← Excess Returns 
Excess Returns
Even God Would Be Fired | Wes Gray on Bubbles, AI Valuations and Why Size Was Never the Edge
00:56:07
Loading summary
Transcript93 lines
- [00:01]
Sponsor Voice - Accenture
This episode is brought to you by Accenture. When your advertising operations fall out of sync, everything else follows. Spotify and Accenture are working together to reinvent the rhythm of ad sales using automation, analytics and smarter workflows to simplify campaign delivery and access better data across the business. The result? Less time spent on operations, more time connecting brands with the moments and fandoms that matter most. Learn more@accenture.com Spotify
- [00:31]
Sponsor Voice - Google Chrome
this episode is brought to you by Google Chrome. You think you know a browser, but Gemini and Chrome, that's new. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50 page restoration block, or finally break down that long article you've had open for weeks. Gemini and Chrome is here for it, ready to make anything online make sense. There's no place like Chrome. Check Responses Setup required compatibility and availability various 18.
- [00:59]
Justin
Wes, thank you very much for joining us. It's been a while since we've seen you, bud. Nice to see you.
- [01:04]
Wes Gray
Likewise gents, long time no talk.
- [01:07]
Justin
We always like to check in with you to talk markets, to talk factors, ETFs and a whole host of various, I think topics that we're going to work through today. What we thought we'd do is kind of take the first part of today's kind of discussion and talk about how maybe you're thinking about markets and looking at markets from a factor perspective. You guys run a number of factor based strategies at Alpha Architect and then in the second part, what we thought we'd do is kind of shift over to what you're up to on the ETF Architect side of things where you're doing 351exchanges and helping firms launch and convert to ETFs. And it's been, you know, a really fun, fun time to watch, you know, the success that you've had over ETF Architect. I think there's over 100 funds now on the platform and over 37 billion in assets, which is just amazing. And it's been fun to watch the success of that business for sure.
- [02:03]
Wes Gray
Been on a good run. Glad I live in Puerto Rico, that's for sure.
- [02:11]
Justin
Made that time.
- [02:13]
Wes Gray
I did. We had timing on that.
- [02:16]
Jack Vogel
Yeah, we launched our ETF Justin, not too long after Wes launched QVOM and qval. Obviously the path of success was Wes was a little bit different than ours going forward. Wes has turned it into like this massive business. But yeah, congratulations on that. That's awesome.
- [02:31]
Wes Gray
Hey, it's always good to be lucky then. Good, right?
- [02:34]
Justin
Well, and it's Just an interesting story around that wasn't the core business to begin with, but kind of what came out of that for doing it for other ETFs. I mean, that's how that business really evolved and, and developed. I mean, it wasn't like that's where the company started, you know, was you were doing it for maybe one or two other ETFs, and then you realize, you know, we have a, we have a business here. There's white space that we can attack.
- [02:57]
Wes Gray
Yeah, no, exactly. You know, as you guys know, I have a PhD in finance, and the last thing I want to do is herd cats and do ops and compliance. And that was. That's not what I signed up for when I started a biz. That sounds like my biggest nightmare. Um, but, but we were kind of, in some sense, it's kind of like Amazon, where I'm like, hey, we're going to create an online store. And then quickly you realize, like, wait a second, we also created this massive tech infrastructure and everyone on the planet needs a server. Oh, let's create aws. That's a way better business. And I don't think Jeff Bezos, I don't know, you could, you could ask him, but I don't. I imagine he also didn't start Amazon thinking that was going to be like a big component of their business. Just kind of like when we started, you know, we were not thinking about that, you know, in 2010. It was just serendipity and circumstance.
- [03:51]
Justin
Yeah. But I think one thing on that is, you know, you're. You're a former Marine, you know, Pat's a form. You guys are very process driven, very efficiency driven. And so I think that was kind of just in the culture embedded in the organization, which allowed, I think, you guys to kind of get into this other line of business.
- [04:09]
Wes Gray
Yeah, no, for sure. Yeah. We've always been trying to do more with less, and a lot of times the marketplace doesn't value that until you enter the vanguard world and everyone's like, oh, no, we all have to be in the ETF business now. And as you guys know, like, if you can't get low cost and efficient in ETF business, you die. And so obviously having infrastructure capability, the ability to deliver these services at low cost is super critical to survival. Because if you don't have that and your product has to be, you know, too high price, you're not going to survive in the ETF business.
- [04:45]
Justin
Right.
- [04:45]
Wes Gray
So it's just good timing, good circumstance, and executed on the plan.
- [04:50]
Justin
Yeah, we'll get into the 351exchanges and some of the ETF stuff in a couple minutes here. But let me just kind of come into the markets for a minute. So, you know, one of the questions or one of the debates right now that's out there is, you know, are we in a bubble? I'm not going to ask you whether or not you think we're in a bubble or not, but I'm just wondering from a factor investor's perspective, you know, is there anything that you can do if we are in a bubble, do you think there's anything that investors should. I mean, how, how do, how, how do you think about this given that you're a factor investor and given how you run money?
- [05:27]
Wes Gray
Yeah. So unfortunately, you know, as you guys already pointed out, like trying to predict a bubble, it's, it's easy to kind of know if you're in a bubble or in a situation with high animal spirits and everyone's nuts and everyone's a degenerate gambler. But then the next question is, well, great, how do you time it? It's just like being a great short seller. It's not about picking the stock that we all know is going to go to zero. It's about doing it at the right time. And that's actually, it turns out to be insanely difficult. So as you guys know, like in general, on average, not all the time. If you pay high prices for something, you would expect lower returns in the long run. Similarly, if you pay low prices for something that is high earnings yield or whatever, you would expect high returns on average in the future. Great. So that means right now, because obviously we have extremely high prices or like low earnings yield, I would expect to earn low returns on my overall portfolio in the next 20, 30 years. Great. That sucks. Thanks for telling me that. The question is, can we, but can we use that information to actually make us better? And the fortunate answer, as you guys already know, is no. Because if you try to do any sort of like model that tries to time based on valuation, they don't work. Right. It's just, it's, it's just the fact, it's empirical data. It says like, good luck, the only thing that works might be momentum or trend. And so unfortunately, I think you just gotta bare your teeth and grit it and just plan on lower expected returns over the next 20, 30 years. That doesn't mean that will happen. But I don't know really what you can do outside of just strategic portfolio management. Be diversified, keep your fees down, etcetera Even if, you know you're in the middle of a bubble because the timing's
- [07:18]
Justin
so hard, and maybe it's the same answer to this, but when you look at, like, the market today, and it's very concentrated, and there's been other times where the market's been similarly concentrated, maybe not as concentrated as today, but how do you kind of think about it from a factor investment standpoint? Are you, you know, is that level of concentration, how would you address that?
- [07:40]
Wes Gray
Would you say so again? You know, I look at everything in the marketplace through, like, the factor perspective. So, so if you look at, for example, like the SB 500. Yeah, it's really concentrated. Fine. That happens. It's happened in the past. What are you buying right now? Well, if you think about it, you're basically, you're basically taking a huge bet into large cap. You could argue quality, maybe growth, and just because that's inevitably what the market portfolio looks like right now. And then, so you got to ask your, you got to ask the question like, okay, great, I'm going to allocate to SB500. No problem with that. Maybe I want an allocation to that per particular risk profile, but do I want that much? Right. Like, like how much, you know, large cap quality growth as a percentage of my overall equity bucket do I want. And we all know the expected returns on those factors, they suck over the long haul. But relative to other things, and, you know, if you have tracking error issues or career risk problems, then you're just kind of stuck with that. But obviously, if I could think in a, you know, without, you know, in a vacuum here, and I was trying to build a portfolio that, that wants to be diversified across factor risk, etc. You know, you would, you would, I would think you'd want to kind of pull down some of those bets because right now they're obviously magnified versus history.
- [09:00]
Justin
How do you think about value investing and intangible assets anyway? I know one of the advisors on your platform who we know well, Kai Wu, Sparkline Capital. I mean, he runs some intangible value strategies and, and, and that's what sits inside those funds. But how do you think about sort of value investing, traditional, systematic value investing, when intangibles are becoming more and more important.
- [09:27]
Wes Gray
Sure. So I think if you think about through the lens of like a book to, to market type, systematic value investor, then obviously you should have rethought that, you know, 30, 40 years ago, because even 30, 40 years ago, if you rank stocks on book to market, 20 to 30% of them aren't even going to be making money like on what Ben Graham, you know, Warren Buffett Planet. Does that make sense? None of them. So I, I just, the whole premise doesn't make any sense to me and like I've always thought about it through the lens of like hey, why don't we focus on income statement items like operating income, earnings like actual like you make money and then sure, if I can make a lot of money and pay a low price. I love those stocks versus not so I think book to market centric people should definitely be reading Kai's books and white papers and adjusting their metric because it never worked in the first place in my opinion. But then if you roll back to like okay, great, so Wes, you like, you know, earnings, you like operating income, etc. Now how does that get affected? I would argue that it doesn't. There isn't that much effect because like Google, they don't have a lot of book but they got a lot of earnings, a lot of operating income. Right. So I just think those kind of metrics naturally, it's just they're less effective by you know, intangibles versus book. There's obviously some because of how you account for like expensing R and D and what have you, but I just think it's marginalized, you know, in the end. Could you refine it?
- [10:59]
Jack Vogel
Sure.
- [10:59]
Wes Gray
But it's mainly a book to market problem which we don't use anyway. So yeah, they should fix that.
- [11:06]
Justin
One of the points you made when you were on with us last time was that small cap value works not because the companies are small, but because that's where traditionally you find the cheapest stocks. Yeah, explain. Let's shake that out. Explain your view on sort of the small cap premium.
- [11:24]
Wes Gray
Yep. So it's not my view, it's just what the data and the research says. Right. So if you look at all the smart guy people that do like long, short factor neutralized studies of all this stuff, I, I think there's a consensus now and AQR's probably got the, the main paper out there that size synthesize, you know, you pull out the value effects, the quality, whatever, doesn't really have that much expected return. It sucks. Right. But that's because they're looking at through this complex view of you know, comparing long short factors synthesized for and that no one understands that. So, so in order to make this easier for people to understand, Jack Vogel, who's, who's obviously on our team, you guys know he, he's like, hey, let's just look at long only portfolios and just do a simple experiment. Let's go look at equal weight mid and large cap versus small cap. You could do it equal weight or you could do it value weight. What do you notice first? Well, the liquidity is 10 times bigger in the mid large cap equal weight portfolio than the small cap portfolio. What do you also notice? The value characteristic is the same. You know, whatever their average PE ratio is, they're the same. The only difference. And what he also noticed, what's the empirical statement? Their expected returns are the same. What so, so you now you have a portfolio that has 10 times liquidity, 10 times the average market cap compared against the small cap thing. But because it's equal weight construction which makes the valuation characteristic roughly the same, they earn the same return even though there's a dramatically different size effect. Right. And that's because we did that experiment by design because we already know mid large equal weight is going to have a similar value characteristic but way different size component and we can show empirically they earn the same return. Where people get confused is they go pull up data off of French's website and go, oh, look at small value versus large value. Well, large value is a market cap portfolio which if you look at the value characteristic on that it, you know, on average it's going to be way, way more expensive than the quote unquote small cap value. So you're not actually holding value constant, you're actually getting a little bit of both. So, so that, that's why it's just a simple way to explain it to normal people that value is what matters, not size. So if you could go, if you said, hey Wes, there's a bunch of micro caps that I can buy for like two pe and that's that universe. And anything above micro cap I have to pay 100 pe. I'd say, well yeah, then you should buy the micro cap portfolio not because it's micro cap, but because the PE is 2, not 100. Right. And Vice versa. You know, if, if all the mega caps had a PE of two and all the small caps had a PE of a hundred, I would say go buy the mega caps. Right, because valuation is what drives the is drives the returns, not size. But a lot of times they happen to be co mingled is the problem
- [14:38]
Sponsor Voice - Indeed
when you need to build up your team to handle the growing chaos at work. Use indeed sponsored jobs. It gives your job post the boost it needs to be seen and helps reach people with the right skills Certifications and more. Spend less time searching and more time actually interviewing candidates who check all your boxes. Listeners of this show will get a $75 sponsored job credit@ Indeed.com podcast. That's Indeed.com podcast. Terms and conditions apply. Need a hiring hero. This is a job for indeed. Sponsored jobs.
- [15:09]
Jack Vogel
Do you think there's anything too, and I don't know if you're in this in the weeds day to day now, but do you think there's anything to like the deterioration of the small cap universe? Like people talk about, like the Russell has way more unprofitable companies and like these great, you know, companies are staying private longer. Like, does that change the opportunity set like for a factor investor at all?
- [15:26]
Wes Gray
There might be. And I think again the issue there with, I think a lot of those studies, they're looking at book. And so if you guys, it's the craziest thing, I recommend everyone do it. And this is why book to market people had to add a quality component. Because basically those two things equal earnings to price is if you look at book to market ratios and you segment, let's do small cap, large cap. But then you just look at one other metric percent that are, that are actually profitable. It's terrible. So if I'm small cap investing and I'm using book to market, that is like R2k value. You know, it's like, oh, I'm buying all these cheap companies, these value stocks and you're like, wait a second, this is junk. Because like only 50% of these things even make money. Like, whereas if you redid the Russell thousand value and say, well, let's do Russell 2000 value, but rank on price to earnings or something, or just whatever, it doesn't really matter. I think a lot of these arguments fall apart because if you bought cheap small stocks based on actual, like they make money, they're high quality, etc. I think, I don't think you would see those sort of effects. But when obviously people do those studies that you're talking about, like, oh, has it deteriorated? Well, it's because you're using book to market and that was not really value because by nature the small cap high book to market, like the percentage of those that are profitable might be 50%. Whereas like if you, if you just do the bigger universe and use book to market, as you're sorting, you know, probably 80, 90% of those at least be profitable. So you kind of like have a missing quality component which is there. And we already know if you buy low quality junk, it Underperforms. And if we don't account for that, then we might be saying it was a value, an issue with value and small caps. But really it was probably more of a quality problem to begin with.
- [17:20]
Jack Vogel
Yeah, it's funny, I remember way back in the day when we were talking to you, I was asking you why not use a value to toss it? And your point was basically that yes, if you're using price to book, like and you put the other metrics in, you're getting this quality that's coming in there. But if you're using the other metrics, you kind of have that already. So it's like a more, it's a more interesting conversation than many people think in terms of like the argument for using a composite depending on what you're starting with for your metric.
- [17:43]
Wes Gray
Yes. And we write, I probably wrote a post like 10 years on this. But, but 100% like book to market is weirdly negatively correlated with quality. Right? Because book to market has all these dirt bag companies that don't even make money. But if you make money, this is why S and P for example has a requirement, I think that you have to be profitable because being profitable is a quality factor component. But, but if you just do a sorting of like, you know, let's just keep it simple. Price to earnings or earnings to price, everyone to look at it, it gets booked to market. Earnings to price is cheapness and quality because by nature if you have earnings, you have to have this quality characteristic. And so the only way to fix book to market is I have to add a quality component. And I got to create all these like stupid stories and do like crazy PhD thesis on this. What I'm like, well duh, you could have read Ben Graham's book, you know, 100 years ago and said focus on earnings, you got to be profitable before we even would think of you as a cheap value investment. Because just because I buy cheap book to market but your book earns negative money, I mean that's just a sucker bet. Like, I mean, you know, I'm saying like it's, I think the academics out academic themselves and for whatever reason we got anchored on book to market and then they found quality. It's like, well, you know, did you not ever look at what percentage of the book to market firms actually made money in the first place that would already told you, you obviously need to fix quality. So the whole, the whole thing is just kind of funny to me frankly. But whatever. Do you think AI is going to try outsmart us all in the end.
- [19:28]
Jack Vogel
Yeah, eventually, like, yeah, I'm hoping it doesn't become a podcast host because that's the last thing, that's the last thing I got left. So hopefully it doesn't take.
- [19:35]
Wes Gray
I think you're, I think you're good, man. I don't even like looking at AI images. It's just not that authentic. So I think podcasting is, I'm bullish on podcasting.
- [19:45]
Jack Vogel
Good, I'll take that. Do you think there's anything like changed in the market? One of the things we think about a lot is we've had all these great growth companies and if you look at like base rates going into this 20 year period, like a lot of them have defied what's possible and I don't know, they're higher margin companies, they're taking advantage of technology. Like I would bet if you look, you know, if you look historically there's a reason there's no growth factor in F and French is because it has horrible performance. But if you look for the past 20 years, like there's probably the growth factors probably performed pretty well. Like do you think there's anything that's changed about the market or do you just think this is just one of those periods we have in history where, you know, things change?
- [20:18]
Wes Gray
Yeah, I think the problem is these effects are always on average. So as you guys know value. Well there's many arguments for why value works but like the behavioral argument is like, okay, people get too excited, overpay and on average after the realization event they're like, oh great, it wasn't, you know, we weren't going to build stairs to the moon. You know, we were only going to build into the top of Everest. And even though that's really cool, we priced in going to the moon and you know, everything kind of like, like goes back to, to reality. But that's an average effect, obviously AI and you know, I mean if you were to ask me like even you know, five years ago, what do you think about this AI thing, I was like, yeah, it's kind of cool but you know, it's not going to change the world. You know. Now as a daily user of this thing and I'm like, oh my God, if I don't use this, I'm going to lose my job. I'm like, this is the most amazing technology that's ever existed on the planet Earth. So there probably was a in sample opportunity where actually the prices on those things were undervalued and it was the anti value effect. But now I would think it's. We're back to kind of like, okay, we have to bet X any. And again, knowing the odds sheet on how this works right now, I would think that AI, of course it's amazing, of course it's going to grow like gangbusters. But the prices are also set to go to the moon, not necessarily Everest right now. So I would still think that, you know, because we have to bet out of sample all the time, that it's. There's probably still a value effect there but there was this one time role where I think these things probably were undervalued relative to, sorry their growth and performance which can happen. It's not like value always beats growth all the time, which unfortunately we all know all too well.
- [22:13]
Jack Vogel
So are you a power user of AI? Like in terms of personally in the business, have you found like a ton of value in it?
- [22:18]
Wes Gray
Yeah, I mean I use them all and I love Claude. I'm just honestly continually amazed and I personally think we're AGI already. Just, I mean I'm not that smart but. But it's not AGI, but it's definitely artificially smarter than me at this point. So it's beat me. There's obviously way smarter people out there. I don't know when it'll beat the smartest 200 IQ folks, but I am massive power user. We're getting our team up to speed. Everyone's got different department degrees of adoption, but I, I just think it's amazing for at least the kind of work that I do and building systems and processes and code and all this stuff.
- [23:02]
Jack Vogel
How do you think about AI with respect to like going back to your roots of like factor investing. Like you could argue it might help factor investing, but you could also argue like people have pretty much beat the crap out of that fundamental data for like a long time and it's probably not likely to unearth something we haven't already found. So like how do you think about that?
- [23:17]
Wes Gray
Yeah, so I can't remember some, one of the books we wrote, I can't remember which one we, we did like, like I always go back to this like Ben Graham, I think it was in 1972. There's some medical journal he talks about, hey, if you just go buy the top, you know, 10% cheapest price, you know, earnings to price stocks and have like some basic quality like debt to earn, whatever. I can't remember what it was, you know, from 1920 to 1972 it made, you know, 20% with high volume. And so we did add a sample with the most brain dead thing you could ever do from 72 up to whatever that is, probably Cuba, I can't remember, you know, another 50 years out of sample, exact same results. And there's been a lot of technology from like you know, 72 to 2010 or 15, whenever that was. Now has there been massive technology leap from 2010 to now? Of course. But I almost bet that if we lived out of sample another 30, 40 years, probably when we're like almost dead at that point and someone said, hey, let's just go back, test the Ben Graham Strategy again. Top 10% earnings to price with some brain dead like quality factor. I bet you anything it's going to earn, you know, whatever it is, 17, 18% with 20% volume and massive relative performance problems or whatever. But over the whole period it probably worked. And that's because I think these things are probably just cooked in the books somewhere. But who knows? Maybe I'm wrong, but that'd be my guess.
- [24:51]
Jack Vogel
Do you think? I'm just curious, if you look across the market, do you think AI is going to be a source of alpha for people? I mean right now we've got human beings competing with each other for alpha. I mean do you think the future of the world is like AI is competing with alpha or you think it all just kind of evens itself out and things don't change?
- [25:04]
Wes Gray
Yeah, I think in the short run game of trying to bet the nest tick the next quarterly earnings estimate, I can't imagine like all these pod shops that, you know, they're, they're focused on like how do I make money tomorrow or the next week or the next month. And they have massive incentives and massive capital investment in all these technologies. I mean I would think that's probably arbed out or earning a fair cost of capital at this point, but I don't know how. They're not even in the game of like the Warren Buffett game. What about the next 10 year, you know, investment horizon? Like I don't think Millennium is thinking about 10 years from now because they would get fired, you know, in a quarter from now if they didn't make money. So, so I would, I would think that it has massive effects in like market making short horizon bets like, like where there's a lot of like bet, you know, prediction outcome, prediction outcome, prediction outcome. You're trying to outsmart everyone's computers. But I just don't know if they're that kind of technology is really that applicable to, you know, maybe five years out Maybe it is. I, I mean who knows? But I, I don't know or haven't heard of a lot of like big capital providers that you know, use it at that time horizon. Maybe they exist. But I don't know, maybe it'll, maybe
- [26:24]
Jack Vogel
it'll make us all long term investors again. Like maybe a lot of the short term edges will all be, you know, armed out of it and maybe, maybe we'll get a chance to like be Warren Buffett again. I don't know. It doesn't seem like people do that these days.
- [26:34]
Wes Gray
Yeah, who knows? Or maybe things weirdly they get insanely efficient in a short run sense, but in the long run sense they get way out of whack. So like short term cost of capital to like basically how are the gamblers are gambling with each other with no real, you know, paying attention to fundamentals or you know, cash flows. That's insanely hard to win in that game. But like maybe gets easier if you can think beyond your nose and you have like actual capital that can withstand a 5, 10 year horizon and deal with like, you know, all the career problems. Maybe there's huge edge in that, you know, I don't know. But, but I can imagine, you know, theories like that could be true since you're.
- [27:18]
Jack Vogel
You don't talk about this stuff too much on podcast these days. We're bringing out all the West's greatest hits today and I wonder. It was funny I was doing. We have like an AI system that helps me do like the excess returns quote of the day for Twitter and the one that came up yesterday was even God would be fired as an active manager, Wes Gray. So I thought it'd be interesting for you to talk about that though that paper you wrote and what you did there, because that's really interesting and I think it's very applicable to what's going on today.
- [27:41]
Wes Gray
Yeah. So that paper there is kind of like a fake investor where let's pretend you know all the future and you know the whole data set and you just get to sort stocks on their five year performance as you're cheating basically. Right. So like we're just going to cheat and be. We call it God. And it was going to create this return path of if you just cheat, right. You're like Biff from Back to the Future. If anyone knows what that is, you're just cheating. And then the question is okay, great, even if you could cheat and you're like the best quote unquote, five year, you know, Warren Buffett or whatever you know, what would people think about you in the short run? And kind of the point of that paper is like, even like this perfect God investor has massive insane drawdowns, can underperform the S and P, and you still get fired even if you're literally, you can't even get better than this person, you know, and that, and that just kind of highlights this whole issue with the transition of like being able to invest for the long haul in a smart way and in the, and invest in the short run and survive. Like, it's almost like two games that, that everyone has to play. And the long game is very, it's just challenging for folks because you have to look at the stock ticker every day and it's going to tell you, you know, you're either an idiot or you're a genius. And just the human nature is to react to that, unfortunately.
- [29:08]
Jack Vogel
Do you think beyond behaviorally, do you think people are better investors today than they were in the past? Like, I could argue both sides of it. I could argue you've got more people in the vanguard type stuff today or in the stuff you put out, like low fee, intelligent stuff. But I can also argue we've got the confetti flying all over the place and we've got the cryptocurrencies and, you know, all that, all the day trading and all kinds of that stuff. Like, do you think people are better behaviorally now or do you think that's just always going to be the same?
- [29:30]
Wes Gray
No, I think, I think probably your average hasn't changed, but maybe the distribution just in the sense that it's almost like bimodal, right? Like, like the opportunity and the availability of options to allow you to be kind of a long term Warren Buffett. There's so many out there, people that are already tied on that mentality. They can now execute on it with like beautiful options, great, you know, discipline, et cetera. But then the other side of that is also the, the consumer demand and the opportunities to be a degenerate have, have blossomed. So, so if your mentality is like, you like a little booze, you like a little drinking, the casino is definitely open and people flock that way. But, but there's also those people that are like, you know what? I got to be disciplined. You know, I got to stay away from the boozing and the party and in the casino. I want to go over here to church or whatever. The analogy is, there's a bunch of great churches you can go hang out at low cost. So I, I think that Just the consumer marketplace has gotten so filled with opportunities to fill whatever desire you want. You probably have a bimodal distribution where, like, probably the average looks about the same, but if you don't look inside of the data, you'll notice, like, oh, my God, there's these people over here on Degen island that are just destroying their lives in their capital base. And then, oh, my God, you got people on Vanguard island, like, they're all going to be billionaires 100 years from now or what, you know? You know, I'm saying, like. Like, I think it's just. Just the nature of. Of what's happening in the world is now you can kind of. It's kind of like tv. Like, you guys remember back in the day, we had, like, the three channels like abc, CBS and abc, CBS and NBC. And we all had to watch these three channels, and we all kind of liked it because you have to. Whereas now you've got 10 million channels and no one even watches the same thing or is even cognizant of what the other guy's watching. Right? You. There's so many niches, and so I don't. I don't know if general TV desire, utility or viewership has changed, but just like, we've kind of transitioned from, like, a few goods and services to thousands. It's just people can go branch off into whatever they want a lot easier thanks to, you know, capital, free markets or what have you.
- [31:48]
Jack Vogel
I was trying to explain to my kids this the other day, like, in terms of cartoons and stuff, and I was like, when I want to watch a cartoon, I had to put on the channel and like, whatever was on, that's the cartoon I had to watch.
- [31:56]
Wes Gray
Yeah, exactly.
- [31:57]
Jack Vogel
You don't understand how this works. Like, I don't even think it's possible.
- [32:01]
Wes Gray
No, I. I know. And one of the things that I will say, though, because I always explain this to my kids, is that, like, you and I, we could all talk about Nintendo games, and we could go talk to any one of our genre, and we're going to all like, oh, dude, you remember Zelda, Super Mario? Because we all had that shared experience. Whether it was good or bad. We all had it. Because that's all you had where nowadays, like, I imagine, like, at 30, 40 years, when kids are, like, trying to like, oh, did you play the, you know, xyz, blah, blah, blah, and they're like, no, I never even heard of that, you know, because there's like a million games to choose from and no one has any sort of shared experience or shared background on anything because like, choice is, is so wide nowadays. So it'd be interesting from a sociologist perspective. We'll have to see what they say.
- [32:49]
Jack Vogel
Yeah, I got the, I got the emulator thing that you pay for for the switch and like, yeah, my seven year old and I now play Super Mario Brothers like the way it was back in the day.
- [32:56]
Wes Gray
Oh, wow.
- [32:57]
Jack Vogel
Like the coolest thing in the world to like play something I played growing up and like have him actually enjoy the game, which is pretty cool.
- [33:02]
Wes Gray
No, no, that, yeah, that is awesome. I, I haven't been able to get mine that they, they, they like their, you know, Roblox and Minecraft and what's the Fortnite and you know, all these things. I, I wish I could get them in the Super Mario, but not, not happen on my side.
- [33:21]
Justin
I'm sure he crushes you and Mike Tyson's Punch out Jack.
- [33:25]
Jack Vogel
Oh, yeah. But it's cool that they like it because it's such a change. You know, it's obviously the graphics aren't nearly as good. It's such a change from what they're used to, but it's cool they like doing some of it.
- [33:33]
Wes Gray
No, that's true. Like, I just played Dragon Quest, which used to be called Dragon Warrior because now they're doing like the remakes and, and I was like obsessed with it because I was getting like all this nostalgia and I, I was trying to get Jack, but my 11 year old, not, not obviously the one here, he. And I just couldn't get him into it. He's like, dad, this is so boring. And I'm like, it's not that boring, man. So, so I'm having the opposite problem. I, I can't, I, I want to get that connection, but I just can't get it. I'm failing as a father, I guess. But what can you do?
- [34:06]
Jack Vogel
I guess we should get back to investing after all of our.
- [34:08]
Wes Gray
Yeah, yeah, exactly.
- [34:11]
Jack Vogel
The one of the things we've talked about a lot on the podcast is the impact of passive investing. And I'm just wondering if you as a factor investor have any thoughts on that. I mean, you're familiar with Mike Green's work. This idea that, you know, more and more people are investing in things that don't care about fundamentals. Does that have any impacts across the market? I'm just wondering, do you have any thoughts on that at all?
- [34:28]
Wes Gray
Yeah, I mean, I, I think inevitably it has to have an effect when, when you have like, let's say vanguard clicking the vwap button buy on billions of dollars every single day and every active manager or everyone else they're selling from is putting vwap sell. Like in the end supply and demand have to matter for prices at some level right now. So I, I'm sold on the argument that there has to be an effect. I just don't really know what the effects are or you know, because it's just, it's such a dynamic ever changing system. It's just unclear to me. And the other thing is you don't have a control sample so I don't know if anyone can ever prove anything to anybody because there's no such thing as all else equal in the stock market. It's just you only get one run at it and we're all looking at the same data and there's co founding effects. So I actually think intuitively Mike is probably correct empirically how he can prove this and I just find it very challenging to show evidence for it per se. I know he has a bunch of evidence and a lot of stories but I know there's other smart people that have other stories and other evidence but I'm a buyer that it must have effects for sure.
- [35:50]
Jack Vogel
So for the back half we want to switch to 351exchanges because this is really interesting what you've been doing there and it's one of the examples of the Amazon thing you mentioned at the beginning of taking what you have and then figuring out other ways you can use it. So maybe a good place to start is can you just explain what a 351 exchange is?
- [36:05]
Wes Gray
Yep, sure. So 351 is a part of the tax code where Congress set up, you know, seven 80 years ago where essentially you can set up a new C corporation and you can do so by contributing property and that contribution to property is not deemed a taxable event. And so how the heck does that have to have anything to do with an etf? Well an ETF legally is structured as a C Corporation but it elects to not. It doesn't be taxed as a C corporation so they want to be taxed as a Rick a regulated investment company. But an ETF is a new ETF is a new C corporation. It's just it elects to have this weird taxation. And so 351 is. And it is just code out there where hey, we're going to set up a new company, it's called an etf but and we want to contribute, we don't want to contribute cash like normal. We'd like to contribute our current property that is a bunch of low basis, you know, stuck portfolios. And I'd like to contribute that into this new etf, but I don't want to pay taxes. And that's what 351 basically outlines on how you can do that. And then you know, the natural question is like well why would you want to do that? Well as, as everyone kind of knows, I think at this point like the ETF is the best place to manage capital. It's where capital is treated the best. Right? Tax efficient, fees are low, super transparent, easy to interact, tons of liquidity, blah blah blah. Why wouldn't you want to manage capital in that wrapper? Well the kind of 351, the whole point of it from a congressional standpoint is we want to facilitate capitalism and free flow of capital where it's free from frictions to move to where it's treated best. Well that's kind of what ETF351 is doing is like hey, you're over in a area and you would like to get to the place where capital is treated best, the etf like but I don't want to pay taxes and deal with this friction costs. Voila. That's a 351. That was the whole congressional intent of the thing. And so we're just, you know, we use that to facilitate in the ETF infrastructure world.
- [38:17]
Jack Vogel
So what are the best use cases for this? I mean I know no, subject to the rules, like a concentrated position that you have a lot of gain in would be one like what are some of the best use cases for this type of thing?
- [38:26]
Sponsor Voice - Indeed
Usually?
- [38:27]
Wes Gray
I mean any situation where, where you basically have an under diversified or just basically a pain in the ass like operational nightmare because you got legacy stocks like crazy portfolios where you're like geez or you got lots of duplication in your exposure but you can't do anything because you have low basis. You're just stuck with suboptimality. Those are perfect. So a good example would probably be like dead tax loss harvesting portfolio. So you bought the long only taxes harvesting and then they forgot to tell you in the pitch that after three to five years you're just left with an overpriced index fund that has high tracking error and and is a huge nightmare and there's no tax benefits anymore. If anything there's tax cost because if there's M and A or what have you, you get it, you have so what am I going to do with this mess? I need to solve this so 351 is perfect, right? Like I'll throw the diversified portfolio in and now I can regain access to this beautiful, you know, track the broad index at low cost, tax efficient, low fee. You know, so things like that where you're just, you're moving from complex, annoying pain in my butt to simple, clean, beautiful, you know, that's obviously the, the easy use case.
- [39:42]
Jack Vogel
That's an interesting one too because so many people started these direct indexing type portfolios in the last three to five years and then they don't realize, you know, especially in a like a raging bull market like we've had. After five years it's like there's no losses left to harvest. Like you're just stuck with this portfolio like that. That's a really interesting use of this thing.
- [39:58]
Wes Gray
Yes. And you're stuck paying high fees and you can't do anything and you have tons of complexity. And you know, I'm sure if you look at those old pitch decks on probably page 1000 of disclosures that mention that we were asked back in 2012 to do a huge forensic due diligence on these programs and we quickly identified like, well, why would we do that when you could buy a Vanguard fund for three BIPs. Yeah, you don't get the harvesting benefits. But I also don't have this massive baggage and problem to deal with on the back end. But obviously there was a huge, you know, sales institutional mandate to you know, build out like the long only tax house harvesting. You know, they got gazillions of dollars now. People obviously have moved to long short version of that, which makes a hell of a lot more sense. But unfortunately that, you know, they weren't there 10 years ago. And now these people have the problem of like stuck in long only tax loss harvesting. But whatever.351 is a potential solution for that.
- [41:01]
Jack Vogel
Just one more for me before I hand it back to Justin. Can you talk a little bit about those rules? Like I know for instance if I'm a tech executive and I have 100% of my portfolio in one stock, I can't put that in. I don't think mutual funds can go in. I think there's certain types of ETFs that can't go in. So can you talk about the rules? Like what the rules are for this?
- [41:15]
Wes Gray
Yeah, so going back to that 351 statute, like new C Corp, no problem. And if we weren't electing to be a Rick, you could contribute single stocks in there. Right. But obviously we elect to be A Rick. So within that statute says, whoa, if you're going to set up a new ETF or a new C Corp. But you want it to be a Rick, you have to. Only if you want to get the tax free treatment. You have to contribute diversified portfolios, right? And that's where you get that 25% rule which, you know, no single security over 25%. And they also have this 50% rule which is the top five contributed securities can't be more than 50% of the total.
- [41:51]
Jack Vogel
Right?
- [41:51]
Wes Gray
So the IRS basically says you can get the tax free benefit if you, if you transfer into a ric, if and only if you start, you're already starting off, quote, unquote, diversified, right? And so that's really the big snag is you have to contribute a diversified portfolio to get the tax free treatment when you convert your property into the etf. That's the most important rule. There's a bunch of other rules about, you know, C Corp. Can't contribute for a lot of complicated reasons. You know, anything that can't live in an ETF, naturally you obviously can't contribute. Not because 351 doesn't allow it, but you can't like contribute your house. Because I can't go to a market maker and say, hey, can you make a market on my house value? They're going to be like pound sand. We're going to make your spread 10% wide. You know, so obviously there's things that you could do with 351, but we also have the constraint that, you know, we're running an etf, a registered fund, you know, so we got to comply with the 40 act rules and you know, things that you can actually trade and operate inside of an ETF wrapper.
- [42:55]
Jack Vogel
I was just clean up my garage the other day. I guess you can't take that, unfortunately.
- [43:00]
Wes Gray
Now if you didn't, if you didn't want to be an ETF and if we just wanted to set up, you know, Justin's, you know, hobby store and you wanted to contribute all your junk in your garage, you could do that under 351 and you could do it tax free. But, but unfortunately, you know, we want to set up ETFs and qualify them as a Rick. So we can't do that.
- [43:21]
Justin
This has obviously been the tax code for a long time. How did you. Remind me again, how did you guys like kind of uncover this? What was the genesis story there?
- [43:29]
Wes Gray
So it's a long story. It really wasn't even feasible till 2019 when they did the, the 6011 thing because in 6011 it actually says you can seed with property explicitly, which is a key component. The other thing is you need to have like an understanding of like active ETFs and their use of custom baskets that needed to be clarified. So 2019 is when it was even like operationally made any sense to even consider it. And then long story of how we actually got buried into this. But we, we, we got approached with doing a hedge fund conversion, which is a 368 conversion. Another part of the code where you can do tax free conversions from like one organization to another organization. Type in this, in this case an LP to an etf. And then, and we ran into this law firm where, you know, they just, they do tax free exchanges. And then I don't even remember how we basically that kind of triggered this idea of like, oh wow, there's tax codes that allow you to move from one thing to another. And then eventually we got told about, well also if you do it with an SMA, you know, you could do it with this 351 thing. And then, then we did a, then we did one. And then, and then we're just like, oh my God, we're all in on this. Because this is like brain dead. And so we kind of strategically pivoted as a firm. Like we need to figure out how to do this better than anybody. So you know, we kind of had like a, you know, four or five year head start on the industry. Now everyone's like, oh crap, we got to do a 351. But you know, it just, it's not like you just wake up and do a 351. There's massive complexity. I mean, just all the lessons learned and you know, things that we've dealt with over the years, I, I, I don't wish that on my worst enemy to just be like, hey, go launch a 351 with zero experience. I'd be like, oh God, you know, it's so just kind of lucky. Just. And as you guys know, like, we're like, I was raised on tax efficiency because we're, you know, funded by a huge family office. So going back to when we started in 2010, you know, I quickly like took off my fama Chicago hat and was like, oh, this tax thing. Actually your good point, that matters a lot more than just, you know, how much alpha I can get. I need to get the alpha after taxes. So we just have huge spidey sense on anything that could, you Know, lean into tax efficiency for clients.
- [46:01]
Justin
And so when the assets come in, it's like you guys are, it's not like the taxes, the tax actually is due whenever the investor sells the etf. So the assets come in, they get converted into the etf, which is some type of strategy. It might be like a factor based strategy or whatever. And then you know, the investors holding the fund, but the, their basis is like everyone's basis. Their, their contribution. Yeah, right. So you guys track that like on an individual level.
- [46:31]
Wes Gray
So. Yes. So what happens is the fund inherits the basis of all the contributions, right? So if, you know, let's say you, Justin, you, you submit zero basis in a million dollars of property. Jack submits a million dollars and a million dollars of property. The fund is going to have the two lots, right? It's going to have the zero basis on a million. It has everyone's junk but you guys individually. Your basis in the etf, Justin, would be zero. Jack's basis in the ETF would be a million. Right? So, so the individual contributors, they don't have any change in tax position because otherwise there'd be all kinds of weird arbitrage and crazy things you could do. And generally speaking, the IRS doesn't like that. That's not the point of a, of a transfer rule. Like you shouldn't gain a tax benefit by the, just the transition. Like your position should be the same. It's just maybe you're in a different structure, what have you, but the fund itself does take down the, like everybody's problems. But, but as you guys know, like in an etf, again, the fundamental reason people like the ETF wrapper is it's not like you're not creating a social problem because if you contribute a zero basis lot, Jack contributes $1 million lot. You know, when it, when it makes economic sense, where we have to go do a rebalance to achieve our investment objective, if there's a tax issue with that trade, we're going to be like, well, we could do it the old fashioned way and buy and sell the stocks. We have to pay a bunch of taxes. Or we could do it the ETF way and elect to do that through the basket process and everyone wins, right? So it's, again, that's one of the key reasons why people love managing capital inside the ETF structure to begin with.
- [48:22]
Justin
Have there been any situations where firms have come to you and been super excited and you just said, you know what, this isn't going to, it's sort of situations where you've had to kind of turn people away for one reason or another, I guess.
- [48:35]
Wes Gray
Oh, yeah. Every single day. And. Yeah, I mean, that happens all the time. Because. Because the. The problem, you know, the problem with tax stuff is, is you just don't want to mess with the. The bear, right? And. And the problem is, like, they have all these rules as they're written, and nowadays you just go to Claude and say, hey, Claude, please read the whole Treasury Code and tell me, like, the 10 different techniques to go around it. Not pay taxes. It'll give you the answer. The problem is there's the soft side of, like, intent, right? Because. Because laws are usually written with, like, an intent and, like, an understanding of. Of what they're supposed to be used for. And even though you can technically, like, do all kinds of games and, like, use financial engineering to achieve a civic outcome, if there's no actual, like, economic merits or any investment reasons to do so, it's obviously just a scheme. You know, that's how you get in trouble. And because, you know, whether it's good or bad, we kind of lead this business in some sense. Like, I don't mean to be like. Like, think I'm so awesome, but, like, you know, we do over half these deals at this point. I feel like we kind of have an obligation to kind of set the standard. And so. So we just have a much higher bar for, like, you know, if people come in and it's pretty clear that they're, like, trying to suggest something where I'm like, yeah, if I'm an IRS judge, I'll be like, you're an idiot. Get out of here. You're going to jail. Like, like, we want people that have good culture that want to follow the intent of all the laws out there, just because, you know, we feel like we should set, like, the standard, you know, to the industry to not be crazy. And so as we get calls from hedge fund guys all the time like, oh, look at this great idea. I got to do this and that. I'm like, nope, we're not doing that. Go talk to Joe down the street. It's just. It's not good for anybody to do these kind of things. So, you know, we try to just be as clean as we possibly can.
- [50:34]
Justin
So separately, on the platform, there's also, you know, advisors can use you to launch ets, and you're getting much more maybe selective in terms of. Just because of the size at this point. But are you finding that, you know, there's still a lot of interest in converting, like, Mutual funds or big, large pools of SMAs into sort of the ETF wrapper.
- [50:56]
Wes Gray
Yes, there's, there is demand as far as the eye can see on all of these things. Right? And I think you got a little bit of bateman because they did like the mutual fund ETF share class. So that kind of. It's still not out there yet. It's operationally nightmare. I don't think it'll really be in the marketplace for probably at least 12 months. And I think it'll be a TBD. What the consumers think about it. I don't think it's like a written in stone this is a good idea just yet. But it certainly paused a lot of conversions because people are like, maybe we should see how that plays out, maybe go down that route. But you know, outside, like mutual fund conversions or hedge fund conversions, where there's frankly just an economic problem. Because If I'm making 2 and 20 and you're like, oh, I got to go to transparent low cost man, let's, you know, unless gunned in my head, let's not do that. Right? Same thing. Mutual fund, I'm 1%. And yes, I'm bleeding out every day. But like, do I really want to go to 50 bips and compete in the ETF business, even though I know I'll probably be dead 10 years from now? Like, the answer is now, let's just cash flow this out a little bit longer. Right? So, so there. It's inevitable that eventually they'll start converting because the clients will say, you know, we're not giving our money anymore. But I think you're going to see that, like, slow play as we've already seen. But anything where that's not the case, like 351s, you know, weird situations or other asset managers embracing the ETF and not fighting it anymore, it's just, you know, unless they change the rules, it's just all money flows to where it's treated best. And that's the ETF wrapper. And, and you're just going to keep seeing just an avalanche of capital, you know, fight its way into the structure.
- [52:45]
Justin
One of the things that you've kind of hit on here is, and you do it both on the alpha architect side and it's sort of in, in the culture is, you know, trying to make things cost effective, make things transparent, sort of like vanguarding these areas that you're operating in. Are there any other areas of the market that you see this sort of, you know, opportunity in to make things more cost effective, more transparent that you're, that might be a business opportunity or something that people aren't paying attention to.
- [53:17]
Wes Gray
Yeah, I mean a lot of things if you're outside of the realm of what an ETF can tackle efficiently. So for example, like derivatives, long short futures, like because the Rick statute, you know, you have to set up the amenities like any, any kind of businesses that like you can't get Vanguardized, you can't get etf. Like another one might be like micro cap stocks or like liquid turds that you know the market maker is going to be like no, you can't make an ETF with like 200 million dollar companies because we can't trade it like anywhere where the ETF industry can't naturally fight you. You know, that's where all the margins are. So because the ETF industry, you can't get Vanguarded basically. Right. So, so that just means anywhere where the ETF industry can try to figure out how to solve that problem, there's obviously opportunity because your margin is my opportunity. It's just the problem is as you guys know, the ETF Wrapper 40 act has so many rules. We, you just can't do everything and compete everywhere. Which would be nice because then everything would be cheap, transparent to tax efficient and low cost. But that's just not reality. So with that all that said, like, like I would just look for like, like nowadays like derivative based strategies with options. Those used to be crazy. They, they started moving slowly into the ETF wrapper. Now they're becoming more and more ubiquitous. You're starting to see costs come down and Vanguard doesn't compete in that space. That's the other thing there, there's like the ETF world which is obviously way more competitive than every other rapper. But then within ETF world people always ask, does Vanguard do it? If Vanguard does it, you know, it's like why would I even like let's just not do that. But if Vanguard's not willing to do it, like bitcoin options, derivatives, okay, yeah, we gotta compete. But at least we're competing against like profit motivated. You know, it's kind of like apples to apples competition. So I think there's some opportunity there like maybe take you know, crazy buffered ETFs from 60, 70 bips down to 30 and build an enterprise out of that. Like anything where like Vanguard's not involved. It's like the ETF has already made inroads into like operating efficiently. But you think like, ah, you know, I don't, I could live on 30 bips, not 60. There's opportunities there for sure.
- [55:40]
Justin
Good stuff. Wes, we always appreciate you coming on, spending time with us. We know you're, you're busy, so this is. You're always welcome on the podcast, but we appreciate your time. We have one sort of standard closing question. It's one we haven't asked you yet, which is what's the one thing you believe about investing that most of your peers would disagree with you with?
- [56:01]
Wes Gray
Well, usually my peers, like my buddies, would agree with this, but they're weirdos. But, but if the question is more like the broad marketplace, I, I would say that you should embrace and enjoy underperformance. Right? If you think about the long game, because it's actually, even though it sucks to like get destroyed and like underperform and feel like you're a big idiot, that's also kind of like why on average you're going to get paid more if you're willing to deal with the pain, right? So it's kind of like this counterintuitive nature where people hate underperforming and hate losing a bunch of money because, yeah, that sucks, but in a counterintuitive way. That's kind of awesome because if I got cash, I could put it in there and I could invest at X ant and hopefully earn higher returns. So I think that's something that, that I believe in is, you know, having a strategy that sucks, loses a lot of money, has big drawdowns, is actually awesome in the long game.
- [57:02]
Justin
Good stuff. Thank you, Wes.
- [57:04]
Wes Gray
No problem. We'll see you guys later. Appreciate it.
- [57:07]
Justin
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns network@excessreturnspod.com if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on this podcast
- [57:27]
Jack Vogel
should be construed as investment advice. Securities discussed in the podcast may be
- [57:32]
Wes Gray
holdings of the firms of the host
- [57:33]
Sponsor Voice - Accenture
that refresh you've been putting off until the right deal came along. It's here. Wayfair's Black Friday in July sale is happening now, so you can finally get the style you've been waiting waiting for for less. Get up to 80% off area rugs and up to 60% off outdoor and bedroom furniture. Shop Wayfair's huge selection of styles and find the piece to fit your style, budget and space, plus free shipping. Black Friday in July ends July 27 shop today@wayfair.com Wayfair Every style, every home for their clients.