So, good that someone else had verified our result, but essentially, what this step does, is we say, “Hey, since the momentum premium seems to do really well in quarter-ending months, what we do is we try to rebalance our portfolio right before those quarter-ending months occur.”
So, you know, you would wanna rebalance at the beginning…Sorry. At the end of November or the beginning of December, in the anticipation of people potentially buying up the high-momentum names as the month went on so that they have them in their portfolio, to show shareholders, at the end of the quarter.
Meb: I’m looking forward to the days when we start front-running you guys, and then everybody starts front-running us, and we’ll have to start rebalancing our interviewer [SP] portfolio at the end of September. So we’ll be a whole quarter ahead. Okay. So you end up the same thing with the portfolio, I think, also 50 names. Is that about right?
Jack: Yeah, around 50.
Meb: Forty, 50 names?
Jack: Yup. So we take the 50 names from…We go from 1,000 to 100 to 50. And then step four is just, when do we rebalance? That’s correct.
Meb: So, I think this is probably a good little segue, you know. We talk a lot on this podcast and on the blog about, you know, indexing and when you start to move away from the market cap index. And we often say, “Look, if you’re gonna be different, be different.” And so you guys have developed some pretty kick-ass tools.
You know, one feature on your website we’ve talked about before is your Visual Active Share tool. So for any of our listeners who probably missed our discussions on this, maybe you could start by giving us a quick synopsis of what that is. The general, you know, thought process behind it, and then, of course, what y’all’s tool actually does.
Jack: Yeah. Well, let me give you the genesis and kind of what how and why we wanted to build this tool, right? So, as you mentioned, you know, if you’re going to build a different portfolio, right? There’s two ways to go about it. One way is you just kind of closet index and, you know, you built something, call it value, call it momentum, but it’s really just the index.
The other way is you build a truly unique portfolio. And so the question is, for a lot of people, investors, and financial advisors in the marketplace, it’s really hard to get through what I call, like, the cloud of marketing, i.e. You don’t really know what you’re buying because you can kind of easily be, you know, duped by good marketing, right?
And so one way to measure it, there’s a professor, Martijn Cremers, has a couple of papers, and that him and the AQR guys argue back and forth about how good this measure is, but it’s called Active Share. And what Active Share is you basically examine the weight in the portfolio, and you compare to the weight in the market-cap weighted portfolio. And by doing this, you can create a measure that will vary from zero to one, where zero means you are essentially the market cap weighted portfolio, i.e., your vanguard, and one, or 100%, right, means that you are completely different from the market.
And so that’s great, but it involves math. And there is some question as to, do you really just wanna be different than the market? The answer is probably, no. You wanna be different but you also wanna have a tilt, right?
And I do recommend, you know, it’s called activeshare.info. Martijn Cremers has this pretty cool site. I recommend people to take a look at it. But as opposed to just doing this mathematical number-based formula that’s gonna range from zero to one, we were like, “Hey, this would be really neat if we could show for any given ETF,” That’s what we currently have. Just ETFs, U.S. ETFs, “in the marketplace, what the actual underlying stocks are in the portfolio?”
And what I mean by that is, on the X-axis and Y-axis, we allow anyone to pick what you want to rank something on. So you could rank it on market cap or, and book to market. And if you click on, you know, SPY, the S&P 500 ETF, you’ll see that it’ll plot all of the little stocks in there. And the circles represent how big each individual stock is in the portfolio.
And you can compare different ETFs in this tool that we built. So one could actually say, “Okay, well, you say you’re a value fund, let me compare you to the S&P 500, and see how different you really are.”
Meb: And the nice thing about that is that so many, you know, people talk about stuff on, kinda, subjectively, but when you look at the visuals of this it’s actually kind of striking because, there’s so many funds out there, what we call the closet indexers, and here’s kind of the big rub, is that you can buy a lot of the buy-and-hold market-cap weighted indexes for very, very low fees. S&P 500, 5 basis points. So 0.05%, you can get these funds, but a lot of the smart beta…Oh my God. Am I the first one that said it?
Jack: You are.
Meb: Son of a…
Jack: I’m excited now.
Meb: Oh, man.
Jack: I’ll get the most expensive mixed drink at the bar.
Meb: I’ve banned some phrases in the office. That’s one of them. Anyway, you can say it as many times as you want now. So, so many of these funds that get marketed, it had high fees, and they may not look like high fees, so they may only be half-a-percent or 0.8%, but you essentially are buying the S&P 500.
And so there was actually an interesting podcast between Bill Miller and Barry Ritholtz where Bill had estimated that something, like, 70% of active funds were really just closet indexers that charge, in the mutual fund world 1%, 2% a year. What’s the domain to go find this? Is it just on the Alpha Architect website?
Jack: Yeah. So on alphaarchitect.com, it’s if you click on the “Tools” button, you have to register and be a financial professional, but it’s free. But, yeah. You can check it out on our website.
Meb: So for investors, what’s the, kinda, line in the sand? Is there a particular number they should be looking for when they’re thinking of active share, or is it kind of some rules of thumb that you may give suggestions for?
Jack: Yeah. So I’ll give a couple things. So maybe just, let me go back to, kinda, what you just mentioned previously, which is, like, how high of a fee people are actually paying, right? And so we’re actually building a new tool. I hope it comes out at some point. And it’s a tool that Cremers has as well. It’s called Active Fee. And let me give you an example.
So pretend you have, like, a smart beta fund that charges 30 basis points, right? If you have a, let’s say, it has an active share of 10%, i.e. It’s 90% the market, 10% active, right? If we assume that you can get the market for zero, let’s just assume for simple math. That really means your active fee that you’re paying there is, like, 30 BPS divided by 10%. That’s 3%. What I’d say is I think people should try to understand how much they’re paying, what the active fee is, for the funds they are invested in.
And now, directly answering your question, you know, what’s, like, a good active share number? What I’d say is, and although I am a fan, and I think you are too, Meb, of high active share funds. Although I am, I would recommend that for each advisor and investor, understand that the more active a portfolio is, the more it’s gonna have a higher tracking error, right?
So let’s just say you’re an advisor and you don’t wanna deviate from the index by more than, you know, 50 basis points, you then have two options, right? You can buy a lot of closet index smart beta funds, right? And you’ll basically just bob around the index, or you can buy, you know, 90% S&P 500, and then on that other 10%, maybe buy some super highly-active funds. And you probably get to the same destination. So I think it does vary from person to person.
But personally, you know, if I want to track an index, I’d probably just recommend that investors pick a high percentage of passive, and then on whatever part they wanna deviate, pick a more active fund as, kind of, a satellite.
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Meb: We’re gonna pivot a little bit because we only have you for an hour, and we’re burning through time pretty quickly. I wanna talk a little bit about your new ETF. And we can’t really mention it online so we’ll talk about the research. But listeners, if you wanted to spell out the ticker name, it sounds, like, Voldemort. I don’t know if that was intentional, but the evil wizard from “Harry Potter.” So we’ll talk about the theory, and research behind the index.
And something, you know, our firm has in common with you guys is appreciation for, not only value and momentum, but also trend. And you guys wrote a great white paper called “The Value and Momentum Trend Philosophy.” And in it, you talk about, kind of, just what you were just talking about.
It says, “Our indices are designed with a unique segment of investors that are long-term oriented, willing to invest the time to understand our processes and have enough courage to sometimes be vastly different from the crowd.” So let’s talk a little bit about how you construct this into index and the philosophy behind the value momentum trend research.
Jack: Yeah. So basically, well, the value momentum piece is, we, kinda, spelled out earlier. We, kinda, use the same philosophy on value momentum, both in U.S. and international. And as I had mentioned before, you know, combining value momentum, especially when you use price momentum, like what we do, tends to have very good portfolio benefits.
So how we actually combine those two is, there’s, I would say, two recommended approaches. One is, like, a simple equal weighting, i.e., you know, 50% value 50% momentum. We’ve done that in the past. I would say for anyone at home that wants to combine the two, that’s the simplest and probably good idea.
What we do is we actually use risk parity between the two, and all risk parity does is a kind of…and these are equity, all equity portfolios. So you don’t get huge deviations of weights, but risk parity, generally, will slightly over-weight on average value relative to momentum. So, you know, usually it’s, like, 55% value, 45% momentum. But that’s clearly gonna deviate over time. So that’s how we combine the two.
And then the next aspect is something I know, Meb, you’re a fan of, with what you guys do as well. And we’d recommend, you know…I still remember reading your paper on trend, trend following a long time ago. But trend following, what do we do is we say, “Hey,” you know, “We just wanna be invested when the trend rules are positive.” So we look at 12-month, both moving average rules and time series momentum for U.S. and international indices and…
Meb: And explain what time series momentum for the readers if not familiar.
Jack: Yeah. So time series momentum is, it’s actually very highly related to a moving average rule. All it does is, it takes the total return to an index or whatever portfolio you have over the past year. So let’s say your portfolio is up 10%. You then subtract off the return to cash or T-bills. So let’s say it’s 1% now, right? And if that number is greater than zero, that would indicate you should be invested. If it’s negative, you would either sell or go to market neutral. And so we apply those rules on the S&P 500 and the EAFE indices. We don’t do it on the individual legs.
We get that question a lot, like, “Why don’t you apply the trend rules and time series momentum on value momentum?” And we, like, to say, “Well, one is, you know, the evidences doesn’t really add too much.” And the second thing is trend following, we think, is kind of like, it should be a broad thing where it’s, like, big news. So we try to look at the big asset classes, i.e. U.S. stocks, which is the S&P 500, and international stocks which is EAFE, and kind of use those as the indicators as to whether or not stocks are trending up or down.
Meb: And theoretically, you could potentially get some added benefit of your portfolio stocks versus the S&P as well. So if you’re using Futures or whatever it may be to hedge, you may get the additional benefit of staying in the equities that outperform the S&P over time.
So you put this all together, and I assume this sort of portfolio is probably totally long or mostly long at this point, right?
Jack: Yeah. Currently, it’s pretty much…well, it is. It’s long only right now.
Meb: Pretty much hundred per-, but everything is going up this day and age. All right. So you have listeners of the show and be like, “Damn. Everything you just said makes a lot of sense.” And you guys have even written a book on this topic called “DIY Financial Advisor” that touches on a lot of the themes of rules-based portfolios, as well as doing it on your own, as well as potentially hiring an advisor, robo-advisor, automated advisor which, you guys also have one.
What are your thoughts on the, kinda, do you look across the universe of robo-advisors, you know, you guys, what you’re doing is quite a bit different in individual account solutions as well as the ETFs. Jack, what’s, kinda, your experience and thoughts on the best way to implement it for people? Or is there a best way?
Jack: Yes, so I think, you know, for each investor, probably the most important thing’s understanding their own behavior, you know. So as you mentioned, we have a robo-advisor that essentially runs a strategy very similar to the one we outline in our book. And a lot of times, you know, we even give the signals away on our website.
So, in theory, you know, if you read the book, you go to the website, and if you wanted to follow what the trend following on the asset classes, you could just do it yourself. So a natural question is, you know, why do some people sign up?
I even had a guy today I was talking to on the phone. And I said “Well, you know, you really could just do it yourself.” And he responded, “Well, I don’t trust myself.” And so, I think the robo is good because, in general, it’s a low fee. So ours is 25 BIPS. I know, Meb, yours is zero. I think there’s a small fee that you have to pay as well for betterment. But pretty much, it’s cheap, right? It’s cheap asset allocation that one can get.
As you mentioned, there’s different solutions, so, you know, Vanguard and other portfolios, they’re, kinda, just buy-and-hold portfolios. Then there’s other firms, like ours and yours that, kinda, have different portfolios that are, I would say, more customized, and definitely different than your standard just buy-and-hold portfolio.
Meb: It’ll be fun to watch it play out, you know. We’ve been a kind of, a commentator, observer, participant, in this space for many years now. And, you know, the big commentary for a lot of the critics has been that the automated solutions will really struggle during bear markets because they don’t have the human element. And so it’ll be kind of fun to see, you know, every bear market has a different personality.
You know, 1987 crash looks different than the 2000 bear market, which looks much different from the 2007. So, it’ll be, you know, fun is not the right word, but it’ll be interesting to see how it all plays out, and particularly the tactical solutions, like we both have, versus the just buy-and-hold etc., etc.
So let’s get to, sort of, the potpourri round where we have a handful of shorter questions as well some tweets have chimed in with their questions, with some shorter ones. You have done a significant amount of research for a pretty young fellow. What are you excited about most, looking forward? You know, can we pull aside the curtain? Is there any things you’re working on? Any unanswered questions you have that are particularly on the forefront of your brain?
Jack: Yes. So, I mean, things that I get excited about is just, I really do love that Visual Active Share tool we have, and we’re probably gonna build some other cool tools to help advisors and investors pull back the curtains for funds.
And I’m just excited in general about, I think, there will be in the next, you know, well, I think as millennials start to gain more assets as well as, you know, try to influence more decisions, you know, more data-driven decisions and more transparency as to, like, what one is buying.
So, kinda, the tools on our website, I think, are, like, very beneficial to anyone who really wants to invest in ETFs. I don’t know. I think that’s, kind of, exciting where you can now go in and be like, “Oh, well. I thought that ETF was a value ETF but I realize it’s really just buying the S&P 500. So maybe I will buy something else.”
Meb: So a similar question, and this is kind of tangentially related, maybe too close. But it says, “Being a quant, with so much market data has been mined already? Is there an area that you believe still holds a final frontier, that the, kinda, quant can go, to experience certain type of gains?” Any thoughts there? Is that secret sauce?
Jack: In public equity markets?
Meb: I don’t know. That was the question I read. So you can interpret it. You can apply it to sports betting. I know you’re a sports fan. Have you ever turned your lens on quantitative sports betting at all?
Jack: I have not. I think probably because I’m more concerned that I will become fully enthralled and do nothing else but spend all my time on that. And one day, I do look forward to doing that.
What I’d say is anything in general where there’s, I would say, from a data standpoint, some sort of market friction or arbitrage is probably the best spot, as far from a quant approach, you know. If you can just create a better way to get around that friction or arbitrage but…
Meb: Well marinate on it. We’ll have you back on in a year and we can talk about it again.
Jack: All right. All right. Will do.
Meb: Speaking of rabbit holes. I mean, when I was living in Lake Tahoe once, and I don’t have an addictive personality, really. I remember buying…my roommates had a video-game system, and we were all varying degrees of, kinda, ski bums at the time. And one of them had bought Grand Theft Auto, and I played for something, like, 12 hours straight. It was the most depressing, I think, day of my life afterwards. And then, I just, we ended up returning the game.
I was like, “I can’t have this around. This is terrible.” So, sorta, similar idea on the sports betting. All right. So let’s move on. What has been the biggest greatest investing difference of opinion between you and Wes?
Or is this, like, Dr. Evil and Mini-Me. Are you guys, like, clones of each other, and where you’re just, like, always agree? Is there anything where you guys are, like, hacking back and forth, and you’re like, “Wes, you’re an idiot. We can’t be doing this,” or “You are a fool,” or vice versa.
Jack: I don’t know if there’s…
Meb: I mean, it’s kind of a loaded question because you guys tend to be pretty evidence-based, you know, yada yada. But is there anything that you guys ever, other than him tearing your ACL?
Jack: Yeah. Other than that, there’s maybe some stuff in commodities we slightly disagree on.
Meb: Oh good. So what’s your opinion on commodities? A lot of people, you know, we’ve seen this full cycle where everyone got hot and heavy about commodities in the mid-2000s. After they had that monster run oil trading in $150. And then, of course, every single institution and individual rushed into commodities, and now you have, kinda, the opposite happening where almost every institute…we just saw, Harvard is getting rid of all of their commodity exposures and, kinda, moving to a more passive allocation anyway. What’s your thoughts on commodities? I’d love to hear it.
Jack: Yeah, I mean, we kind of use it. We’re not just, like, standard buy-and-hold investors, I would say, in commodities, but more from, like, a trend follow, carry component. You’re right. A lot of people are getting out of the crisis alpha strategies, and it’s, kind of, it’s almost, like, who’s gonna be the last one standing there still running the crisis alpha strategy? I don’t know.
I think a diversified trend-followed, managed futures can be beneficial to a portfolio. The question is always, what is the size that you have it in the portfolio? As well as, you know, do you truly understand it? So a lot of times investors don’t understand that crisis alpha is great in crisis periods, but, you know, in non-crisis periods, it has a low CAGR, on average, with a high standard deviation.
So, you know, you’re right. If you started investing in some sort of trend-followed commodity or trend-followed future strategy in 2010, you’re probably looking at yourself saying, “All right. I’m seven years into this. What’s going on?” But, yeah. We’re still fans of it, just, we do have some slight disagreement within that realm.
Meb: And the big thing, too, with commodities, listeners, is that you have to distinguish too between really what’s essentially investable commodities. So you have the spot price of gold, whereas if you really wanna invest in most of these commodities, through commodity futures and a lot of the first generation commodity indices were developed not very intelligently. So they had no way to take advantage of the role, yield of the futures contracts. As well as some other things you mentioned, like, carry and trend.
And you’ve seen a lot of second-generation commodity indices that I think are much better, but also from a standpoint of a trend follower, I think that that makes even more sense in commodities. We could do an entire show on commodities. Maybe we will at some point. A couple more questions. “Personally, what is your most memorable investment or trade?” And this can be either positive or negative. Do you have one that particularly stands out in your mind?
Jack: What I would say is, yeah because I used to, like, probably everyone else in that listens to your show, at some point, and probably you still may be, you know, just a stock picker, right? And I would say, you know, now I pretty much just am a rules-based investor that invests in portfolios that are generated by rules.
But I will say that my last stock, individual stock that I owned was the Titanic. It was a, you know, Premier Exhibitions which is a stock that basically has rights to the Titanic. So, you know, I went down with that as they realize they couldn’t actually dig up the Titanic, and make all the money that my theory and research had led me to believe that they would be able to.
Meb: There was another thematic equity called Odyssey Marine, OMEX. Do you remember this one at all? This was a company that had the technology to go locate shipwrecks. And so they were going around and unearthing and finding treasure from shipwrecks that had, potentially, gone down with a bunch of coins. And they were actually really good at it. But the problem became not their business model. The problem became where they would get, like, detained by Spain.
Meb: So Spain would be like, “Whatever, that was our ship. It went down in the 16th century and we’re keeping all the gold.” And so they got stuck in court. I mean, I remember there were some former presidential candidates were investors. And, I have actually no idea if the company still exists or what has happened to it. But we’ll look it up after the show, post a chart on the show notes and look into it.
But I mean, you can’t imagine a better story for a stock, but my God, I don’t think the quantitative value filters would have ever picked it up. A couple of other Twitter questions, then we’ll wind down.
One question, you know, which is a traditional question is, essentially paraphrased is, “Do most of your quantitative methodologies,” you know, “you guys are targeting mid- and large-caps. So for an investor with ability to wade in the smaller waters, does this work in the micro-cap arena?” So looking at below $1 billion market cap. Have you guys looked at that at all or any thoughts there?
Jack: Yeah. I mean, a lot of the research, both ours and other papers, show that, you know, a lot of these anomalies work really well in micro-caps. Especially, if you’re gonna do, like, the long-short anomalies. And again, then the question is, well, what’s, like, the limit to arbitrage, right?
If you try to short a, you know, short a micro-cap stock or even just buy a micro-cap stock, you know, the bid-ask spreads and everything become sometimes, it can overwhelm the strategy. But, yeah. Definitely value investing works in micro-caps, it’s just there’s clearly a limited scale to that. So one of the reasons we don’t focus on that is just due to the scale issue.
Meb: And here’s another one. I’m gonna read the question and I’m not gonna let you answer it because the question is so wonderfully worded. It says, “When enterprise value to EBITDA underperforms, have you ever investigated why?” And I’m gonna kind of take that question. Feel free to answer. But massage a little bit [SP] and say, we didn’t really get into factor valuations. So, you know, Rob, and Cliff, and others, have chimed in a lot lately about, you know, certain measures.
And so you have a measure, like, enterprise value to EBITDA that works well over time, but due to flows and the fact that Alpha Architects got $20 billion into their funds, that may have pushed some of these factors to historically expensive levels, or historically cheap or whatever it may be.
Where do you, kinda, you guys stand? Where do you stand on the on the theory there? Is this factor timing something you think is possible? Is it something you guys implement at all? Or what’s the takeaway?
Jack: Yeah. I mean, our view on factor timing, and again, we generally just focus on value momentum is that, it’s next to near impossible. So we’re, kinda, more on cliff as a side [SP] I would say on this one, where we think it’s very hard to do.
You know, one thing we looked at, I wrote a post about it, said, “Hey, a great timing rule would be if,” you know, “valuation spreads between value and growth get really large, i.e., like, the cheap firms are a lot cheaper than the expensive ones. Maybe you wanna, like, switch to value. And then if they get narrow, you wanna just go to momentum because everything’s kind of grinding up.” I would say that doesn’t really work that well.
One thing that could potentially work, and it’s slightly, I don’t know if it’s statistically significant though, is just kind of using, like, a trend. So, you know, looking at value momentum saying, “Hey, value is doing better, let’s switch to that. Momentum may be doing better, let’s switch to that.”
But, we don’t do that for a couple of reasons. One is we, like, the overall, like, portfolio diversification benefits of having value momentum. The second is, you know, sometimes there’s tax consequences to doing such a switch. And, you know, we generally view everything, we generally deal with taxable investors. So, you know, making a drastic portfolio move and paying taxes on it is not in the best interests of a taxable investor.
Meb: Yeah, that’s just too much work.
Meb: You know, sometimes simpler is better. Jack, we got to let you go. It’s been a blast. Where can people find more information if they wanna follow you, your writings, your funds? Where do they go?
Jack: Yeah, so our website is alphaarchitect.com. My twitter is @jvogs02. And then, Wes and our company, where all our blogs come out is @alphaarchitect on Twitter. And, yeah. I’d say feel free to stop by our site. We have the free tools such as the Visual Active Share that I pointed out. And it’s, again, free for financial professionals to sign up.
Meb: So, everyone, lesson learned buy some Voldemort. Also pretend you’re a financial professional to get access to all Jack’s tools. Jack, it’s been a blast. Thanks for taking the time today. I owe you happy hour. Any time you find yourself in Los Angeles.
Jack: All right. Sounds good, Meb.
Meb: All right. Listeners, thanks for taking the time. We welcome feedback and questions. Send them to Jeff at firstname.lastname@example.org. As a reminder, you can always find the show notes. We’ll post a bunch of the links to the articles we talked about today, and other episodes at mebfaber.com/podcast.
Subscribe to the show on iTunes. If you’re enjoying it, please leave a review. We’re almost to 200. So I appreciate any and all things you have to say. Thanks for listening friends, and good investing.
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