CHRIS: Good afternoon, everyone.
Just a quick introduction
to our veteran guru
overall finance guy, Wes Gray.
WESLEY GRAY:
Thanks, Chris, and I
appreciate you inviting
me here to Google.
I actually have a huge
respect for the firm,
we use it both personally
and for business.
And I'm the founder
of Alpha Architect,
and our business is focused
on empowering investors
through education.
And part of our effort is
we do a ton of research,
including writing books.
And one book we've written
with a couple my colleagues,
Jack Bogle and David Folk, is
"The Do-It-Yourself Financial
Advisor."
And the thesis of this book is
that financial advice, as it
currently stands, is too
complex and too opaque,
but you can make it
simple and transparent.
And a potential thing
we should consider
is if financial advice can
be simple and transparent
and still be effective.
Maybe we don't need
intermediaries and all
these expensive advisors.
And so that's the
argument here, is
that do-it-yourself
is not for everyone,
but it's not impossible.
So what is the problem
with advice that's
too complex and too opaque?
Well, you make the wolf of
Wall Street really rich.
Why is advice complex?
Because complexity sells.
If I'm a broker or an advisor
and I say, go buy and hold
Vanguard funds
forever, you're going
to say well, why the heck do
I need you to be my advisor?
Why am I paying
you all this money?
So advice has to be complex,
even though it may not work,
because it sells.
So this is what
we face out there.
What is the problem with that?
Let me orient it to this slide.
So on the x-axis you
have Goldman Sachs,
which epitomizes the
smartest people in the room.
If anyone can beat the
market, Goldman Sachs
should be able to beat
the market, right?
And over here on
the right you have
Vanguard, which is the exact
opposite of Goldman Sachs.
They don't even try
to beat the market,
they say we're going to
deliver you the market exposure
at the lowest cost possible.
On the y-axis right here, we
have the percentage of funds
by these respective
entities-- the smartest people
in the room and Vanguard.
And these are the percentage
of funds that over the last 10
years-- from '04 to 2014-- that
beat their respective benchmark
indices.
Goldman sits
unfortunately around 10%.
So 1 out of 10 funds provided
by Goldman Sachs-- which is just
an example of the smartest
people in the room--
doesn't beat the
passive benchmark.
Whereas Vanguard over here has
a hit rate of around 45% to 50%,
which makes sense.
If I'm not trying to
beat the benchmark,
I'm going to have some
that wins some that lose,
but on average I'm
going to be average.
Great.
What do you notice
between these two folks?
The key difference is the
average fee charge-- 120 basis
points or 1.2% for the
average Goldman fund,
17 basis points for the
average Vanguard fund.
So 1/6 the cost with
way better performance.
And as Jack Bogle says here,
who's the smart money now?
So just because you are really
smart and you're an expert
and you have all
the expertise, that
doesn't mean that your
clients end up winning.
You may win, but the
clients may not win.
So we need to consider this.
And this is the problem
with too much complexity
and not enough transparency,
is the wolf gets rich.
We don't, as the clients.
So what is the solution?
Well, the reality-- just from
an evidence-based perspective--
is that financial
advice can be incredibly
simple and transparent.
And the simplest
thing that we could do
is what we call the
60/40 portfolio.
60% in a global stock index,
40% in a global bond Index.
You could probably manage
this in your underwear
from your dorm room for 15
to 20 basis points, right?
Totally easy and actually
really effective.
If you look historically,
this portfolio works.
So if anyone's going to
add layers of complexity,
they need to be benchmarked
against the cheapest,
most liquid, and simple
porfolio that one can imagine.
And I'm only going to
believe your extra complexity
if you can show me via evidence
that it actually is superior.
One of the biggest
challenges to DIY the expert.
Don't listen to
experts and be very
skeptical of what they have to
say for the following reasons.
One, experts know that humans
suffer from behavioral bias.
So at another point in my
life-- almost 10 years ago--
I actually got to hang
out with the Iraqi Army,
and we have two types of people.
We have the rational
people-- which
I happen to be part of this club
this time, usually I'm not--
we have irrational people.
What do rational people do?
Well, we wear our Kevlars.
Why?
Because if this hut back here
gets smashed with a mortar
and a piece of cement goes
blazing toward your head,
you want to have
something protecting you.
So you wear Kevlar.
We also bring extra ammunition.
Why does that make sense?
Well if you get shot at, it'd
be nice to shoot back, right?
So we've got to bring
extra ammunition.
We also need to bring a
source of water-- which
I don't know if you can see
on these two rational folks
here-- because in 125 degree
weather, if you're not drinking
and hydrating you're
going to probably die
of heatstroke before you
die of an IED or something.
So rational people
in this environment
do this sort of stuff.
Then we've got
exhibit B. No Kevlar
because wearing a Kevlar--
it's heavy, it's hot,
why would I want to wear that?
I'm going to hold it.
Ammunition?
We don't need ammunition.
It's heavy, it's hot, I
don't want to carry it.
Leave that back at the barracks.
And of course, don't
bring a source of water
because in Arab culture
over there-- especially
within the military ranks-- it's
kind of weak to drink water.
So we're not going
to do that, right?
What's the point?
The point is when we're
in distressed, emotional
situations, we sometimes
do irrational things.
And that's not to say
that in a financial market
it's like being in a combat
zone, but in many respects
it is.
Because it's emotionally
charged, people on CNBC
are saying the world's
going to blow up,
and this is going to
inspire bad decision-making.
So remember this, we're
influenced by bias.
Even smart people that work
at Google suffer from bias.
The other thing we've
got to recognize
is that humans love stories
at the expense of evidence.
So we've got the
fancy-schmancy hedge fund
manager who's got his yacht and
his house in Martha's Vineyard.
He's like hey, all
you've gotta do
is do what I do and
you can have this, too.
It's a great story-- good enough
for him, good enough for me.
Even though the evidence
says time and time again
when we buy expensive,
overpriced products,
we allow the hedge
fund manager to afford
the yacht and the Martha's
Vineyard location.
But we don't get afforded
that location because we're
paying him all the fees.
It's a great story.
People have studied the
human belief in stories
at the expense of
evidence in great detail.
BF Skinner almost
60, 70 years ago
said why do human beings
believe in crazy stories
even though there's so
much evidence to suggest
that their beliefs are insane?
Why do they have
these superstitions?
So they look at the pigeon,
because the pigeon's
about as basic an animal
as you can get, right?
So what they do with these
pigeons, they say OK pigeons,
we're going to make you hungry.
And then we're going
to put you in a cage,
and every five seconds a piece
a bird seed's going to pop out.
And what do pigeons do?
Pigeons are random, so they'll
bee-bop around their cage.
And one will kick left, a piece
of bird seed will pop out.
All right, nice,
eat my bird seed.
Be-bopping around,
just by randomness
they may kick again to the left.
Bird seed popped out.
Pigeons start thinking
if I kick to the left,
bird seed comes out, right?
And they start
developing this story,
and they get this superstition.
And then the researchers say
OK, now that we've established
this story and this
superstition-- which is just
based on noise-- can
we untrain this pigeon
to stop believing that if
we give it enough evidence?
So start tweaking it
around where it actually,
systematically when it kicks
left, it doesn't get food.
And what they find is
that once an animal--
even a pigeon, and this
applies to humans--
gets stuck in a story, trying
to give them a lot of evidence
to convince them they're
wrong is actually
incredibly difficult.
Because stories sell.
Why is this important?
Well, consumer
beware-- experts are
very well-trained at
exploiting your bias
and very well-trained at
telling you great stories.
And the irony here is
that, in many respects,
I should be
considered an expert.
I don't know why, but
I was on the cover
of Barron's last week,
I got a PhD in finance,
I've written four books,
I'm doing all this research.
So I'm the expert telling you
to not listen to the expert.
Which is actually the best
advice you could possibly
get from this discussion here.
So everything I say, make
sure it goes in one ear
and out the other, right?
So with that disclaimer up
front, let's analyze how
can we potentially add
evidence-based solutions
that can improve this
so-called 60/40 porfolio?
And there's a lot of
metrics we can look at
to try to improve
this thing, but we're
going to focus on two here just
because of time constraints.
And one is asset allocation.
So trying to determine
how much stocks do we own?
How much bond, how much
commodity, how much whatever?
And the other one
is stock selection.
Do we just go buy
a Vanguard fund
or do we try to
become Warren Buffett
and pick value
stocks or whatever?
So we're going to walk through
both of these in detail
and discuss how and why we
may want to add complexity,
or maybe we don't want
to add complexity.
So first, asset allocation.
So before I tell you
what's going on here,
this paper is a 2009
paper in the "Review
of Financial Studies."
Which if you don't read
geeky finance research,
you probably don't
know what it is.
But it's a top
tier, A publication
that all the finance
professors have to be aware of.
And what this paper shows--
or what these authors attempt
to do-- is they
say listen, people
who've won Nobel Prizes for
these ideas of mean variance
analysis and modern
portfolio theory-- which
are rampant throughout society.
I teach it in all of
my classes, everyone
has to teach modern
portfolio theory.
But they asked a
simple question,
does this crap actually
work in a practical sense?
And they say, you know
what we're going to do?
We're going to look at the 1
over N rule-- equal weighting
of portfolios.
So if we have 10 assets-- i.e.
N equals 10-- let's just
put 10% in each asset
and use that as our
asset allocation scheme.
And we're going to
compare that against all
the whiz-bang fancy models
that have been published
in academic research,
with tons of math
and nice closed-form solutions,
all these good things.
And I'm just showing you
an example right here,
and I'll just read
what the authors say.
Of the 14 models we evaluate,
none is consistently
better than 1 over N rule.
That is remarkable.
All that brain
damage and power that
went into solving this stuff
that wins Nobel Prizes gets
published, but has absolutely
limited practical benefit.
That's remarkable.
They're basically saying
this stuff doesn't work.
Here's some of the evidence,
just to give you one example.
They do this across
multiple asset classes.
It's an academic
journal, so they've
got to do robustness tests
until they're blue in the face.
But since you're
on the x-axis here,
you have the Sharpe
ratio-- which
if you're not
familiar with that,
it's just a risk-adjusted
benefit, higher is better--
and they compare fancy
models against 1 over N
when they're looking to
allocate across S&P sectors.
So you have utilities,
financials, whatever, energy.
We could use a fancy
optimization model
to try to pick and
choose the weights,
or we could just do 1 over N.
And remarkably 1 over N-- which
is insanely easy and robust--
has the highest Sharpe ratio.
So not only does it
equal their perform,
it's actually beats
most of these things.
What's the bottom line?
When it comes asset allocation,
complexity does not work.
It's just the evidence.
So if someone tries
to sell you something
that sounds really cool,
it probably is really cool.
Remember, the evidence
doesn't back or support
that it probably
works out of sample.
So what could be the
implication of that?
And this is just an example,
and these are all frameworks.
I'm not saying you should
do this or your shouldn't.
But we have our
baseline 60/40 up here,
and we know that doing
things that are crazy complex
don't really add much value.
But maybe we can add
one degree of complexity
to build a little bit
more robust portfolio.
So one idea out
there is presented
by Meb Faber and Eric
Richardson in a great book
called "The Ivy Portfolio."
I think Meb's actually
spoke here before.
And what he shows is
something really compelling.
You can capture 90% to 95%
of the returns of endowments
and very sophisticated
people by simply
allocating-- in an
equal weight fashion--
to five asset classes.
Domestic equity,
international equity,
real estate,
commodities, and bonds--
which you could buy some
ETFs for next-to-nothing
and capture the world's
risk premiums simply.
What I do here is just map
that concept into this 60/40,
and tell you why this might
make a little bit more sense
at the margin than
a generic 60/40.
You still have
your 60 over here,
divvy it up-- domestic,
international--
why does that make rough sense?
Well, that about approximates
the market capitalization
of US securities and
international securities.
So you're kind of passively
capturing those risks.
And instead of doing 40%
all in on a fixed income
instrument, what happens
if we turn into Zimbabwe?
I'm not saying
that would happen,
but there's a risk that we could
have a hyperinflation element.
Maybe for our diversifier
bucket here and that 40%,
we just break it in half--
20% real, 20% fixed.
So instead of 40% fixed
income, maybe some real estate,
commodities, kind of capture
in real hyperinflation hedges,
and then stick with
that fixed income.
So a small tweak that
might make this portfolio's
overall architecture a little
bit more robust than 60/40.
Not to say that
60/40's bad, but this
may be one tweak you could use
to enhance it if you chose to.
So real simple.
I'm not even showing
results here,
but this is also effective.
All these things are
actually effective even
though they're insanely easy.
And they're also really
effective because they're
really cheap, too.
OK, that's asset allocation.
Next is stock selection.
And there's huge debates about
this, because the evidence is
very clear that
over time-- if you
look at the sample
of mutual funds,
they bascially deliver the
S&P minus a bunch of fees.
That's not a good
idea, so that's
why Jack Bogle says
well, let's just
buy the Vanguard
fund for five BPs
and you're going
to be better off.
Why in the heck
would anyone want
to try to be Warren Buffett?
And that's a really
good question
because as you'll find
out here, it's really hard
to be Warren Buffett.
And we also know that
for every active winner,
there's got to be
an active loser.
So when you get
down to active game,
it's not like there's
just free money,
just because you're smarter than
everyone you're going to win.
You're always
systematically having
to take from someone else.
Because in the end, it
basically is a zero sum game,
for all intents and purposes.
I happen to be a believer
in active stock selection,
and I'll tell you
my story of why.
So I used to hang
out with this guy.
His name is Eugene Fama.
He's now a famous Nobel
Prize winner, right?
I'm doing my dissertation at
the you University of Chicago.
I came back from
the Marines and I
was feeling happy about myself.
I was like, what
could I do that would
be so ridiculous at
the school that it just
would be interesting.
I'm going to try to show Eugene
Fama, the guy who basically won
the Nobel Prize for the
Effecient Market Hypothesis,
that this value
investing stuff works.
Because I've been reading
Warren Buffett, reading Ben
Graham my whole life-- I
think this is compelling.
I'm going to figure
out how to study
this in a nice, robust way.
So I go read 4000
reports submitted
through this organization called
valueinvestorsclub.com, which
is started by a guy named
Joel Greenblatt-- he was
a famous hedge fund manager,
famous value investor--
and I tabulate all
these results up.
And I have right in my one
chapter of my dissertation,
value investors have
stock picking skills.
Send it to our friend
here who's probably
the hardest working
man in finance.
And of course, he immediately
responds in email,
your conclusion has to be false.
I'm like, oh crap, that just
wasted a year of my life.
So I run down to Professor
Fama's office, I'm like,
what do we mean it's false.
Did I screw up in my
statistics or the study.
He's like Wes, calm down.
He's like, your
analysis is fine.
But you can't say that value
investors have stock picking
skills.
You have to say the
sample of value investors
you analyzed have
stock picking skills.
I was like, all right, so I
just got to change some words.
He's like, yeah, words matter.
I was like, roger that,
I'm out of this place.
Sign the diploma, I'm
out of the pain train
that you call the Chicago
Finance Ph.D. Program.
And I walk out of
that place thinking,
OK markets are not
perfectly efficient
because there is evidence that
some people have this ability.
And it seems to be compelling.
More studies that have come out.
So this is a study from Cliff
Asness and some of his friends.
Very compelling paper published
in the Journal of Finance.
Value and Momentum everywhere.
And they highlight
that value, which
is classified by just buying
cheap stuff everyone hates,
and momentum, which
is buying securities
that have strong relative
performance are everywhere.
They're in every asset
class you could imagine.
It's super compelling.
And I've written books
dedicate each of this.
So Quantitative Value is
a whole book dedicated
to systematic value investing.
We're interested in a manuscript
on another one on momentum.
This stuff is baked in the cake.
It has worked.
So the natural question
is valuable momentum
are open secrets.
They've been working
for over 100 years.
Why isn't everyone doing this.
And this gets to
the understanding
of how and why active
investments actually
work and are sustainable.
And we have to have
a whole framework
for this, called the sustainable
active investing framework.
And the best way
to think about it
it's like playing
at a poker game
when you're in
the stock markets.
We need to know at the
table who is the worst poker
player at the table, right?
Because we're going to need
to take from someone else
because it's a zero sum game.
But simultaneously,
you can't just
know who the worst poker
player is at a poker table
because if they're someone
way smarter than you,
you're also the fish, right?
So we need to know who are the
best poker players at the stock
market investing table and
what are their capabilities
and limitations.
Only when we can identify
the bad poker player, which
is usually represented
by investors that
suffer from some sort of
systematic behavioral bias
that actually can
influence stock prices,
and simultaneously we
understand the capabilities
and limitations of these
good poker players--
either people with billions or
dollars or resources and access
to all information in the world.
Only then can we identify
a sustainable active
opportunities.
And the bottom
line is real active
investing that works can't
be easy because it'll
get arbitraged out immediately.
Value investing is
a classic example
of how we can take all
that mumbo jumbo theory
and put a little meat
on the bones here.
So what is value investing, what
is the so-called value anomaly,
just to give you a reference.
So this is some results from a
paper we published a while ago.
Essentially, value
investing and the value
anomaly is this idea
that if you just
buy cheap stocks, like this
sort, 1,000 securities on PE
ratio, and you just
systematically every year buy
the cheapest ones and you
create portfolios where you also
buy the most expensive
ones, represented here
by Glamor-- top
20% most expensive,
top 20% cheapest-- over time
no matter how you figure out
how we're going to measure
value, you get this spread.
Of anywhere from 4%
to 7% in this sample.
That's each year.
If you compound 47%
for 40 years, that's
the difference between being
Warren Buffett and being me,
right?
You're going to be
rich if you did this.
So this is the anomaly.
You just buy cheap stuff.
So what is going on here.
So back in the literature,
value investing and this anomaly
can be explained by
one of two things.
Extra risk or maybe
it's mis-pricing.
How are we going to study this.
Well Lakonishok,
Shleifer, and Vishny,
in a Journal of Finance
1994 paper, do exactly this.
This was over 20 years ago.
They say, how are we
going to determine
whether this is because of
extra risk or due to mispricing.
So what they did is
they sourced securities
on book to market in this case.
Expensive to cheap.
On our y-axis here is the past
five years earnings growth
rates.
And you notice is a monotonic
relationship between price
and past fundamentals.
What is the implied
market expectation
embedded in these prices.
Well, these securities
are expensive because it
is necessarily implied
that that will continue.
Why else would you pay a lot
of money for a stock, right?
Why would you want
to buy Facebook
at whatever PE it is right
now, unless you thought
Facebook was going
to continue to have
this amazing growth, right?
So it's extrapolated
out into the future.
That's why these are expensive.
Similarly, down here in the
trash can, amongst the cheapest
securities that no
one really likes,
these are the dead
dinosaur companies
or whatever it might be,
they're dead and dinosaured out
and cheap because they've
done poorly recently.
And the implied
market expectation
is they're probably going to
do poorly in the future, right?
That's why they're cheap.
If everyone thought they were
going to do well in the future,
they would be over here.
They're not.
So we know the expectation
that's baked in the cake.
This is going to continue.
And this is going to continue.
Well what actually happens in
the future-- systematic, meaner
version in results.
The gross stocks never
achieve, on average,
what the market thought
they were going to achieve.
What was baked in the cake.
Similarly, cheap trash stocks
were expected to basically
all go bankrupt and on average
they never go all bankrupt,
the world gets a
little bit better,
and there's [INAUDIBLE] version.
So why does value work.
And why does growth
or expensive not work.
Because the price
valuation is essentially
proxying for a bad
market expectation.
So when you own
the cheap stocks,
and it turns out it's
not as bad as thought,
you essentially front
run a market expectation.
When the expectation changes you
make money and beat the market.
Similarly, these gross
securities here-- they're
expected to do Groupon example.
Go forever, oh,
you're only making 20%
you know returns on
your revenue, not 50%.
Chop you in half.
That expectation changed, you
underperformed the market.
So this is baked in the cake.
Mispricing explains
some component
of the value known, right?
Clearly there might
be some risk as well.
But you can't deny that
mispricing is in there.
So why the heck
don't we all just
go buy a bunch of cheap stocks.
Here's why.
It is painful and the best
poker players in the room
don't like pain.
So from '94 to
'99-- this is just
a performance of a generic value
strategy versus the broad index
when internet's going
crazz-- six years of getting
your face ripped off.
Do you think anyone
managing money,
either in a delegated
sense or on their own,
could stick to a program where
even on the cover of Barron's
they say Warren Buffett has
lost his magic touch, right?
Value investing in
particular in strategies
that actually have staying
power have to be painful.
Why is that.
Well a lot of this has
to do with the agency
conflict and the problem with
delegated asset management,
right.
Because if you give money
to an asset manager,
you gave him two options.
So you're giving this
money to this expert.
Option one, you
tell asset manager
I'm going to deliver
you a strategy that's
going to be the market
by 25 basis points a year
for the next ten years and every
year you have a little hedge.
They're like oh, that
sounds amazing, right?
Or you give option two.
I got a strategy
or system that can
beat the market by 5% a
year over the next 10 years
but I guarantee there's
going to be a three year
period where you lose to
this thing by 10% each year.
A delegated asset
manager who knows
his clients could be crazy and
focus on short term performance
may punt on this long
duration arbitrage
because there's too
much career risk.
And these career
risk-minded folks
tend to be the best poker
players in the room.
Because good poker players
get allocated upon a capital.
But we know they have
this agency conflict.
So certain strategies go right
to the heart of that conflict.
Where they know they
work but they're not
going to do because they want
to clip a coupon on basically
a closet indexing
strategy, right?
So good strategies that are
sustainable have to be painful
or everyone would do it
and the smart poker players
have already arbitraged it out.
So we mapped value-- and you
can do this with any strategy
if it's active-- into the
sustainable active framework.
Worst poker players
are basically
those that overreact to bad
fundamentals-- this company is
dead, blah blah blah-- that we
know on average fundamentals
never are as bad as
people think in extremes.
And people aren't going to
do this stuff, especially
in concentrated, heavy
careerists-laden format
because you get fired.
And people like to
keep their jobs.
So this is a place where
presumably, we know the edge.
And we know why others
aren't doing it.
But we need to have the
capital and the discipline
to actually stick
with this opportunity.
Because it systematically
got to be hard, right?
So active investing is
something that can work.
But clearly it's
not for everyone
and you really gotta think
hard about how and why it
can work out of sample.
So I hope everyone's
ready to DIY
because you've got your
[INAUDIBLE] allocation.
And you know stick simple, keep
robust, diversified, low costs
on stock selection.
Best solution for probably
90%, 95% of people
stick with the Vanguard Fund
because you're probably not
wired to be weird and crazy.
If you do want to do active,
know the sustainable active
framework.
Be wired to not be cool at
a cocktail party sometime.
And that's all I got to do.
But let's take a test
now, which will identify
whether you actually have the
capability to be a DIY investor
or not.
This involves a little bit of
interaction, which is good,
so we can wake you guys up.
So I'm going to ask you guys
to all stand up right now.
So everyone get
out of their seat.
And I'm going to tell you
what the situation here is.
So this is a time back in
2008 during a financial market
crisis.
I'm not going to
tell you when but you
all know that the
market blew up.
And if you think-- and this
is going to be monthly time
series popping out here.
So if you think that the next
return is going to be positive,
raise your hand.
If you think it's going
to be a bearish market,
keep your hands by your side.
So think about your
history, we're 2008 here.
Think about it and you could
Google it probably-- cheat.
What do you guys think?
So everyone everyone's
bearish here.
AUDIENCE: [INAUDIBLE]
WESLEY GRAY: All
right, so you're
a bull you got to sit down.
So it was actually bearish,
It was actually bearish.
OK, next period.
Think hard about
this, It's in 2008.
You don't know when.
So if you think It's going to
be bullish, keep your hand up.
If you think it was
bearish, keep it down.
A lot of bears in the room.
Bears got it, all right.
Next one-- I told
you momentum works,
we're standing here, right?
Just in the opposite way.
Bullish or bearish.
Raise your hand if you're
bullish, if you're bearish
keep it by your side.
A lot of bulls around here.
All right, all the bears
you got to sit down.
If you're bullish,
you're going to stand up.
We're starting to identify the
real stock pickers in the room
here.
All right.
Next one.
This is pretty good,
Google's got a smart crowd.
This is a lot higher
percentage than normal.
Bullish or bearish.
A lot of bulls.
Sit down.
So who's out geniuses
in the room here.
All right guys, are ready?
What did I just do to you.
I just manipulated
everyone in the room
with framing,
anchoring, availability,
and hopefully you
got to experience
that the human mind
is so good at trying
to interpret total noise
as actual signal, right?
And hopefully you just
experienced this where you
really felt like, oh yeah, '08,
it looks kind of like September
or what have you.
And that's why you got to
ask yourself, before you DIY,
you might need a
psychology coach.
Because unless you're
wired to follow a process
and hang on to it
like grim death,
there is a benefit to
having an advisory component
or someone that helps you
as a psychology benefit.
Which seems crazy that
you'd pay money for someone
to like keep you in line, but
that could be a huge value
proposition, right?
In 2008, if your advisor tells
you don't jump off the cliff,
even if they charge
a ton of money,
there's a huge benefit to that.
So really when it comes down
to determining, should I
do this myself and
save all these fees
and not deal with all these
idiotic expert people that
are just trying to sell me on
stuff, you've got to remember,
am I wired to actually
be able to do this.
And if you're not,
unfortunately, you probably
should go essentially hire
a psychology coach, right?
If you get real
rich or famous maybe
got to burn some money
on state and tax lawyers.
But that's really
your decision point
and hopefully this
made that clear.
So in the end our mission is
to empower investor education.
We facilitate this,
we offer free tools.
You want to do
some back testing,
you want to do your own
trading, go buckwild.
We kind of have a Google
mission on our blog
where Google's mission
is to essentially capture
all the world's data and make
it organized and understandable
for people.
We do that in the
finance context.
Where we read source journals,
decipher all the mathematics,
and try to see what is
the bottom line here.
So we're trying to
organize finance knowledge
so it's digestible and
understandable for people
so they make better decisions.
And then of course,
you know we're
a for-profit just like here.
If you get bored and you're like
this is a waste of our time,
we offer services
that actually help
implement some of these things.
But in the end we
don't really care
if you work for us or you do
yourself, our mission again, is
to empower investor education
and help the financial service
sector essentially be better
and serve clients better.
And we think that's done via
education and essentially
radical transparency about just
what works and what doesn't.
Because it's got to
change where it can't just
be opaque and complex.
To just get extra fees where you
win but none of the clients do.
We think the financial
industry needs
to be simple and transparent
and focused on educating people
so they make better decisions.
So thank you very
much for your time.
And I'll take any questions if
there are any in the audience
here.
Yes ma'am.
AUDIENCE: I think I missed
the point of [INAUDIBLE].
AUDIENCE: Hi, thank you.
I kind of missed the
point of the exercise
to determine whether or not
you're a do-it-yourselfer.
Isn't like the biggest
factor whether you're
OK with losing money for
long periods of time?
WESLEY GRAY: Not really.
It's really about how much
you can control, look yourself
in the mirror, and say yes, I
can control my own innate bias.
If you can do that,
do-it-yourself
is a great approach.
Because what we
see all the time is
an engineer is actually
a perfect DIY people.
Because they're kind of, in
general, focused on process,
robustness, and you
just stick to systems.
The issue is a lot of times
people build a system,
they're like, wow, this works.
And usually it
works because it's
in a sustainable,
active situation where
it works because it
sometimes doesn't work.
So we could do the back
testing, do the research,
we're like, oh yeah,
this is money good.
And you're like we're
going to do it forever.
And then of course, it
can't work all the time.
So the minute the quarter
comes out, the year comes out,
and you're like I should have
just bought the Vanguard fund,
should have just done this
or that-- if you don't
have that ability to
stick to that program
because you're letting your
innate bias start to move you
away from like doing the process
that initially actually added
value, that that's
why you sometimes
need an outside source
to help you do that.
And that's why there's a
lot of interesting business
models like Wealthfront
right now for example, right?
Those are great
solutions because there
are systematic, process-driven,
transparent, and cheap.
And that's great for a huge
segment of the population,
awesome.
The issue is, are
you the person that
can actually do that
or do you actually
need the psychology coach.
And as far as I know
right now, humans
are still the best psychology
coach for other humans
because when the machine says,
oh, stick to the program,
don't worry about it,
we're like, stupid computer
I'm going to throw it out.
I'm just going to sell.
And so that's a challenge
for like automated players
out there that are basically
delivering great solutions
but that's not the skill
of being a good investor.
We can all generate great
processes and great systems.
The skill is having
the discipline
to actually stick to the thing.
And some people
just need a human
to kind of be like, yo,
calm down, chill out,
and stick with it.
So that's why I'm
highlighting here.
Like, we all have this
weird bias and wiring that
can potentially run us astray.
And DIY is really
good for people
that can stick to the program.
But if you feel like
maybe you can't, that's
where you might need some help.
Or you could just go put your
money under a pillow too.
That's another way
to DIY but then
you're losing out
on the opportunity
to grow your wealth.
Yes ma'am?
AUDIENCE: I've recently
been thinking about things
like Wealthfront and
what's the other--
WESLEY GRAY: Betterment,
there's lots of them.
AUDIENCE: Yeah,
so they basically
do like they rebalance
your portfolio [INAUDIBLE]
I heard every month
or two or something.
WESLEY GRAY: Yeah.
AUDIENCE: And I'm wondering
what the advantage of that
versus just like, every
year, like you were saying,
just get like get those same
stocks or those same index
funds that they offer?
WESLEY GRAY: Yeah.
AUDIENCE: And just
leave them for a year.
What is the advantage of
doing that so frequently,
given that there might be
taxes associated with the sale?
WESLEY GRAY: Yeah so the reason
they do a lot of the trading
is probably related to like
tax loss harvesting, where
the idea is if you
have a loser and you
can realize that and
distribute that loss,
it can save you on taxes.
So it may be beneficial to
let winners kind of ride
and systematically
harvest losses
because you can use
those losses to offset
taxable gains in the future.
There's a fee you
got to pay for that
and there's frictional cost.
And you pay 25 basis
points for that.
And it could be nice because
you can distribute losses.
You can also pay
five basis points
and go buy the
Vanguard ETF, which
has 100% tax deferral
on it because it's
within an ETF structure.
You don't get short term tax
loss harvesting benefits.
So you can't distribute losses.
But it's deferred
capital gain forever
and only costs you
five basis points.
So I think you got
to figure out, OK,
25 BIPs, plus the underlying
fees of the thing,
let's say it's 35, 40 BIPS.
Versus DIY, maybe
I can do it myself
for 10 to 15 basis
points with ETFs.
And if that 15, 20 BIP
differential there.
And if you just
don't want to deal
with it because it's a pain
in your butt, fine, you know.
But if you do, you can make
an argument either way.
It's really about what's
the value of your time
and do you want to
do this yourself.
Or you want to do an
automated solution
and does that price
differential make sense.
I think if you're wired to
actually want to do this,
we always recommend people take
control of their own capital
because you care about
your money what else does.
You can basically do what
they do very cheaply.
But a lot of automated--
they're just not that expensive.
So it's more about a question of
what's the value of your time.
What you probably
don't want to do
is pay someone a
huge fee to do that.
Like maybe for 25
basis points you
can invest in low cost funds.
But I don't want to
maybe pay someone
100 basis points to do that.
That differential is too high.
And if you're really
cheap, you don't even
need to pay the 25
BIPs, you can just
buy them direct and totally
dis-intermediate everything.
And people should do
that if they want to.
Why not?
AUDIENCE: Can you explain how
value investing and momentum
investing are in contradiction.
Because momentum
investing you would
have picked those top
stocks but [INAUDIBLE].
And with value investing, how
you account for account loss--
I mean selection bias where
companies have disappeared
from the data [INAUDIBLE].
WESLEY GRAY: Yeah
sure, so to the data
question-- most
researchers enact--
they use crisp
data, which is they
have whole teams that try their
best to eliminate this problem.
Where they get backfill
delisted the data.
They have someone go hunt
down like was that because it
was a merger acquisition,
was that because they
went bankrupt, what have you.
So that is kind of the gold
standard for doing research
because we got to account for
this delisting bias, right?
And I think that's pretty well
fleshed out at this point.
That it's pretty
good, it doesn't
have survivor bias in it.
So the next question is
how can you simultaneously
have value, which is essentially
an overreaction to-- we spend
like a whole book
explaining this
so I'll try to do this as simple
as possible here give me a sec.
All right, so value
essentially seems
to be driven by an
overreaction to crappy news
in the short run, right?
That systematically
mean reverse.
And in theory we
make money on this
because of mispricing because
that cheapness is essentially
a proxy for market-wide
expectation errors.
That we can use to use
that proxy as a signal
to front run future market
expectations, right?
Where people are
like, oh wow, you
know IBM is not going bankrupt.
It's obviously not
going to become Google
but it's not as bad as
expected and you make money
on the expectations
change, right?
Momentum it turns out
it's a lot more complex.
I think in the psychology
people are even
a researcher are trying to
figure out the vast proportion
of the empirical evidence.
And I literally just
got done doing this
because I just
wrote a book on it,
is actually a
momentum, ironically,
is actually the opposite.
It's an under-reaction
to good news.
So this price signal comes out.
And you see this
price signal keep
doing really well relative to
other securities out there.
And prices tell you a lot about
information in the future.
It's saying hey, this
thing is really good
and it keeps going up.
But for some reason, it
should be worth here,
and the thing is moving up.
But it doesn't immediately
go to fundamental value.
There's like this
systematic under-reaction
to this good news
that's coming out.
And you can map that back
to like unexpected earnings
releases and everything.
So they're actually
kind of the same idea.
One is just an overreaction
to crappy news.
The other one is essentially an
under-reaction to positive news
that's associated
with prices only.
The value anomaly
right here, remember
this is a price relative
to a fundamental.
So that's why this is growth.
And this is value.
Momentum has nothing to
do with fundamentals.
Only price.
And if you actually look at
the overlaps of portfolios
between growth securities
and high momentum
securities-- the name-
they're actually really low.
And you also see it in the data.
Growth portfolios under-perform
the market by a wide margin.
Momentum portfolios
kicks the markets butt.
It's volatile as
heck, and it's crazy,
but that growth in
momentum, even though they
sound the same-- and most
people even in industry
don't understand
this difference--
they're totally different.
Growth is about price
to the fundamental,
which is a quotient.
Momentum is all
about price only.
And you can sometimes have
value stocks be momentum stocks,
right?
Similarly, you can have
expensive stocks be high
momentum stocks.
But momentum and value are kind
of different ideas out there.
But it's very nuanced.
And unless you geek out
and do source journal
literature-- a lot of people are
like momentum is just growth.
That's not true.
Especially when you define
momentum as actually
it's defined in
the literature that
captures the actual anomaly
that everyone's talking about.
I don't know if that
answers your question, but--
AUDIENCE: I mean
it's like you're
using price too, its PE--
WESLEY GRAY: For this, yes.
Yeah, exactly.
AUDIENCE: It's
surprising that that
correlates so well with the past
five years earning potential.
It seems highly unlikely
that just doing that ratio
can give you such a nice graph.
WESLEY GRAY: Yeah.
AUDIENCE: [INAUDIBLE] to
relate to growth, which
is just based on price, right?
WESLEY GRAY: Well,
priced earnings.
Yeah.
So this is a price
to fundamental ratio.
And like I said, that's
one of the arguments
of why this works.
It's because price
to fundamentals
basically proxy for an
expectation problem, right?
On the growth side,
people think it's
way better than
it ends up always
being on average yet in value.
But then again, momentum,
and this is a very new--
and if I had a white
board I could actually
like write this up or little
better-- it's only about price.
And there's a lot of
really interesting theories
because one of the
things-- and this
is something even I
don't fully understand,
I don't think anyone
does, I'm just
trying my best to finally
get it-- in general,
values sink in
about fundamentals
and prices move around
a fundamental, right?
That's kind of at
the core theory
of how this whole game works.
But you know, George
Soros and some
these guys they had this
idea of reflexivity.
And I think you can see
it in Palo Alto, where
prices might actually reverse
influence fundamentals, right?
For example, LinkedIn, just a
while ago before they blew up,
the price was way high.
You could have your
options to your employees
and that's fundamentally good.
Price goes down
50%, let's just say
that wasn't even
fundamental-related,
how are you going
to attract talent.
You know you've got all this bad
PR out there like, ah, LinkedIn
is dying.
And now just the
price movement itself,
even if it was
non-fundamental-related
can actually fundamentally
affect the firm, right?
So there's one cause going from
fundamentals to price action.
But I think more
and more-- and this
is where it gets confusing-- you
can argue, I think justifiably,
that prices themselves can
influence fundamentals, right?
If you have a high
flying stock and you
go sell stock equity
for way overvalued,
you can fundamentally
create value for this firm.
Because I used to
be like totally
in the religion of
value investing.
And it's has taken me
a while to come around
to this whole momentum thing.
But now I'm thinking, OK,
it's not just fundamentals
and then prices move around you.
Its prices can actually
influence the fundamentals.
And if prices are moving up
and let's say fundamentally
that's just the price signals
making the fundamentals change,
this can be a proxy for
maybe non-linear benefits
that the market doesn't
really appreciate yet.
Because stocks moving up,
oh wow, our cost of capital
is way lower than it used to be.
Because everyone
just loves our stock,
even if they overvalue it.
That's great because
I can do acquisitions
cheaper than the other guy
who has crappy price action.
Because his cost of
capital is higher.
So that momentum could
actually indirectly
be affecting the fundamentals
but the market's not really
appreciating that yet.
And so I think momentum
is way more complex.
That's why I think it
also works a lot better.
It actually works way
better than value.
Because it's totally
counter-intuitive.
Who wants to be the bag holder
on a 52 week high stock, right?
There's disposition effects.
Most people, when
it's moving up,
they want to book
the market, right?
So you have supply shocks coming
on when things are moving up.
Wheras when they're
moving down, everyone's
like they want to hold it.
They're like, oh, we don't
want to realize that loss.
It's too painful.
So there's a lot of weird
psychological things
that they are involved
with momentum.
And like I said, I don't
think anyone understands it
as explicitly as value,
which is a little bit easier
to understand.
Momentum is somewhat
interesting.
And it's certainly
one part behavioral
driven, certainly
one part risk driven,
because it's way more volatile.
It's really interesting.
And the value-momentum
combination
is really interesting
because they're
unrelated to each other.
That's another
anomaly in itself.
Value is kind of anomalous.
Momentum is kind of anomalous.
When you put them
together, because they're
like yin and yang, you get all
these weird portfolio benefits.
And no one can explain that.
That's totally like a puzzle
in research right now.
Sir?
AUDIENCE: You, with the sort of
burgeoning momentum strategies
[INAUDIBLE], do you
think that momentum
will be [INAUDIBLE] away?
WESLEY GRAY: No,
because I think momentum
sits in that sustainable
active framework.
And this is really how
all these things work.
So momentum-- it
seems pretty clear
that there's some behavioral
mispricing component.
It is so painful to write.
Like value is kind of painful.
Momentum you will
die sometimes, right?
And that's what you want.
You want strategies
where you've got
to be the last bag holder
that's willing to be like, no, I
understand how and
why this works.
And I want to see it
be horrific sometimes.
Because now I know
it's sustainable.
Whereas if I have
a strategy where
like I do all this
research and it just
makes money like a
Maddoff return stream,
I don't want to do that.
Because there's
tons of physics PhDs
that are going to figure that
out and arbitrage that away.
So we want systems that
are mechanically exploiting
some behavioral issue but also
really painful for basically
delegated asset managers
to really follow
in their purest form
because they lose their job.
But that's good because you
don't have all the capital
competing in a way.
And momentum is
totally hair-raising.
Like, if you're a concentrated
momentum player that's
trying to exploit
this anomaly, you
are going to get fired a lot.
Same thing with value.
If you're a like a Warren
Buffet-- Warren Buffet
is unique because he has
kind of captured capital.
But if you do strategies like
him, people every few years
are going to think, oh,
Warren Buffett such an idiot.
What a dope, you know.
Like he's under-performing for
five years or whatever it is.
That's actually the
greatest signal ever.
When you see redemptions coming
out on strategies that you know
work because they exploit
the systematic bias problem.
Because that's why they work.
Because the people that
used to believe in them
and went on the
active side, give up,
and then they contribute
to the very anomaly
they're trying to exploit
because they're selling out
at the worst possible time.
And you've got to be that weird
person that's the bag holder.
And that's why active
investing is insanely hard.
Because you've got
to be a weird person.
And that's why most people
should go buy Vanguard funds.
And most active
products you buy are not
going to be the
active products that
work because they're basically
closet index funds that
essentially just do what
the Vanguard funds do
but more expensive.
You want active
things to be insane.
Where you just feel painful
sometimes to be in this thing.
Because then they're
going to work.
Because they're sustainable.
And so it's like a
weird dynamic game
that you have to think through.
So it's not easy.
Sir.
AUDIENCE: Is it possible the
value anomaly now is gone?
Because it's under-performing
for a long time now.
WESLEY GRAY: Yeah.
AUDIENCE: And even
Eugene Fama himself
said that the pace
of communication
is a lot greater now
because of the internet.
When the [INAUDIBLE]
were done, there
was no internet in most
of the time period.
WESLEY GRAY: Yeah.
AUDIENCE: You think that
fundamentally, things might
have actually changed now?
WESLEY GRAY: Well I think
the actual evidence right now
is the exact reason.
It's like the exception
that proves the rule.
Values underperformed and
so if all of a sudden I
saw a massive capital inflows
to value funds right now,
I would be afraid it was
getting arbitraged away.
You see the exact opposite.
Values dead, what
a dumb strategy,
you see redemptions coming out.
Which is exactly in line
with why the thing works.
And to the information
thing, I actually think
all the information, the
ability to like go on Robinhood
and buy a stock
like on your phone,
watching CNBC, tons of
info, all it's doing
is giving people
availability bias.
Because true, active
opportunities--
they're basically
long-duration arbitrages
that have a lot of
noise in the short run.
And if you match
short-duration capital
with a long-duration
opportunity,
they end up contributing
to the anomaly.
And the more information
is available,
the more people can buy
and sell at their whims
and their emotions,
in my thoughts,
it's actually making
these things worse.
Like the more you have
availability and access to edge
that will give you
overconfidence in whatever idea
or story you're
believing in, I think
it's going to make these
things even better, frankly.
Because now anyone can go buy a
stock they like in an instant.
They can go do
their own backtest.
And if people just go
backtest willy-nilly,
without understanding
robustness, frameworks,
like competitive dynamics
of market places,
they're going to just
backtest-- oh wow,
this is like easy
money, start doing
that-- it's just contributing
more and more to the problems.
So I think they're actually
more sustainable now.
I think information just forces
people to make worse decisions.
Because it's more available.
It's more in their face
they've got more saliency
and they just make
worse decisions.
And empirically, we
could investigate
how and why these anomalies
would get arbitraged away
because at the exact worst
time when they stop working,
if you saw tons of
capital coming in,
I would be really worried.
Because that means the
people are being smart.
But you see the exact opposite.
Fun flows away from the
short-term losers all the time.
And that just contributes
to this thing.
And it also attributes
to why the best poker
players don't want to do it.
Because they're losing
assets and losing their jobs.
Sir.
AUDIENCE: I got a question
about active investing
in terms of how
to read momentum.
I mean, for value it seems
like you could fairly
straightforward price
the fundamentals
and determine what's
cheap and expensive.
But I mean momentum, do you
read technical indicators
to get a sense of
what is that or are
you looking at momentum against
the actual fundamentals?
You said it's just based on
price, so I assume mostly
[INAUDIBLE].
WESLEY GRAY: Yeah, yeah, so
it's just pure price-based.
So the classic academic
anomaly that's momentum
is essential what you
do is, every month,
say you have 1,000
securities, you just sort them
on their past 12 month return--
just to keep this really easy.
And it turns out that those
that are in the top say, 100,
tend to outperform
the next month, right?
And those in the bottom 100--
they were relatively weak
and tend to continue to
under-perform, right?
And you keep doing
this every month,
you get this huge
momentum spread.
Very simple, just 12 month look
back, sort, you get the spread.
That's the most generic
version and that itself
is really effective.
But it's also painful as heck.
Now I have a whole
book about this
but, if you believe in
the behavioral theory,
and you think it's an
under-reaction to fundamental
news or fundamental
information that's
going to impound those prices.
And it's just empirical facts.
You can Google it, it's
called Frog in the Pan.
It's the name of the algorithm.
The idea is that if the frog
is in the hot boiling water,
they immediately know
and they jump out, right?
You can also put a frog in
water and slowly heat it up
and then they get killed
in the end, right?
Because they have limited
attention to what's going on.
They don't feel it.
So same thing with momentum.
If you tweak the algorithm where
instead of just generically
buying all the best
relative performers,
those top 100, what happens if
you have a biotech in there.
It's up 100% because
yesterday it got FDA approval.
That's like the
frog feels the heat.
It jumps out.
Everyone knows about, it's
on CNBC, it's all great.
But what about these
momentum stocks.
They're in the high
momentum bucket
but they're just
slowly grinding there.
It's like more of
a stable momentum.
It's just like you see this
price movement, like 50
BIPs over 200, 300 days.
Versus like the ones
that just go up in a day.
Well it turns out that
the momentum anomaly
is almost exclusively driven
by those securities that
are in that high momentum bucket
that had that slow grinding
momentum.
Because if you get like the
biotech that shoots up 100%,
those are efficient
market price.
They're just high risk,
high reward deals.
And that goes back to
the behavioral bias.
It's an under-reaction to news.
Where when you see the FDA
approval, it goes up 100%--
everyone sees it,
everyone reacts to it.
Whereas this small grinding
kind of information
that's being released
over time that's more
likely to be under-reacted to.
And that's exactly what
we've seen in the data.
It's still painful.
But that's all you do.
You don't need to
make it that complex.
And there's some seasonality
things and what have you,
but you just e-mail me
when the book comes out,
[INAUDIBLE] there's a
whole book dedicated to it.
But the summary is a
slow moving momentum
is better than wacky moment.
Question?
AUDIENCE: [INAUDIBLE]?
WESLEY GRAY: Yeah.
AUDIENCE: If you have
the opportunity of time
on the other axis, mean
time of investment,
and suppose for our
401k type thing,
[INAUDIBLE] type of investment,
will you go to 100% stock,
rather than 60%-40%?
WESLEY GRAY: Yeah.
So this is just a generic
endowment portfolio.
But you're going to always
get the most tax efficient,
highest risk-free
associated with equity.
And you can really juice
that with valuable momentum,
especially working in a system.
This bucket over here is
the diversifier bucket.
So if you really
have 30 year horizon,
and you can really
stick to that,
then no, it doesn't make
sense to have diversifiers
because you only have
diversifiers because you may
have a liquidity need, right?
And the reason that matters if
you have a lot of volatility,
but you might need
to take liquidity.
Well, the thing blew up and
I need to take liquidity,
I'm screwed because we
do it at the bottom.
But if you generally
don't need to touch
this thing for a long time
and you have the discipline
to deal with the fact it's
going to go all over the place,
you should have
less diversifiers
and exploit your long
duration capability.
But you've got to make sure
you're mentally wired to know
what you're about to get into.
But yeah, you wouldn't
want to do this.
It's like a young person that
doesn't need that capital
for 30 or 40 years.
AUDIENCE: [INAUDIBLE].
So some of us who have investing
by buying Berkshire Hathaway
stocks?
WESLEY GRAY: By buying what?
AUDIENCE: Berkshire
Hathaway stocks.
WESLEY GRAY: What is it?
AUDIENCE: Berkshire.
WESLEY GRAY: Oh, Berkshire.
Yeah, yeah, got it.
AUDIENCE: And then
they see the news
that Warren Buffet himself says
that OK, for my [INAUDIBLE]
I leave some and I will
leave it in [INAUDIBLE].
WESLEY GRAY: Yeah.
AUDIENCE: Then [INAUDIBLE]
or are they simply buying
a simplified [INAUDIBLE].
So out of these two
models which one
do you think more-- [INAUDIBLE]
passive value investment?
WESLEY GRAY: Well, it
all comes down to this.
Because if you're
going to be active,
if you're not wired
to deal with pain,
you're going to be the
worst active investor ever.
So the vast majority of
people should just not
pay all these extra fees for all
these crazy marketed products.
It's all crap.
You can buy it way cheaper, more
effectively at Vanguard, right?
And you don't have
a psychology problem
because the market's
down 30, you're down 30,
you're just like, well whatever,
I'm relatively good to go.
The minute go on
active angle, you
take on a whole new level
of psychology problems.
And that's why it works.
Because now you're in
this competitive game
where you've got to be that
weird, wired person that
does crazy stuff.
And be willing to be the
bag holder at maximum pain.
Because then you'll capture
all the rents of this active
strategy where all the people
that don't have that discipline
can't.
It's all about that
relativeness which seems
to drive this risk premium.
So Warren Buffett says this
because he understands this.
And he knows that
unless you're wired
to deal with years of just
looking like an idiot,
you're way better off
being a passive person.
Because otherwise
you are going to sell
at the worst possible time.
So that's why he makes
that recommendation.
That's why I make
that recommendation.
This is not for everyone.
It's the worst.
It gives you like balding
gray hair like I got, right?
If you want to be
chilling out on the beach
and not worry about life, just
go buy your Vanguard funds
and chill out and you
keep your hair nice.
It'll stay brown and you
don't have to worry about it.
Active investing is going
to make you go insane.
And that's probably why
you get a risk premium--
because it sucks.
You know it's terrible.
But that's life.
Markets are not
efficient in the sense
that prices always
reflect fundamentals.
But they're insanely
competitive.
So it's not like
money grows on trees.
There's always a
premium and a cost.
And it's just a
matter of like, am
I suited to take this cost
better than the person offering
that risk premium to me.
And value people earn that
because they're usually weird.
They can feel like an idiot at
the cocktail party and be like,
I don't care.
A lot of people
can't do that, so.
We'll go over here.
Sir?
AUDIENCE: So I have
a couple questions.
Number one is are
there any funds
out there that are
capturing that momentum
premium you were talking about?
WESLEY GRAY: There are.
I don't want to talk my book
here but here's the thing.
Another thing to understand
about active management
is there's the business
of active manager, right?
And if I'm a large
institutional firm--
and really I get paid
on just assets-- when
I'm designing a product,
most products that work
are going to have some
scalability issue.
Momentum is a perfect
example where momentum,
to get it to be
effective, it has
to have relatively
high turnover, right?
That's how that system works.
But the problem with the
relatively high turnover
is its relatively
high frictional costs.
So if I try to jam a billion
dollars into this thing,
I can design the
program one way.
If I need to jam $20
billion in this program,
I need to maybe need to
diversify and dilute this thing
out so it can take on capacity.
Which is now a
business decision,
not necessarily
like an optimize,
capture the premium
over time decision.
And so just when
you buy products,
think through the economics
of the manufacturer
of that product.
Are they building
this for performance.
Or are they building
this for scalability
and to try to jam as many
assets into it as possible.
And because markets at the
margin are insanely efficient,
the meaning is
like Buffett says,
if you gave us $20, $30 billion,
you'd want to fire us, right?
Because we can't do
active, weird things
anymore because you've
got to jam too much money
through the same door.
And so yeah, that's the problem.
When you're looking
at products, like
understand the situation of that
manufacturer of this product.
Are they trying
to build something
that works in
expectation or are they
trying to form a
portfolio where they just
go and have a bunch of salesman
jam it down your throat,
but it can take on like
$20 billion, right?
And maybe you, as the buyer
of that product-- everything's
called momentum,
everything's called value,
but the construction of
these things matters a lot.
Because the name
doesn't mean anything.
It's really about what's the
engineering of the product.
Yeah so there's definitely
momentum things out there
and we do that.
But I don't want to-- I mean
you we're all about education,
go learn on your own
and we can talk offline.
But there are some
people-- Alpha Architect--
that is trying to build like,
generally intellectually
honest products that
have limited scalability.
And we're trying to do them like
the intellectually honest way.
And we just tell
people like, this
is going to suck sometimes.
But if you have a
horizon duration,
this is at least the honest
way to go about this.
But unless you're wired to do
that, you shouldn't to do that.
But not many people do it
because they'd rather just
raise like 100 billion assets
and charge a lot of money
for it.
So.
AUDIENCE: All right, so the next
question is related to that.
Which is that some
strategies just suck.
Other strategies
are good, but they
are going to suck at times.
How do you differentiate?
WESLEY GRAY: Well let me
step back here, actually.
There's two worlds
out there, right?
There's the investment
horizon game, which
is what I'm talking about here.
There actually is
another game out there
of the best poker player game.
This is a real game.
It's like proprietary
trading hedge funds
where there are strategies you
can devise with a ton of work.
Where you get some
competitive information edge
where in the short
term, it's actually
like a true edge, right?
They always have
capacity constraints.
And they may not
even be that painful.
But the issue there is
that's the trading business.
You're always having
to adapt because you're
competing against all
the Google people, right?
And all the physics PhDs--
where you find a system,
it works for a while,
all of a sudden
it's actually not even painful
because you can leverage
out and make a lot of money.
But it starts to decay.
And you can always be on the R&D
game of inventing the next best
trading strategy.
Those aren't sustainable
opportunities.
They're not painful
and they work,
but that's different business.
That's the trading business.
Back to here, basically
the way to look at it--
the more pain and the more
delegated asset managers
would not want to do
this, in expectation
that's probably going to
work better at the margin.
So whatever strategy
to do, if it's
less full on a
relative tracking--
like it attracts
index with less pain--
it's going to generally
work less well.
It's just a general rule
because of competition.
If it's less painful and
there's less likelihood
of getting fired,
it's probably not
going to have as much kind
of career risk premium built
into it.
Where if it's more painful,
and it's more likely
the delegated asset
manager gets fired,
you're going to capture a
bigger career risk premium.
And so it's not that
ones good or bad.
It's really about pick
your poison essentially--
is what I would say.
So it just depends how much
bang you want for your book.
And if you're better suited to
take careers pain than maybe
other people are.
And DIY people are very
well-suited to take career risk
pain because you can't
fire yourself, right?
So that's why disintermediation
is a beautiful thing.
Because if you're Google
engineer and you sit here,
like learn about all this stuff,
and you have the real horizon,
and you understand
how and why it
m you're in the perfect
position to take on career risk.
Because it's not priced for you.
It's priced for delegated asset
managers, not as an individual.
You can just eat it.
Because what are you going
to do, fire yourself?
You can capture that
premium better than anyone
but the problem is
you've got to invest
a lot of time and
knowledge and education
and figure out how it works, so.
Sir?
AUDIENCE: Regarding
individual investors,
it seems like the
general strategy here
is that because a lot
of people [INAUDIBLE].
But given the size of the
institutional [INAUDIBLE]
component of [INAUDIBLE] is
it a reasonable expectation
that a smart person could
outsmart that on average?
Like the distribution
of investors
seems like it'd be a
wide range of people
losing money and making
money in that process.
WESLEY GRAY: Yeah, there
is a huge wide range.
But again, it goes
back to-- I believe
there's supposed to be,
in theory, like risk
premiums associated with
taking on risk, right?
Equity risk premium, you don't
know what's going to happen.
I think embedded in a lot
of strategies and algorithms
is career risk premium.
Because the people that manage
the billions and hundreds
of billions of dollars, they
need to maintain that business.
And they know that
if you deviate
a small amount from an index,
you're not going to get fired.
So you can earn a
little marginal spread
over the Vanguard
guys because you
can charge higher for
effectively what they're doing.
And that's a great
business decision.
Take minimal career
risk, make it
a little bit different but
never too much different,
because you can lose your AUN
and lose your whole business
model.
But as you get strategies
that get further and further
away where they can go 10%
under the index, 10% over
and go crazy, there's going
to be a premium there.
Because the marginal
price setter
is these institutions that
are the smart poker players.
And they all know this
too they just won't do it
because it's too risky.
And their client base
is not hyper educated
and they're not Warren Buffet's,
they're like mom and pops
who look at their
statement are like,
what, three years down, like
this guys out here and sell it.
So there's a premium
I think that's priced
in systems and strategies that
basically eat career risk.
Because the marginal
price setters
are the smart poker
players in the world.
And they don't want
to eat that risk.
Because that's painful and they
like to keep their business,
right?
And that's just I think
the equilibrium that
actually has happened.
AUDIENCE: Since there is a
model like, because we're
an individual that won't
lose their job over this
necessarily, you can
take greater risks
than an institutional investor--
WESLEY GRAY: You can
take greater career risk.
Because remember, there's real
risk, which in theory, like
in economics, is how like
the risk is correlated
with like your
consumption over time
or whatever wacky
macroeconomic model.
But you're a position
to take the career
risk, which is relative risk.
So I always tell people,
imagine you're an alien.
And you land on
the world in 1927.
And the alien's like,
I got two options.
I can buy this S&P
thing that makes
9% a year with an 80% drawdown
or whatever it is, right?
You can buy this other thing
called value and it makes,
let's say 12% a year
at 80% drawdowns.
The alien, who doesn't care
about what S&P because he's not
benchmarking or whatever,
he's like, well yeah,
do this other one, of course.
But if the alien is now
a delegated agent working
on behalf of others and he's
benchmarked against that S&P
products, and he has
now a business reason
to like kind of not deviate
too much from that, in theory,
he would be all in on
this value strategy.
But because there's
this pricing,
he's always benchmarked
against S&P,
he's going to price
that at some level.
Because that's painful if
he deviates too far away.
So it's all about
the relativeness that
build the relative tracking
error in this career
risk associated with being
a delegated asset manager.
That gets priced because the
marginal price setter embeds
a career risk premium that
shouldn't be priced in theory
like in an economic model.
But it is priced because
there's so much delegated
asset management.
And you don't want to be
the weirdo that gets fired.
And an individual doesn't
care about that risk premium
because who cares.
Like I don't care
about relativeness.
Or you shouldn't.
You should just care
about absolute after tax,
after fee risk adjusted returns.
So you're just in
a position to be
able to exploit that basically.
Yeah?
AUDIENCE: So on
the 60-40 question
that was asked earlier,
every once in awhile,
although rarely,
but every once in
a while I see an
article or graph that
intends to prove that
some kind of rebalancing
like yearly or
quarterly or whatever
actually ends up better than the
60-40 model than [INAUDIBLE].
Is that unlucky?
Lucky for them, unlucky
for us data points?
Or is there any
sustainable [INAUDIBLE]?
WESLEY GRAY: I think
again, this is where
the danger zone is of DIY.
The answer is yes,
there could be.
The problem is the minute
you start adding complexity,
assuming you're not
going to do it yourself,
there's a huge
risk that you start
adding one layer of complexity
that maybe adds value.
But then people
need to spin that
and make that insanely complex.
And you pay a lot of money
in it, eat a lot of taxes,
and on net it
wasn't a good idea.
So can you add things like
this, like smarter rebalances
are more complex
programs where you
could find a robust genuine
effect that works better.
Yes.
The problem is how do you
identify what is the signal
and what was the
noise, especially
after all the fees and
additional things that
usually will come with
a whiz-bang mouse trap.
So yeah, maybe it adds 50
basis points a year, let's say.
Or let's say you have a cooler
rebalance program that's
more systematic and exploits
some sort of anomaly
or whatever and it works.
The problem is it may
have a real genuine edge,
but after the taxes,
the frictional,
and the cost of
accessing it because you
have to pay the whiz-bang
smart PhD person on net,
you would have probably
been better off just doing
some plain vanilla thing.
So it's more like an
optimization accounting
for fees, brain damage, taxes.
Whereas if you
operate in a vacuum,
sure there's a lot
of great things
you can do that have
insane complexity,
but then you get into that
risk curve of-- because
of the salesmen, expert, they're
good at exploiting your bias
or good at telling you
great stories-- it's really
hard to start to differentiate.
Like, is this complexity
actually doing something for me
or is this just a
great sales pitch.
And most of the time,
you end up paying
a lot for the sales pitch.
But the complexity didn't
actually add any value for it.
But yes, certainly there's ways
to do better than everything
I've told you here.
But the intent here is to
help a DIY person facilitate
a good after tax, after
fee outcome, if they
wanted to go down that path.
Sir?
AUDIENCE: To follow up
on that and clarify.
If you have an immersification
[INAUDIBLE] diversifier
[INAUDIBLE].
As you rebalance, you can
do like tax harvesting
[INAUDIBLE].
But if you're 100% equity
like a young person who
doesn't care about
a diversifier,
you lose that advantage.
So what's the trade-off
there between [INAUDIBLE].
WESLEY GRAY: Well you
could still be 100% equity
and still do tax loss
harvesting, right?
Why couldn't you do that?
Because let's say you own
S&P and it bombs out, sell
it and buy it like at
something like 99% correlated,
you still own S&P but you
still booked your tax loss
harvesting error.
AUDIENCE: [INAUDIBLE]
WESLEY GRAY: Yeah but I
mean it's pretty obvious.
Like Russell 1000, S&P
500, S&P 450, and just
go on Yahoo Finance
or Google Finance
and they have the
same chart path.
So you can always
use Bloomberg or we
do like formally
but as a DIY person,
you know it's correlated because
you just map the charts over
and they look exactly the same,
that's probably a good tax
loss harvesting candidate.
But you could do that
with an all equity.
Just in general, think about it.
If I'm 60-40 in a vacuum,
and maybe an annual rebalance
to keep like the things in line.
Bonds, like a 10 year bond,
the yield is whatever, 2%.
That's what it's
going to earn if held
to maturity, effectively 2%.
Whereas equities
usually have a component
of what you can get for
free, which is the 10 year
bond, plus an equity risk
premium, which is usually
say 3% to 4% over time, right?
So just mechanically, equities,
if you're a long term holder,
you're going to get
paid that risk premium.
Where if you add
the diversifiers,
which have low
expectations, they're
great because they
help you diversify
and that's why you're
taking a lower expectation.
But you just want to rip it
and get the highest [INAUDIBLE]
possible.
You don't care about risk
because you've literally
got a 30 year horizon.
The argument is
why would you have
more diversifiers
which lower expectation
if you don't need to pay up.
Because you want the risk.
Because you want to just
bang it out of the park.
So you may want to tilt
out on the risk curve.
But it just depends though.
If you can't handle
that, then you
might need diversifiers
just to make sure
you stay with some equity.
Because some people go
into equity, it blows up,
they sell all of it and
of course it bounces back.
So it's all about the psychology
of investing and doing
things that help you
stick to a process.
AUDIENCE: So it says right
there, active is simple
but it can't be easy.
And I think you
mentioned that you have
to be ready to take some pain.
WESLEY GRAY: Relative pain.
AUDIENCE: If you look at
the equity curves instead
of the RAA system and
[INAUDIBLE] TAA system
and dual equity
and dual momentum,
they are like beautiful
equity curves.
Like low drawback.
How do those kind of--
WESLEY GRAY: So when you start
in like the trend following
world-- I didn't
talk about the here
because it's a
whole other-- we can
talk for a whole day on that.
Trend following, this
is another thing.
Coming out of Chicago,
I was like, what
are you guys talking about.
Technical-- this is
the dumbest idea ever.
But at some point, you've
got to break from religion
and start getting back to
evidence-based decision making.
And long-term trend
following is very
clear over a long horizons.
And we could give you a whole
lecture about the behavior
of it, why it works.
And I agree, those charts
look kind of smooth.
But that's because you're seeing
the chart over a long horizon.
When you start zooming in,
there's a lot of whipsaws.
So there's a lot of
opportunities where the trend
rule says, hey go to cash.
And the market goes
ripping higher you're like,
wow I'm an idiot and you
want to give up on it.
And also,
trend-following rules are
great because they do
protect that drawdown.
But again, going back to
the relative risk premium,
that I think is
price and securities,
in an absolute sense,
if you could say,
hey I'm going to deliver you
S&P with half the drawdown,
they'll be like well yeah,
why wouldn't you do that.
But then you go to
the real marketplace
and sometimes, even though
you're delivering that S&P
with half the drawdown,
you may be in cash
when S&P goes up 30%.
And you're going to feel
like a big idiot and think,
this trend-following
stuff doesn't
work, why would I ever do this.
And a lot of delegate asset
managers think that too.
Because it's all
about staying power
to a process in the system that
where you do your research,
you try to understand like
why does trend following work.
And I can tell you I think
it's dynamic risk aversion.
And we could do a
whole lecture on that.
So there's reasons why I
think long-term trend works.
And there's definitely reasons
why other people don't do it.
Imagine a mutual fund
manager or a delegate asset
manager or even yourself where
you sit in cash sometimes.
Meanwhile, the market
goes on a ripping run,
you're going to lose
your entire business.
So that doesn't make sense.
It's much better just
to go with the crowd
and follow the lemmings.
Because when you're down
30, maybe you're down 29,
you're not going to get fired.
Whereas if you're just flat
and the markets on a 30% rager,
and they're like, you
you're in cash and bonds.
You're gone you're out of here.
And then of course, people
have short memories.
So trend-following is real hot
in '08 and those guys raised
a ton of money because it
saved them from the draw down.
But now they've
all underperformed
because we haven't had a big
face-ripping draw down yet.
But guess what, everyone hates
trend following right now.
They're like, oh this is stupid.
It whipsaws all the
time, doesn't work.
Bunch of idiots data mining.
What will happen when we
have another 50% drawdown
and the thing protects
you from half of it.
Everyone's going to
love trend-following,
it's just the cycle of life.
It's just investing,
it's how it works.
And It's all about the backtest.
See if they value momentum.
If you look at the chart, you're
like, who wouldn't do that.
But you start zooming in and you
look at these relative periods
where real time
you underperformed
by two or three years,
like who can stick to that.
And all these programs
are like that.
