Interview With Wesley Gray: Masters in Business (Audio)

He uh comes out of uh University of Chicago in an MBA PhD program and decides to take a little time off in order to join the Marines, which he did as a captain, went overseas in Iraq, where he served as an information order officer embedded with the Iraqi Army, and Um wrote a book about it, Colds Embedded and Really a fascinating uh An unusual background discusses throughout his career how Iraq and and the prosecution of war are in some ways very similar to investing. Alpha architect is

a quantitative firm. Uh West crunches a lot of numbers. He's a big believer in factor investing. He has long since been a proponent of both momentum and value, which is a somewhat unusual combination, but they are two of the six main factors UH that are out there. I

thought the conversation was absolutely fascinating. If you are a fan of quantitative investing, or if you enjoyed our previous podcasts with people like Ammanual Derman or MEB Fabor or any of the other quants we've spoken with, UH, you'll really enjoy this. So, with no further ado, my conversation with Wes Gray. This is Masters in Business with Barry Ridholts on Bloomberg Radio. My special guest today is Dr Wesley Gray. He is a former captain in the United

States Marine Corps. West graduated Magnicum Laudy from Morton. He earned both his m b a. And PhD in finance from the University of Chicago before becoming a professor of finance at Drexel University. He currently runs the site Alpha Architect, as well as running an asset management shop for high net worth individuals. He is the author of three soon to be four books on quantitative investing, as well as numerous academic articles. Wes Gray, Welcome to Bloomberg. Very happy

to be here. So let's talk a little bit about your background, because it's kind of unusual. Lots of people take some time off between college and grad school. What did you do between college and grad school? So what I did is basically, right out of undergrad actually directly enrolled in the University of Chicago paced program at ripe old age of two, spent two years there getting hazed,

you know, fighting against Russian math champs to compete. And then after two years in a PhD program, you you get to your comps stage and I passed the comps and I said, you know what, um twenty four, I'm hating finance at the moment. I needed to do something that I always wanted to do, and that was serve

in the military. So I asked for a special four year sabbatical uh to basically serving the Marine Corps at left for four years, which is probably first time that's ever happened, I imagine in Chicago finance PhD program history, and then came back and finished up. So let's not skip over that middle part. Those four years were the middle of the Iraq War. You were embedded with the Iraqi Army as a captain or lieutenant. What was your rank. When I was there as a lieutenant lieutenant, I called

you a first lieutenant. Yeah, well I got out as a captain, but okay, I serving there as a first lieutenant and your nickname amongst the Iraqis was Jamal. How did that come about? Basically? I was the intel guy in our our mid team military transition team, and so the intel guy is supposed to know how to speak

the language, you know, how to influence the people. And one of the things you learned about reading about Arab culture is it's really important to learn the language and hang out with the people in order to you know, be able to better influence them. So I used to hang out in what they call the swats Uh and I was down there and they would always call me lulas um gay because they can't say ours very well.

And I was like, you know what, guys, let's try to find a language so instead of gay, instead of great.

You know, and it's usually not the greatest idea to walk around with a bunch of Marines when when I ras are calling you malasam gay, you just get some ridicule subtimes um and they just couldn't say it, so as like, can you guys, name me, and they literally had like a naming party where there was probably fifty Iraqis in the uh in this swaha it's maybe you know, thousand square foot you know, cardboard building type thing, you

can think about it. And they came up with Jamal, and then I was called Malasam Jamal, and uh, I kind of like I actually that was my identity. Even when I came back, I still felt like I was Malasam Jamal. That's funny. So how did the Marines and your your time in Iraq helped prepare you for a career as a quant in in finance. I'd say the biggest thing is just understanding that in all endeavors, humans

are involved. And when humans are involved in any sort of decision making or activity where there's a lot of emotion, stress and chaos, they do crazy things. There's certainly a

level of emotion involved there. And I think in the military what you learn is it's all about standard operating procedures, training to do things that seem you know, mundane and dumb and checklist driven now, but when you get into a chaotic situation, you think, God, you did that, so you don't rely on your natural action you're rely on

your standard operating procedure. You know. Perfect example might be I remember I was in the palm groves, an area called Haditha, which is kind of you think out in Alomar Province where a lot of the isis guys are now and I was on Iraqi patrol and literally a dude gets shot in the chest fifteen feet in front of me. You know, natural action is hit the deck, you know, go to the ground as fast as possible.

Another natural action, which you're not supposed to do, is go run to the person who just got shot and see what beat on him? And now that and they're gonna go shoot me now, so what. But what you train to is when there's a casualty, the first thing you do is hit the deck, fine cover, figure out where the other guys are, to make sure you secure the area. The only way that you you have a reaction to do that because you have stand operating procedure

and you're trained to that standard. Just like in financial markets, I think a lot of time, like let's say there's a fifty draw down in your portfolio, your gut reaction is sell everything. But that's not what you should probably do. So you need to have a process or something in place before you hit chaos. So when you're actually in chaos, you you know, you're act in a more rational, i'd say logical way, And I think that you see a lot of that between military and investing. You know, I

started on a trading desk. The head of the desk was a former Marine jungle combat instructor. There was someone else who was a former seal on the desk. Now, what I always found fascinating wasn't just the standard operating procedure for what to do. It was preparing emotionally for the firefight. Like, how can an investor prepare emotionally for those big draw downs? Yes, so I think it's just

like in the military. You try to train as close as you can to fight and have ultimate faith and confidence in the leadership and the decisions and the process that you believe in. And when you have that, i'd say belief in what you're doing, and you really put a you know, good faith effort into working on that. When you hit chaos, if you believe in your training, you're more likely than not to stick with that process. I'm Barry Ridhults. You're listening to Masters in Business on

Bloomberg Radio. My special guest today is West Gray. He is a former captain in the Marines, served as an in bed with the Iraqi Army on behalf of the U S Marines. He runs a shop called Alpha Architect and has written numerous books on quantitative investing. Let's talk about a book of viewers that I really enjoyed quantitative value. When we think of quantz and we think of value investors, we really don't think of those as having a big overlap. Up. Tell us how you came to the idea of value

that was quantitatively driven. Sure, so I had start out with this being a total bible thumping Ben Graham intelligent investor stockpicker did that for ten years my own personal money, and thank god I had the opportunity to eat a lot of humble pie along the way, and I was thinking, you know what, this whole Warren Buffett Ben Graham idea makes total sense to me. But after you get engaged in the activity of stockpicking, you realize that you get

very emotionally involved. And even if you understand the biases you've memorized. You know Kniman's book, even if you know it, and you know how the biases influence you. You start to realize you still can't control against the biases. So I thought, hey, you know, fundamentally, value investing makes sense by cheap stuff everyone hates. Great. The problem is hold it for a long time, hold your nose when inevitably it told the underperforms for potentially multi air stretches um.

But at the same time, how can we implement this process in an objective discipline way such that I can pull out monkey brain from making bad decisions, uh, you know, from trying to be a stock picker, because I learned my lessons basically on that. That's quite fascinating. So some of the things you reference in the book. Obviously the benefits of using a quant approach is you're taking out

the human elements. One of the things you reference in the book is the importance of finding the highest quality stocks. So first, what does it mean when we say a stock is high quality? And then how do you screen for those? Sure? So, so stepping back, it's really important when we when we talk about quality in the context investing, to understand given it's already cheap. So with value investing the way we look at it, you have to be

buying the stress cheapest securities in the market. Only within the cheap does quality start to help add value. So if you just look at quality as a standalone, you know, characteristic of a security, it's unclear that it adds any quote unquote alpha or edge. It's all about looking at quality. Given you're in the cheap stocks everyone hates. So the step one is screened for an expensive stock. Step two

is within those cheap stocks. So how do you identify what's quality and what's not amongst the cheap So, given we're in the in the cheap bin, which are security, obviously there's something going on and that's why they're cheap. We have a table like the we call it the quality table. There's two legs to it. There's understanding the fundamental quality of the business and there's another thing called current financial strength. So in assessing economic mode, we try

to objectively ascertain is this company a good business? How do we do that? We look at things like long term geometric means on return on assets, return on capital. We look at long term free cash flow generation, profit margin dynamics, like if you have fifty percent margin year and year out, that's probably good business and we want to quantify the quality of this business to essentially generate returns hopefully an excess of their cost of capital. But

that's not enough. That's leg one because we're dealing with cheap stocks that have issues. So we can one ascertain that there historically have some indication of being a good business. But then current financial strength is now at ten point checklist where we want to make sure are you going to survive the next few years? I e. Are you making money? Are you're paying down debt? Are your repurchasing stock? Is your current ratio is improving? Uh, it's literally like

a pre flight checklist. So are you a quality business organically and do you have the current financial stature to live for the next few years? So eventually hopefully you can get revalued up to not be a value stock anymore and hopefully be a growth stock in the future. So is it safe to say that companies with strong balance sheets have stocks that outperform? Or is that overstating it?

I think it is. I think cheap stocks with strong balance sheets on a risk adjusted basis and from a you know, betting standpoint, or better than cheap stocks with bad balance sheets independently. No, because there's a few reasons why everyone knows Google is great, Facebook's great, Procter and Gambles great, So what's the edge? And then secondly, it's also easy to buy those names for someone to recommend them. So it's emotionally. Emotionally or are you referring to the

principal agency issue the principal agent problem? And also just emotionally, it's easy to own high quality securities. But when you look at it objectively from like an evidence based standpoint, just as an independent analysis to I, we think quality is not that valuable and it doesn't make any sense it would have edge were cheapness. Everyone hates these things. They're hard to own, like it's crazy, They're hard to hold.

There's a lot of pain involved and unfortunately, you know, just like in the Marine Corps, no pain, no gain. You know that that BAC holds and financial markets unfortunately as well. So let's talk about stocks that can cause permanent loss of capital. There's a chapter in the book where you discuss that how do you avoid these stocks? What do you look for to avoid owning names that are going to go down and never come up? The classic value trap, the value trap. Yeah, you catch the

falling knife, as they called on the way down. So, uh, three of them are basically there's there's two or three ways you can think about permanent loss of capital, and these are One would be like a fraud or manipulation. So if it comes out that the business you thought that was making a billion dollars a year is actually making zero, that's gonna be a bad news for equity holders. I would guess, Yeah, same thing with manipulation, like oh we thought we had this, now we have this other thing.

And then the other one that's that's obviously is financial distress or bankruptcy. You can own the best business in the world, but if you're an equity holder and this firm is in distress, the debt holders might end up owning that great company, not you as the stockholders. So so by the time that news comes out, it's too late. What can investors do to avoid owning those names? What

signs should they be looking for? Sure? So, so we do is we leverage a lot of uh, I guess you call them technologies in academic literature where people have built up statistical constructs to try to predict who's most likely or red flagged as being a manipulator, fraud ster, or potentially going to be in a financial distress situation, and we just at the outset say hey, if you're extreme red flagging on any of these sort of things, you're not in our You're not even gonna be in

our potential. Just remo. We're removing, yeah, because we don't want to buy your falling knife situation. I'm Barry Hults. You're listening to Masters in Business on Bloomberg Radio. My special guest today is Wes League Gray. He is a retired captain in the U. S. Marine Corps, an m b A and PhD out of the University of Chicago. He now runs Alpha Architect, which is a unique quantitative

asset management firm. And the first book he wrote was called Embedded, which is something that you pretty much pens right after getting out of the Marine Corps and after spending was it four years in Iraq? Is that about right? It was four years in the service I did uh. I was there for a standard Marine seven months deployment in a place called Haditha which down el Ombar Province there. So what motivated you to sit down and write a book when you get back that had nothing to do

with finance. That was strictly about your time with the Marines. When it was is you know, I remember before the Iraq War, had Colin Pale show us that little white you know bottle that you're all gonna die, and I was like, you know, this is kind of maybe a survive of a war. This is a pretty important thing. I'm a buyer, I'm a believer. And then you know, so when in a Marine Corps, not really for that reason.

I just want to do my service. But when I was I thought, hey, this is a mission that makes sense. You know, it's a win win for America and hopefully for the Rockies what have you. But then after actually living and being embedded with the people, I started to realize that, you know, culture matters, and we're we're in a in this war now, we're really taking on a fifty two year commitment because we're gonna try to change culture and not easy to do. Not easy to do.

And I would argue it's very, very time intensive and costly, and that's fine as a decision, but let's weigh that against the potential benefits um and that book just really opened my eyes to understanding. I would say just Arab culture in general, and how the way they think about the world is just so much different than us. And then the idea that we can impose, you know, our ideas and how we think about the world on them, it just doesn't work. And I have an analogy here.

It's like, you know, it's a fish trying to tell me how to breed it underwater, Like I understand I need gills and understand you need to get oxygen, but it doesn't work for me. Like it's just we all understand each other kind of, but we just it's not gonna work. Um. And that that was the biggest insight when I had to share it, because it changed my mind about the whole thing one eighty about why are we here? And is this really a positive MPV project

for us? So so you can't really just walk into a country with a completely different set of mores and cultures and say here's how you do it. That's not gonna fly, no, no, yeah, yeah exactly. It seems obviously trivial after the fact, but yeah, but beforehand, you know, that's the classic hindsight bias. It's easy to say these things. Acts in In early two thousand three, a handful of

people were warning about that. Everybody remembers the big Eric san Seki, the Army general, warning about you're not gonna do this with a hundred thousand troops. You need a half a million troops. It's more than just hearts and minds. It's really a long process. Nobody wants to hear that before you go in. Yeah, the biggest insight I got action. And also it's a lot of the things I cite

and embedded. It is just my conversations with the actual Rocky people about why they thought we were so weird and crazy and the things that we did say that was that the readers, these Americans are crazy. Um. They try to explain to me their perspective, and a perfect one is okay. So you guys want to go bring democracy and freedom to the Rocky people, and you've done that.

But here's the problem. When you let a country of cage lions totally free out of their cage, you don't give them freedom and Rocky to give them anarchy because you guys in America have a lot of implicit structures, either legal, culturally or trust. Like we're tribal here, guys like like we don't have a lot of that kind of ether in your culture there that it's in stitutionalized here there exactly. In fact, you wrote, the tribe matters

much more than the state. There, you got it. So so the idea that you can bring us freedom and democracy and that's a great thing, and you're helping us, No, you're giving us anarchy. And everyone has a house with one ak in thirty round seven six to mag And guess what if there's not enough police, if I don't like my neighbor, I'm gonna go shoot him because that's freedom. And you guys don't do that in America. You're not really that free. You're still constrained by civil laws and

and all these other things. And the idea that when you give us freedom, you somehow are gonna help us out, No, you're you're you're destroying all law and order in anything that resembled a society here. So so let's bring this back to finance. So what did you learn from the experience there that you were able to bring to the world of finance. You know, I think it's a lot of times like coming from a you know, PhD. University

of Chicago, everyone's rational. This is how the markets work, and yeah, they're probably right, but that fails to consider humans. And there's humans operate in the economy, not agents, rational agents. So I think just like when when we go to a situation like Irock on paper, Yeah, go bring him freedom, democracy, and they will become like America and everyone will have a you know, a pick, white picket fence and three kids. But then you start realizing, wait a second, there's cultural

issues here. There's human elements. Same thing in finance. Yeah, you should go buy cheap stocks and do it, Warren Buffett does. Why doesn't everyone do that? Well, because there's humans involving finance, and it's really really hard. It's really really hard, and we always need to consider the behavioral human element of decision making. I'm Barry rid Hilts. You're listening to Master's in Business on Bloomberg Radio. My special guest today is West Gray. He runs the quantitative asset

management firm Alpha Architect. Let's talk a little bit about quants on Wall Street. So, first question, what do people misunderstand about quants and their models in the world of finance. Sure, so I probably can't speak on behalf of all quants because like every walks of life. There's a lot of varieties within that segment. In one corner when it when you talk about a quant you think about the physics

PhD who's never read a finance book ever. He's data mining, building crazy models and C plus plus and do whatever they do. That that's not the type of quant analysis that we bring to the table. We're we're essentially economists that are trying to think about how the machine works, and we just leverage quantitative analysis and tools that basically allow us to conduct what we consider like scientific method as best we can. So we have competing hypotheses about

how the world works. We grab data, we test these competing hypotheses, and we're always trying to get better evidence space investing. It's not just let's data mind, because we've got better computers and more physics PhDs like we're we're basically fundamental investors that use quantitative tools to help our process and how we think about things in the world. So from your perspective, then models are really never finished. You're constantly testing them and seeing how can I make

this better? Where can it be improved, or what may have changed in the market. That means that this model is no longer delivering any sort of advantage or edge

that it might have been previously. Sure, there's an element of that, and then but the other element is is understanding that when you start going down the model creep situation, it's it's like the old game where the kids, like the little girl first says, hey, you know, the princess kissed the fraud and by the end of the circle, it's like, you know, Spider Man beat up he Man.

So it's a total different story. And it's all because you have small little changes where you end up in a total object place you wanted to end up in the first place. So when when we build models, and when we think about it, it's very very time and ten set of an R and D intenses up front to build the simplest, most robust model we can Simpilicity beats complexity definitely, because we want to look for the what is the real signal here, not the noise, and

let's just focus on that signal. And what we've found is that in financial markets, frankly, nothing's changed. Human behavior is pretty constant, and incentives, specifically like this principal agent delegating asset management problem, those are two constants, and they derive a lot of predictions about what works and what doesn't work. And we keep coming back to the same themes.

Value by cheap stuff, momentum by relatively strong stuff, and trend being good trends and everything we look at at having memorized, like most of these databases at this point, it's it's those three simple muscle limits usually drive all other perturbation of anomaly or fact or whatever the heck. Super looking, So, how do you have momentum and trends as the same group, because normally when you're saying by trends you're buying strong stuff going up, but value you're

buying weak stuff that everybody hates. Yeah, So so really the way we look at value and momentum in particular, is there really two sides of the same behavioral coins. So if you look at value, one of the arguments for why it outperforms is obviously it could be more risky, and we can't discount that. That's surely one component. But there is a mispricing component, we think, and that's what is that an inefficiency? It is, but it's it's hard

to arbitrage, which we can discuss. But what values driven by we think, and by we I mean, like the academic research community, is an overreaction to bad news. Essentially, they throw the baby out at the bathwater. On average momentum, it turns out is there's two competing theories, Like we're talking about relative strength momentum, which is the classic kind of stock selection momentum academics discuss, and that the proponse of the evidence is that it's an under reaction to

positive news, so values and overrea to bad news. The evidence in general seems to suggest that momentum is more of an underreaction to positive news that's being signaled in the price. But because people are overconfident in their own information set, even though the price keeps telling them yeah, and there's disposition effects. You know, you're supposed to let your winners ride and cut your newsers short. What do

people do the opposite? So there's a lot of kind of organic, you know, fake supply that comes on the market for high momentum stocks, and they're only because they're a winner. People are hey, hit the bed. Nobody. I when I started, I used to hear this all the time, and it turns out to be terrible advice. Nobody ever went broke taking a profit. Yeah, exactly, And that's the

worst just supply for for a momentum. Yeah, it just puts supply into the market when maybe the fundamental should be the stocks should be worth a hunted and starts at eighty, but it can only go to ninety because as it starts moving, and who wants to be the last guy owning it on the highest peak? Fear of looking stupid? Yeah, fair looking stupid. So I love the symmetry of overreaction on the value side undreaction on the momentum side. Let me throw a little bit of a

curve ball again. What I learned early in the career, which may or may not be true, is hey, you know managers, when you look at the big institutions, hedge funds, mutual funds, endowments, they have their favorite names, and especially if it's a fund that has a lot of four one K or that sort of inflow, there's only so many names they're gonna buy in. As fresh money comes in over the transom every week, they put it to work in the same names, and that's why you see

some form of of persistency of price action. Is that a fair description of momentum or is that just a narrative that I think that that's basically like the fund flows arguments. And there's actually a new paper that I can't remember. It's some new like germ of finance papers, a theory paper this trying to explain the value and momentum effect via fun flows. Were like one fund is like losing because they own like the you know, the

value stocks, so they're getting out of there. Then other funds they're they're winning, they own the winner stocks, and then you know, because they're winning, they get more fun flows, and then those keep moving and eventually, like the value stocks get too cheap, they may in revert. Momentum stocks unless you keep staying in the high momentum eventually crash

and burn. And there's all these theories about trying to explain value momentum, not via behavioral like overreaction to bad news unreaction to good news theory, but through like a fun flows argument. There could be something to it. I think, I think all no one really knows exactly how and while this works, but it's all about what is the proponance of the evidence kind of tilt you towards because God only knows what really explains value, So you really

don't need to know why it works. You just need to know this works. This doesn't stay with what works avoid what doesn't to some extent. And you know, as this has a great quote about like we all knew the world was flat before, or it wasn't flat before we could explain exactly, you know, why it was. Some of us still held out, Yeah, exactly, and value something. I think that's way more understood because it's more intuitive. Um by cheap stuff everyone hates, you get kind of distress. Premium,

you know, careers, premium were momentum. You know this. We just wrote a whole book dedicated trying to understand this. You know, there seems to be this underaction to the good news. But there's another thing when I started reading about, like what Soros talks about with with reflexivity, at some level, price action itself can actually influence fundamentals. And here would be an example. Let's say we're out in the valley,

like Silicon Valley. We have Google, who's got great price action linked in who just dropped the hunter you know fifty until recently here, But so what do you think when most of your comp and it's all human capital. Business is tied to your stock price Linkedins, so their

price movement momentum fundamentally is changing their fundamentals. And if marketplace can't anticipate kind of the second derivative or nonlinear change, they'll always kind of underappreciate the benefit of good prices because you also get lower cost of capital on the street. If I'm a high flying stock, every banker in the world is going to help me go sell that over

priced stock to fund acquisitions and what have you. If I'm a total Loserville stock, you know, I gotta pay cash like LinkedIn yeah now, and now I gotta like pay real market cost of capital. And you're at a competitive disadvantage compared to this company that can you know, check out overvalued stock to do acquisition until Microsoft comes along advise you at a nice fat premium. So there's there's momentums complex. You mentioned momentum and you mentioned Cliff Assness.

Am I correct in saying both you and Cliff had Eugene Fama as your thesis h advisors at Chicago? Is that right? We have more similar than that, even he was also a working undergrad. So unfortunately both of your your dissertations were on momentum to the guy who essentially invented the efficient market hypothesis. That's right. So so we apparently like a lot of pain and english and fighting

uphill when we probably don't have to. Maybe that's a shared characteristics of Cliff and I is what it seems. You guys have put out a few e t F You've worked and advised on other e t f s. How has the exchange traded fund shift changed the game in terms of cost and execution? I think it's it's revolutionized access to retail I would say more typical investors.

In the old days, you could always get clean, process driven factor exposures as institutional investor, but you never could do it as a retail investor with tax efficiency and reasonable fees. And now the world is your oyster. You can go on your you know, Schwab account by you know a really great factor exposure for low costs with tax efficiency and full transparency. And I think that's revolutionizing

the asset manager business as we speak. So, if people want to read more about your writings and your research, where's the best place for them to find you? Best places just go to ALF architect dot com and sign up for the blog, and that's that's how we communicate to our audience. We have been speaking with Captain Wesley Gray, formerly of the U. S. Marine Corps, now with Alpha Architect. If you've enjoyed this conversation, be sure and hang out for our podcast where we keep the tape rolling and

continue chatting about all things quantitative. Be sure and follow my daily column on Bloomberg dot com or follow me on Twitter at rit Halts. I'm Barry rit Halts. You're listening to Masters in Business on Bloomberg Radio. Are you looking to take your business to the next level? The accounting, tax and advisory professionals from Cone Resnick can guide you. Cone Resnick delivers industry expertise and forward thinking perspective that

can help turn business possibilities into business opportunities. Look ahead, gain insight, imagine more. Is your business ready to break through? Learn more at Cone Resnick dot com Slash Breakthrough, Cone Resnick Accounting, Tax Advisory. West, thanks so much for being so generous with your time. UM, so there's so much stuff to go over. We blew through so many questions. UM, but I really enjoy you, know West, I know West

for a good couple of years. I've followed Alpha Architect for a while and everybody in my shop loves reading his work. Uh. He is another one of the collection of people who are really and I think you made this clear during the the radio portion. He is evidence based and data driven. So much of of finance is filled with myths and heuristics and and shorthand rules of thumb that turned out not to be true. Looking at the actual data um really makes a really makes a

big difference. So let's let's go over a few questions we we didn't get to, including a quote of yours that I that I really like. And I don't remember which book this was, but you said sustainable Alpha requires sustainable clients. What does that mean? Sure? So I've always been puzzled with this question of we find this factor it generates the access for terms. Why is this there?

And why will it continue because you know? Sorry? And why why hasn't everybody found this and stayed with it if it's generally exactly and you have open secrets called value momentum value as the strategy has been around for a hundred years. Momentum was talked about like also two hundred years ago, so it's not like these are secrets, and yet they continue to work. So I needed to

intellectualize how is this possible? And what I started thinking about is is I started thinking about behavioral finance and the two real building blocks of it, which are one understanding human behavior and to understanding institutional incentives to arbitrage

bad behavior. So most factors exist typically because there's some sort of expectation are on behalf of investors that creates a dislocation from fundamental prices, so that that would be either the something like that, because you've got to have someone can't be a perfectly rational buyer and seller, because then prices would never deviate from their fundamental value in efficient market, ipocess would hold. But clearly there's overwhelming evidence

that that happens. But the question is wise does it sustain? And so that's where we got to look at the incentives of those who manage the capital and for easy things that are easy to arbitrage, Like if we see a twenty dollar bill on this table, well let's grab it. What if we see a twenty dollar bill on the table, but there's a grizzly bear over it, Like is that rational that a twenty dollar bills there no, but the problem is to pick up this twenty it's a grizzly

bear there. So sometimes it's it's not frictionless to arbitrage prices, which is a cordline assumption of the Fisher market, I passes, is that competition will always drive prices to fundamental because it's assumed it's easy to arbitrage. But that is totally not true. And I would say the biggest issue with quote unquote arbitrage on things like value or momentum is career risk because to do those strategies, they're really long duration kind of expected winners, but in the short one

they can get destroyed relative to standard benchmarks. We were discussing the pain trade. The pain trade exactly and pain trades ironically are the exact trades you want to own if you want to have a sustainable out of sample chance at outperformance, because now there's you want to have a credible reason why other people on the side of this trade or not make a good decision over overreaction,

bad news, unreaction, good news, or what have you. Then, on the other hand, we understand, well, what are the other competitive players in the market doing and why aren't they already doing this? And it's usually because they like their jobs a lot more than they like actually take advantage of anomalies. That that's the famous Kings quote. Better to fail conventionally than succeed un convention exactly. And there's tons of research about this. It all boils down what

they call the principal agent conflict. There's there's a classic theory paper um under Cipher and rob Vision and in general Finance ninety seven is called limits of arbitrage, and they make this very simple point. We all know what works. The problem is in the short run, it may not work,

especially relative to other stuff. And to the extent that I can't credibly convince my investors that I'm not an idiot, even though I just lost twenty points to the index and they pull my capital, I'm actually not in a position to take advantage of this, so I kind of hold back. So the only way to really exploit true active anomalies is you need to one have a process

that takes advantage of some bias problem. But then more importantly is you need to couple the capital that's there to exploit and make sure it has the same duration as the anomaly it's trying to exploit, which is long term, so long term duration on the capital, long time duration on the anomaly, short term human behavior getting in the

way exactly. And its analogy is like the bank that that we discussed earlier, where a bank lands long borrows short great most of the time, but sometimes you have a run on the bank. Same thing with value strategies, long duration opportunity that more often than not gets coupled with short duration capital. Sometimes there's a run on the bank. And when that run on the bank occurs, the winner in that trade ends up being the Warren buffets, the guys that just hold onto these things like grim death

and will not sell. I have a friend who runs a value hedge funds, if there's such a thing, and he says he'll go through the pain trade for quarters and years at a time, and he said he's been

doing it for forty years. He knows when the portfolio is going to start out performing because usually just before he starts getting all sorts of inquiries about redemption and people have had enough, and it's usually at that moment when when the wheel is turning definitely, we we we know multiple multibillion dollar hedge for manasures with heavy value focus that are literally out of business because of the back half of two thousand fifteen because deep value just

got destroyed and redemptions just overwhelmed their ability to convince the capital stage. So so let's talk about career risk, and let's talk about running money in real time. You run a model, you run multiple models, multiple ETFs, but you run a model that essentially is two sleeves. One is value and the other is is the momentum side.

And invariably one of those two sleeves. And by the way, I've explained this to people and the like, so wait, they first they screened for value and then they screen for momentum. No, these are a dual model where there is simultaneously offsetting value and momentum. Uh, two different screens and two different pools of stocks. But invariably one of those sleeves is getting She'll act usually when one is doing well, the other is doing poorly. Number one, how

does that make money over the long haul? And Number two? What happens in the real world with all but the most savvy institutions or individuals who may have money in a portfolio like that. Sure, So so the way um that value momentum work in a combination, whereas you mentioned,

it's not about an integrated package. It's about pure value focusing on that religion, and then pure momentum focused on that religion, combining the two and they happen to have this very great dynamic relationship where they're like Yin and yang. When one is blown up, the other one on average tends to be working. So you get amazing diversification benefits. Whereas if you look at either of those strategies as a standalone basis, you know you're gonna want to jump

off a bridge it's too volatile. But that combination basically gives you more survivability. From like a human psychology standpoint, pure value, how you im pure momentum combined ran in a very active way, can still have opportunities to have multi year underperformance, but it's more sustainable than just being a pure value person or a pure momentum person where you could go for five ten years in theory of underperforming,

and who can do that? Even I would have problems, you know, sticking to the model probably and I'm like a cold believer in this stuff. So so what do you say to somebody who says, hey, I'm in this portfolio for three years. I understand it intellectually, but you're under performing the benchmarked by forty basis points for three years. How do you communicate, Well, that's part of the model that's not unexpected, and soon it will be out performing

and by a substantial by file undred basis points. How

do you communicate that? So, the way we communicated is this is not for everyone, it's for we have a very segmented component of the marketplace where we need to identify long duration cap roll that's really sophisticated and has minimal agency conflicts where their career doesn't really amiable consultants, No consultants, no, it's it literally who wants to take care of their money best, the guy who owns their own money because they actually have horizon, they don't have careers,

not gonna fire themselves, and they just want to maximize their best chance of long term expected compounding. That is the segment that we talked to. That's a really specific, very specific niche, and the reason we're so hyper focus on that niche is going back to that sustainable, active framework where you need a couple long duration arbitrage with long duration capital in order for it to be a victory. You that's the only way you can believably exploit these

anomalies is the capital. The source of capital, and the education of that capital and its ability to stick to the program is more important than the nuance of your model. Yeah, Like, we can do a billion perturbations of buy cheap, they're all gonna be nine correlated. Do we think ours is marginally better than Joe blows down the street. Sure, but you know if you stuck a gun to my head and said which value molo do you want, I'd be like,

they're all good. That's not the hard part. The hard part is making sure the money that's in it is able to actually exploit it the duration of that. Yeah, and so we that's why we have this saying, like most products on the street, they're they're sold, not bought. For our strategies, we say no, no, we have to have our products be bought, not sold, because it's more important that our clients and investors understand explicitly, maybe even more than we even understand it, how and why this works.

Because it's not it's not about us being smarter than the next guy. There's already hundred peach d guys around here. They got higher i q s and I could ever dream of. That's not our edge, our edges getting the capital matched with a reasonable process that's good enough for our you know, not brains, that's gonna be. That's the buffet trade basically. So let's talk about your dissertation with Eugene Fama. We we mentioned that he was your your advisor.

What's it like pitching momentum to the father of the efficient market hypothesis? So Cliff did value and momentum to the vastness. I actually pitched him on value exclusive. I wasn't going to touch the momentum, pain trade and a dissertation because I wasn't that a wild as Cliff was. Um. But what I did is, you know, I don't I has always been a stock picker. Reading Ben Graham, warm off its stuffed, I was blue in the face. I

believed that that was the way of the world. Um. And so obviously, you know, you have the most famous guy in the world that says no, that's never gonna work. Screw this guy. I'm gonna figure out how to like, you know, let's see if we can an outsmart this guy. So what I did is, um, I'm sure if we were like Joe Greenblatt, a little little book, little yeah,

great book, great ideas. He has this organization called Value Messrs Club UM, which is ah, it's basically like an invite only group of all these hedge fund managers and really smart kind of fundamental stock pickers UM. And you've been doing it since two thousand. I was like, hey, this is a really great data source where there's all these like full scale stock pitches from the by side. Let's look at how it's done over time's let me

guess they stunt the joint on. Well no, actually interesting enough. Well it's kinda but in an indirect way. So when you actually look at the performance of as a whole, they're actually pretty good. Like these people had real value. It's unclear that if you paid in their funds after the but there's certainly evidence that these guys have some skill and an especially when you get that segmented down to like the small value, there's no doubt these this

group has a ton of skill. There's a shortage of information, there's not a lot of coverage, there's more risk's whole bunch. When you read there, when you read their thesis, a lot of these guys are talking about long duration anomalies and like, hey, the cell side is crazy because they're trying to beat the So a lot of it made intuitive sense, um, and it was all good. I literally read every single one of these stock pitches catalog did. I had them all database by, Like what did they

mentioned as to why they liked this idea? Would have you one part of it? I had a theory papers well, which was beyond this discussion. But um, right, this thing up. It actually says that these value investors actually do have skill. And you know the fisher marketypothsis. It just it seems to be some slack in it, which is fine, um, you know. So so I sent it off to him and of course, I you know, the first team I

get is basically no, this is wronging a conclusions false. Um. So I'm like, great, it just wastes the year of my life and I'm totally scared. But you have to you can he I'm told he's pretty open minded, very openustness said, listen, I think you're wrong, Prove I'm I'm not correct exactly so. And and this is my like, oh my god, I'm dead moment. So of course I run down. I'm like, you know, and everyone calls him prof fam I'm sure like Clifaz's price, I would never

call him by his first team. Yeah he's so gane. Let me tell you why. Yeah, he's just too He's too steadily. Like I just feel like, you know, I don't want so many people I have a lot of I'm not a big E M H guy, although I the weak version of it makes sense, but there are so many people I have all this respect for who just sing say the world about him? Yeah, I mean, yeah, a little off track, but as just a human being.

You know, the guy grinds every day. He's super honest, super humble, works his face off, Like I don't care if he's bacon donuts. I like this dude. Um. He happens to be a Nobel Prize winner and that's awesome, but but it's more about a fundamental respect for just working his whole process. Yeah, what he's all about, like not even death act. He's a financial economists. I just

like his the way it carries himself. You know. That's why I said the exact same thing about Charlie Ellis, who was a guest on the show Who and I and I after the show, we walked downtown. I spent like an extra hours with him, and I came away with like, this is the finest human being I've ever met in my life. And I'm hearing the same sort

of thing from the same thing. Just good dude, Like like if I was in the Marine Corps and I could transplant him fifty years or I want to, like, this guy is good to go it regardless of what he knows about finance. But so back to that, I ran down there and and it was the same thing. Like his Cliff said, he's very very open minded empirical evidence, scientific focus, like if you got the evidence, you run the right robustant tests, like all good. Um, so go

down there. And you know, in my dissertation in the abstract for this particular paper, you know, I made an overstated claim. I said value investors beat the market. You know, He's like, no, the sample value investors you analyze be at the market. And so literally it was like that two or three word difference that because semantics matter and that kind of stuff, because one is an overstatement and the other is within the sub slept set of value managers.

I analyzed, they clearly have some skill, but you can't say that value the market. And I was like, he's being very precise, very precise, which was a great lesson. And then and to be more precise on that particular thing. This is not really in the dissertation because it's this is a little bit too practitioner focus, I would say. But after the fact we said, wow, this is incredible. You have all these people that spend all this time, incredible effort in data collection information come up with a

thesis on the stock pitch. Um, I'm really curious, can this be quanted out? Turns out that we looked at like that quant value agorithm, which basically is is essentially a computer version of what the Value Investors Club guys do by cheap high quality firms with a ton of analysis on like the quality component, but cheapness is is

a is a primary. Turns out that the correlation between just buying like a superactive cheap high quality basket is essentially the same and very very highly correlated with kind of what quote unquote the alpha generation is from these stock picker people. So you know it's you know, what is alpha? What is beta? Who knows? Um? You know, alpha is just intercept on a regression where if you put enough factors in there, obviously alpha is always zero,

but to some extent of you know, super concentrated. Wait when you say, obviously alpha is always zero, but is it always zero? It is if you keep adding factors that explain the variants. Because because alpha, so you risk adjusted. You once you once you go through all those different dimensions, since we're talking about Chicago, eventually you can rationalize where

all that alpha comes and eventually alpha becomes beta. Yeah, exactly, because all it is Alpha is literally just when you calculate this stuff formally, beta is the coefficient on the factor. Alpha is just kind of the average intercept, the kind of the extra you get that's unexplained for. So the deviation that you're looking for, why it occurs? Yeah, after controlling for all these other quote unquote risk factors. But let's take momentum for example. Okay, let's say we think

momentum is alpha. If you run momentum and you control for market size, value, blah blah blah, you're gonna have a huge alpha. So what do you do to control for the alpha momentum? Throw a momentum factor on there. Now, what happens the momentum strategy they have no alpha. So now is that because they don't work and they're not miss price or is that just because you controlled for

the momentum factor to say that momentum doesn't work anymore. Well, no, momentum still works and it's been embraced in the factor. But that doesn't necessarily mean that that factor is a true risk factor. What if the returns associated with it are associated with miss pricing problem, not like fundamental risks, like it co varies with your future consumption or whatever you know, fancy you know macro or model that some

economists is coming up with. And so I think the problem with that the idea of alpha's and beta's is alpha is an intuitive concept, is excess return controlling for a bunch of risks. But the mechanical construct, it's a statistical item and it can be totally manipulated. Where obviously all alpha can become beta because you just put the alpha generator on the beta side and you can go

buy it. But just because it can be beta, that doesn't mean it's not alpha doesn't mean it's not real or at least for that subset, And it doesn't mean it's It's not easy to explain, right, because momentum is a great example. Momentum is underperformed as a long short factor for arguably five to ten years. Everyone's like, oh, it's dead. Yeah. One of my old bosses, Chris Gates, he wrote the paper like the long World's longest back tests.

They get data back and he actually expecially says in the abstract momentum factor has underperformed for tenure cycles like seven times. So this is this underperformance recently a momentum Yeah, it's not all that operational, it's just so so one of the one of the things you mentioned before about the two two issues you look at, which is the behavioral side and and the principal agent side. So I would imagine someone like you looks at the FED with Quie and up and all that stuff and says, yeah,

we don't care about that. It's not. What matters is is the behavioral and the agency issue, not all these externalities. It's all about what is the signal? What is the noise? The signal is the huge It just driven from the humans evolved in the game and the dynamics and the rules of the game they play and how that shapes their own synips. That doesn't change no matter what. I don't care about g DP what the FED says, because

it's relevant. Human behavior stay indo chain, stay in the same in human incentives are stay in the same in the institutional construct that we currently live in, which is primarily driven by a lot of delegated asset management. That's funny because as we're as we're recording this, the FET is meeting and uh literally the news is coming out the second and we won't even talk about it because it's meaningless. Instead, let's in the last ten or fifteen minutes I have you, let's get to some of my

favorite questions. Um, well, you mentioned Cliff ass Nests. Who else were other quants that you you admired or who were mentors of yours? Tell tell us the people who who influenced your approach to invest in Sure, I'd say the danser directly like the quants that I admire. Obviously, Cliff as nous I like a lot. He does value momentum. HRS a great firm. Uh, you know, booth at Ata is great. They figured out how to capture small value premium.

And I think probably the most underrespected or under appreciated quant is Jack Bogel at Vanguard because indexing is a form of systematic quant investing. It's just your your systematically buying these market capuited passive indices. And for all intents and purposes, he is a quantitative, systematic investor, and clearly

that's in a world of good for society. And his alpha is we recognize that the cost structure is the most important element investing, and if we could do everything we can to reduce the cost factor, that's gonna our beta is everybody else's is actually a form of alpha if only you've given enough time. Yeah, costs and taxes, or if you can minimize those somehow, that that is always the answer now and that even they talk about like active active is only bad to the extent that

it's the cost of achieving it. The net benefit is not positive, it's negative because it goes in taxes and fees to some idiot people. People are surprised when I said, you know, Vanguard has a trillion dollars in active funds that like really has anybody written a paper or or or a column, and I may have to if nobody has Jack Bogel the quant. I don't know if anyone has. But so now now you've forced me to do this,

that's what's gonna happen. I think he might be the world's greatest quant, just that no one really appreciate it. I'm gonna have to quote you in this and you've just given me an idea. Now I have to get this out before the podcast goes up, so uh, it'll it'll be pretty interesting. So you've mentioned Buffett, You've mentioned Graham. What other investors have influenced your approach? I would say, um, not much beyond that, Like Graham taught me about, you know,

thinking about businesses or stocks is businesses. Buffett actually didn't add any thing onto that. But I just like his like transparent approach and the whole idea that integrity is everything and in the end that's what you live and die by. And he has that old what were you know? You know, integrity spends a lifetime to build, five minutes to destroy, which it has nothing to do with investing,

but it has everything to do with investing. Well, it has everything to do with working in the investment field exact. It's always you know, my my favorite line is no one has a patience to get rich slowly, and the people who are in a hurry invariably run into trouble. You got it. It's amazing. Let's talk about books you mentioned one or two earlier. What are some of your and fiction, nonfiction, investing, whatever, what What are some of

your favorite books? Yeah, so, unfortunately I'm not a one of my weaknesses is I'm very pragmatic and I just read stuff that helps me get better. So you're reading more academic papers, Yeah, I read. I read a lot of journals, four books. Some of the things that heavily influenced the way I've thought about things, and I know you know it very well, like Dan Kahneman's book The Fastest Epic. Another one is, you know Taylor sustained that

Nudge book. The whole idea of like liberty Ryan paternalism, I thought made a ton of sense because I used to be a libertarian. I was like, wait a secondaris humans involved and they make bad decisions. You have to have some bumpers up otherwise that someone just someone just ran maybe with Samantha b at the Libertarian convention, and one of the guys got booed for saying, I believe that we should have um people, the states should mandate tests for driving. We don't just give anyone a car.

And they were booed by the Libertarians, and it's like, oh, so you guys don't understand humans at all. Yeah, yeah, and that's my big I mean, I'm a I'm gonna be a Gary Johnson voter. He was the one who was booed when he said, yes, you should. He's a pragmatic hematic libertarian. That's a subset of the part. And guess what, none of these political folks appealed to the pragmatic part. You always get extremes because that's what sells well. Was but yeah, give me one more book, the other one,

a whole bunch of them. Chardini's books on like the science of persuadion, influence, influence, fifty scientific ways to say yes, like after re and that guy's stuff. It just made me rethink the whole world of of like human thinking and decision making from the perspective of like a marketing person, and how you get influence and bombarded every day in subconscious ways to do things you may or may not

want to do. But it's very important, I think, to be aware of this influenced tactics out there, so one you can defend against it, and then too, you can use it to your advantage, you know, in a sensible, you know, high integrity way. I'm gonna out myself embarrassingly. I've had that book on my bookshelf for years. I still haven't read it. Unlivable. You're not the first want to say that. All right, we're down to our last

few favorite questions. So if somebody, if a millennial's coming to you and says, I'm beginning my career in finance, what sort of uh, what sort of advice would you give them? So back to our discussion about manual labor, I would say, first, get mentally tough. So do sports. Do things that are painful that allow you to be tough.

Adapt because we're in the world where it's gonna change, it's gonna be tough, it's gonna be adapting, and you're competing not with Americans, you're competing with the globe now. So you know, we have a lot of you know, my old students are Chinese guys, and these guys grind, they work harder, faster, stronger, and that's who you're competing with out there. So unless you're you gotta rate rise occasion.

I hear, I hear a lot of marine corps. Yeah, so I would say, just get mentally tough, don't It doesn't even matter what you learn. Get mentally tough and know how to adapt and overcome. And then the other thing I said here I just write down my notes is you know, I become a either a robot salesman or a robot manufacturer because I feel like in the very near future robots are taken over and so you might as well adapt and train to the future and not you know, be a basket weaver guy anymore because

it's not gonna pay um. And our final question, what is it that you know about investing today that you wish you knew fifteen years ago? Well, I wrote down the Big Three, which have been uh, you know, endowed upon me by a lot of our investors who are all insanely rich. And I'm like, wow, that's pretty cool. How how do you guys do that? And there's literally three themes that come out of every single one of these stories. Minimize tax burdens, defer to for to for

have horizon, and live below your means. So always be humble, you know, never rise to the level of what you can afford. Just you know, live within your means and enjoy your life with what you got. Um and and those are the three things and you'll be all right. West Gray, thank you so much for for doing this this. This has just been absolutely fascinating. We have been speaking with Captain Wesley Gray, formally of the U. S. Marine

Corps now with Alpha Architect. I would be remiss if I did not think our producer Charlie Vhmer, my booker Taylor Riggs, and Mike bat Nick, my head of research, our recording engineer Jennie. If you have enjoyed this conversation, be sure and look up an Inch or Down an Inch on Apple iTunes and you will see any of the nineties six other such podcasts that we've had. Uh, be sure and check out the list of upcoming guests,

which is really quite astonishing. I'm Barry rit Halts. You're listening to Masters in Business on Bloomberg Radio look Ahead Imagine more gain insight for your industry with forward thinking advice from the professionals at Cone Resnick. Is your business ready to break through? Find out more at Cone Resnick dot com Slash Breakthrough