Summary of Wes Gray, PhD Presentation to the Denver Chapter
Wes Gray, PhD, the founder of Alpha Architect, spoke to the Denver chapter of the CMT Association in September. Alpha Architect is an investment management firm grounded in academic and quantitative research with an emphasis on educating investors and managing money. Wes Gray earned an MBA and PhD from the University of Chicago and a B.S. from Wharton. His PhD advisor was Nobel Laureate Eugene Fama.
A Practical Academic
Wes delivered his presentation with straight talk and a refreshing practical approach. Attendees were from varied backgrounds including members of the CMT Association, and CFA Association and QWAFAFEW (Quantitative Work Alliance for Applied Finance, Education, and Wisdom) organizations. This led to a detailed question and answer session bringing nuances to light about turnover, taxes, and investor behavior.
Much of Wes’ presentation surrounded his belief that investors can beat the market by exploiting investor behavior from career risk, and closet indexing. He emphasized the two most important factors of quant investing in equities – value and momentum. He summarized research that suggests that both of these factors can add excess returns to the bottom line after transaction costs and taxes
Even God Can’t Remove Risk
According to Wes, in order to reap excess returns, a certain amount of pain is necessary. Investors can concentrate significantly in stocks that possess value and momentum factors to capture excess gains over the long run. With that said, when investors take this approach, the tracking error from the benchmarks can be huge, lasting for multiple years. Many investors can not stomach the pain.
His investment philosophy is summarized in the following formula:
High Risk Strategies + Tough to Exploit Mispricing = Excess Returns
Wes used an example of managing money with perfect hindsight, buying only the very best performers. Even with this foreknowledge, the drawdowns in performance were huge. Another example is the performance of Warren Buffet, the famed investor in Omaha. An analysis of his track record revealed multiple large drawdowns in the 50% range. These examples punctuate that when it comes to outperforming the market – no pain, no gain. This leads investors to the need for managing their own behavior.
Outperformance from Education
Wes believes that education is critical to reap rewards from value and momentum factor investing. An investor that is well educated will be more likely to understand the risks of factor investing and to stomach the long periods of time when they underperform. For this reason, Alpha Architect invests a larger amount of their time and resources in educating investors. Their website blog is filled with articles written about factors, performance, risks, and other morsels of delight for those people who are quant-inclined.
Career Risk Leads to Closet Indexing
Wes pointed out that many managers are concerned about “career-risk” which keeps them from managing concentrated portfolios. Managers have an incentive to weight sectors more closely to the index and to invest in too many stocks. Managers are less likely to lose their job if they perform similar to the index while not severely underperforming. If a manager significantly underperforms for several years, investors and consultants are likely to pull the plug and exit the portfolios at the wrong time. This tendency leads to “closet indexing” as managers hug the benchmark weights and managed tracking error to be smaller than required to make excess returns.
On the other hand, a disciplined investor willing to think long term, can stick to their guns so they have a chance to beat the market by a wider margin. Part of the strategy of Alpha Architect is to concentrate on fewer holdings and to rebalance frequently. This technique is implemented in exchange traded funds which may hold closer to 40 or 50 stocks. This approach is a stark contrast with many ETFs that hold more stocks with a moderate tilt toward momentum and value factors. This, of course, waters down the return and creates a return stream that is much closer to the index
Turnover, Taxes, and Concentration
The table below shows the compounded annualized returns of value and momentum portfolios from 1970 – 2016. They are tabulated by the number of stocks in the portfolio and how often the portfolio is rebalanced. The returns clearly show that excess returns are higher in portfolios with less stocks that are rebalanced more often. But this leads to the question of taxes for individual investors.
Typically, investors assume that higher turnover leads to short term gains which is taxed at a higher rate and thus reducing after-tax returns. Wes pointed out that exchange traded funds can dramatically reduce taxes, even with higher turnover and large realized gains. Due to the nature of the various entities and accounting methods, gains are not distributed as much to ETF holders. If these accounting standards remain, investors could benefit from higher excess returns from faster turnover with less stocks without losing a large portion to taxes.
The tables also illustrate the effect of closet indexing. Value and momentum strategies that have more stocks with lower turnover tend to perform very closely to the index. This approach has historically aligned with many of the ETF vehicles in the market today. Wes believe this is a key differentiator of his ETFs.
Crisis Alpha and Managing Systematic Risk
Wes also touched on strategies for reducing systematic stock market risk by using long-term moving averages, as well as by diversifying into managed futures portfolios that have low correlation to equities. Both of these strategies can add value but in two different ways.
First, managed futures can provide “crisis-alpha.” Crisis alpha is a term coined by Kathryn Kaminski, who also spoke to the Denver Chapter a few months earlier. The concept is that trend-following futures contracts in a widely diversified universe, both long and short, can have large returns when volatility increases. The good news is that volatility tends to increase when equities decline. This leads to a smoother return stream in the context of a diversified portfolio of equities and managed futures.
Second, managing systematic risk by hedging portfolios when the momentum of the market shifts negative. This can be accomplished with simple moving average indicators. This technique attempts to reduce systematic overall market risk that can not be diversified away in the equity markets. In short, a combination of increased diversification and the management of overall stock market risk can potentially add value compared to a long only equity strategy.
Summary
Wes Gray’s presentation challenges the common belief of many portfolio managers and the industry as a whole. Specifically, turnover can be good, taxes can be managed more effectively in active strategies through ETF, and concentration is important.
He also emphasized that career risk and other investor behaviors make it difficult to implement factor investing. It takes mental and emotional fortitude to carry through and hold on to your strategy when times get tough. He noted that in order to outperform it is inevitable that severe drawdowns will occur.
Finally, he made some important points regarding diversification through managed future and lowering overall stock market risks through hedging. All in all, this was a superb presentation that can help both individual and institutional investors improve their own playbook for making money in the markets.
