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- [00:01]
IBM AI Business Executive
The thing about AI for business, it may not automatically fit the way your business works. At IBM, we've seen this firsthand. But by embedding AI across hr, IT and procurement processes, we've reduced costs by millions, slash repetitive tasks, and freed thousands of hours for strategic work. Now we're helping companies get smarter by putting AI where it actually pays off, deep in the work that moves the business. Let's create smarter business. IBM.
- [00:32]
David Gura
The news doesn't stop on the weekends.
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Christina Raffini / Lisa Mateo / Alexis Christophers
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David Gura
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- [00:59]
David Gura
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- [01:05]
Christina Raffini / Lisa Mateo / Alexis Christophers
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- [01:16]
David Gura
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- [01:22]
Christina Raffini / Lisa Mateo / Alexis Christophers
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- [01:52]
Unknown Singer
But I still haven't found what I'm looking for But I still haven't found.
- [02:09]
Barry Ritholtz
Index funds have dominated capital flows since the great financial crisis. One of the rare exceptions is the pursuit of alpha via quant funds. These create very specific return characteristics that aim at somewhat different goals than the big broad indexes. I'm Barry Ritholtz and on today's edition of at the Money, we're going to discuss how to pursue Alpha through exchange traded funds. To help us unpack all of this and what it means for your portfolio, let's bring in Wes Gray of Alpha Architect. He's a quant who also specializes in ETF constructions. Wes also runs ETF Architect. So let's start Very basically, Wes, when you talk about Alpha in an ETF wrapper, what do you actually mean? Are we talking about excess returns over cap weighted beta or is it something else?
- [03:07]
Wes Gray
Yes. So let me frame it because alpha is obviously a loaded word and can mean a lot of things to a lot of people. On one extreme, you got Jim Simons, you know, busting out 50% returns with no risk. But guess what? You are never going to be offered this ever in your life, period. Because if I could do that, I would just manage my own money and become a billionaire. Right. The alpha for the rest of us, at least in my mind, is it's basically delivering unique, differentiated strategies after fee and after taxes that help you shape or differentiate your portfolio beyond the core of what you already have there in the form of like your Vanguard Beta. Right. But let's be honest, we're not going to. It's not the alpha in the rentech sense, it's the alpha in unique, different boutique helps you shape your portfolio outcomes.
- [03:56]
Barry Ritholtz
And just to clarify, if we are to believe Greg Zuckerman's book on, on Jim Simons, it was 62% a year and they did kick out everybody except the founding partners in the medallion funds there. It didn't scale much beyond a few billion dollars, but still 62% annually for 30 years. Nobody's even in second place. It's amazing. So, so let's, let's delve a little deeper into alpha. How do you think of it? Is it behavioral, is it structural, is it informational? Or is it simply here's where the model generates returns above what the market is doing on average?
- [04:40]
Wes Gray
Yeah. So if we're going to talk about kind of alpha or the kind of stuff that we want to focus on in the context of an ETF wrapper that's public and has some capacity, I think it really boils down to boring things like the Vanguard can't do. For example, how do I deliver something low cost, great tax outcomes that's also very unique, trades a lot and is going to change or shape your portfolio in ways that could be favorable for you beyond just buying S&P 500 and usually that's going to be related to diversification, benefits, portfolio insurance benefits and what have you. So you know, it's, it's the poor man's alpha. It's not the, it's not the 2 and 20 alpha, but that's just the reality of, you know, being in a product with a lot of scale and serving the public.
- [05:29]
Barry Ritholtz
So it's funny you say that when I think of alpha, I typically just think of factor exposure, value, momentum, quality, etc. How much of ETF based alpha? Poor man's Alpha is really heavily focused on factor exposure.
- [05:50]
Wes Gray
Yeah, I would say pretty much all of it is. And if it hasn't been factor exposure yet it will be because people just need to invent the factor that then explains that aspect of your performance. And obviously if you're in a transparent wrapper like an etf, everything can be explained with factors at some level. It's just a matter of did we think about that factor yet? And so again the alpha idea is like we want to deliver you these, you these unique market factors, but we want to make sure you capture all those efficiently, low cost and with good taxes. That's kind of the goal of ETF alpha.
- [06:24]
Barry Ritholtz
So, so I have an academic question for you and you're kind of an academic, so you're the right person to ask. You know, you studied with Gene Fama, all of these factors are public and well known. And in an ETF where it's transparent and disclosed, why doesn't this alpha just get arbitraged away? How did this, how does it still persist if everybody knows about it?
- [06:50]
Wes Gray
Yeah, so I think humans are going to human. And let's just take the most basic example, the value factor. Buy cheap stuff everybody hates. Like we all know that over a hundred years or two hundred years, in every market and every data set you can ever find, there's typically some sort of edge to buying cheap stuff that everyone hates. But then there's a dirty secret. For 10, 20 year stretches it can underperform your benchmark and you'll look like the biggest idiot on the planet. Everybody knows it has a long game historical edge. Everyone knows if you buy the cheap house in the neighborhood versus the most expensive, you're probably going to make money on average over long haul. But that doesn't mean everybody is going to go all in on buying like the value factor. Right? They're going to go buy bitcoin, they're going to go do momentum, they're going to do all kinds of other things. So I think a lot of like the quote unquote alpha, it's like alpha in plain sight. But it's, that doesn't mean it's like easy to do because it's, you know, you got to have discipline, you got to have long time horizon, you got to stick to the plan, you got to stick to the program. You know, it's, it's kind of like dieting and like being in shape. Like we all know how to get ripped. Eat, exercise and sleep appropriately. Don't eat bon bons, don't eat McDonald's. But the, the alpha is there. We all know what you're supposed to do, but that doesn't mean everybody does it it's the same exact problem with investing in these quote unquote alpha factors and why they don't get arbitraged away.
- [08:23]
Barry Ritholtz
You know, it's funny, I'm going to paraphrase my favorite white paper of yours that you put out quite a while ago. Even God would get fired as an active value investor or fund manager. How is that possible? I love how you sum up so many different parts in the title of that. But if God's going to get fired as a value investor, what chance do the rest of us have?
- [08:50]
Wes Gray
Well, exactly, and there's been fall on research. I think someone in your shop actually did it. Where what if we were God, the tactical asset allocating manager. Same problem. Like you could underperform the benchmark for a long period even though you're literally perfect. And you're like Biff, if you remember back to the Future where he's got like the little almanac. It's just that the reality is markets are volatile and they generally work in a way that they're going to push you to maximal pain before the gains are there. And that's just the nature of how markets clear and how they work. So is what it is. And I can't explain it, but like I said, humans are going to human in the past, in the present and in the future.
- [09:33]
Barry Ritholtz
So I have a couple of technical questions to ask you and then I want to dive into some of the more really interesting ETFs, Alpha Architect managers. But before we get to that, the perennial challenge with everybody who is a quant and everybody who works with factor investing is that they do these back tests and there's a tendency to either overfit. I mean, we've never seen a backtest that we didn't love. The problem is if the future looks exactly like the past, well then the back test is great. But most of the time that doesn't happen. How do you prevent that sort of overfitting? How do you prevent, oh my God, here's the perfect backtest. And not understand why that model isn't really going to work in the future.
- [10:27]
Wes Gray
Yeah, so I mean, I think at the outset the best rule is just never trust any past performance, especially hypothetical, but even live past performance. The reality is, what you should understand is what is the process fundamentally and then obviously why has this work and why will it continue to work? So for example, if, if someone shows me a back test that says, hey, I made 50% returns a year with like no risk and you don't have a 250IQ, like you know the Rentech guys, which nobody else does. I'm going to say well that's great, it's in the back test and I'll grant you, let's just assume it's true. That's pretty straightforward. Why would it exist in the future? So unless you got a great story about how terrible this is simultaneous to how great it is, it's just not believable or credible. Right. And so that's my benchmark is don't believe any back test, especially if it shows a great thing unless it also shows why it's so bad. Why is there so much career risk? Why is this underperform the benchmark year in, year out, potentially for decades to get me fired and to want to jump off a cliff. Like I want to know that information because now I'm like thinking oh that backtest might actually be legit then. But there's, but there's a trade off. It's not like it's an easy thing to deal with in the future. So you know, that's what I'd say.
- [11:48]
Barry Ritholtz
Let's talk about some other risks from backtests, drawdowns, tracking error trail, risk crowding. What other things do investors tend to underestimate or quants underestimate when they're looking at a model?
- [12:04]
Wes Gray
Just pick them all. They, they underestimate everything. And the reason is because of incentives. So generally speaking I only focus on academic research and peer reviewed journals. Not because academics are the best or smartest or most practical but they have the least warped incentives in a sense that they're also warped too. Like no one's buying.
- [12:27]
Barry Ritholtz
Well, they want tenure but they're not. They want form fitting.
- [12:30]
Wes Gray
Exactly.
- [12:31]
Barry Ritholtz
Fabricating alpha.
- [12:32]
Wes Gray
Yes. Their currency is like ego, prestige, like getting published, which is it's not show you this backtest to go buy my product. So, so just because of the incentive problem tied to like backtest from an asset manager. It's you know, it's just, it's like kind of like there's a, there's a study on how to this drug from like sponsored by Pfizer Research. Like I just can't believe it at the outset. Right. Like it's similar in I think in our business where if it's a back test and unfortunately it was produced by an actual firm that sells the product, you just have to discount it damn near 99% and you know, go look for like other evidence from like quote unquote people who are less biased and, and you know unfortunately that that's really boils down to academic researchers, but they have their own biases as well. But as far as I know, that's the best you can find out there.
- [13:27]
Barry Ritholtz
So let's talk about some of the funds that you help put together and help manage, starting with both momentum and value. QMOM and IMOM are US based or international momentum strategies. And then QVAL and iVal is US based or international value strategies. These seem like such core factor models. Tell us a little bit about these four products and who tends to be the investors in these.
- [13:59]
Wes Gray
Yeah, so, so generally speaking, what's the genesis of these products? And, and why are they very different but also very bad potentially for people? So, so I was an academic, right? I'm a PhD sitting around here spinning the data tapes and I just want to figure out how to invest my own money. And I read all these papers, they're like great, take the thousand largest stocks, you buy the top 10% on book to market and this works over long haul. So naturally, because I'm not in the investment management industry, which we'll talk about in a second, like these products are designed like that to deliver these kind of academic factor looking things like hey, top 1000, let's go buy the top 5 or 10% on momentum and call it a day monthly rebalance. I'm oversimplifying. That's the idea and I like that because it's grounded in the actual formation of how academic portfolios are actually created. Now that's not what normal people do. I learned what normal people do is you start with the S&P 500 index and then you do little tilts, plus or minus. Because why would you want to do those academic factor things? Because you're going to get your booty fired real quick because you're going to deviate like a madman from those underlying core benchmarks. And that's just the, the lot that we chose.
- [15:20]
Barry Ritholtz
But that also means you have a very high active score and you're not a closet indexer.
- [15:26]
Wes Gray
Yes, it's weird. We are not closet indexers and we have very high active share and we're definitely doing something different and unique. But we don't like to sell our products because it's really important that people buy our products to understand what they're getting into because of this whole problem that they can outperform and we look like heroes, they can underperform, we look like zeros and everything in between. It really does require kind of this 10 year horizon and a lot of understanding of the process and why it works.
- [15:55]
Barry Ritholtz
So let's talk about what I think is your largest etf. It's based on a box spread that option riders have been using for a long time to generate low cost lending situation against stocks. Boxx is the alpha architect one to three month box ETF that that's coming up on $10 billion and then a little more intermediate duration underlying box A. Tell us about these two strategies. They seem really interesting.
- [16:30]
Wes Gray
Yeah. So the, the fundamental idea here is that we can access the market price risk free rate through the box spread market which we could have a whole nother podcast on how the heck that works and what it is. But just think about like instead of going through the treasury market where I access what the government's going to give me effectively I can go through the box spread market and access the implied risk free rate amongst like broker dealers, banks and traders and everyone else which is much lower. Yes. And so what box is trying to do is how do we deliver excess returns net of fees and taxes and all that good stuff over the equivalent duration. So we're targeting one to three month duration. You know obviously if you're going to do treasury bills you could do one to three month duration there though. The key goal is how do we beat that? And we, and we have done this and the idea is like it's just that funding market has a little bit less slack and there's some other reasons why it outperforms but we're just trying to capture that net of fees and net of taxes in box and then box A. There's also a trend component but it's the same idea. How do we, how do we access these funding markets and fixed income markets but deliver them in such a way that ideally we can outperform and potentially have other benefits along the way.
- [17:47]
Barry Ritholtz
Let's talk about two really interesting funds. I love the stock symbol Chaos C A O S the alpha architect tail risk. I'm assuming that's exactly what it sounds like. You are managing the potential for there to be a market crash.
- [18:08]
Wes Gray
Yes. So, so one of the with a twist and again there is no free lunch in in options and and broad market exposure. So I'm not here to say that this is a alpha generator in some sense but what that product is doing is most terrorist funds like why do you buy a Telros fund? I want to get protected if the market blows up. Well what's the downside of a Telros fund? Well we bleed out to zero over time because I'm buying puts all the time. So what chaos represents is a trade off where we say, listen, we're going to buy the protection. So if the market bombs out, it's going to make money. However, we're going to be selling put spreads to fund that and we're going to invest your collaterals as efficiently as possible. And what does that mean? Well, that means that we're not protecting you in like say the 0 to 20% range in like a slow bleed out. You're also going to lose money. Right? So, so CAST is just saying, hey, we'll deliver the detail risk, but we're going to have to pay for it by eating risk in like the small drawdowns. But that's what pays for our insurance. And then we're just trying to deliver all that in a tax efficient, you know, fee efficient manner. So, you know, people kind of have terrorist protection but without the bleed. But again, it's just reiterate, it's not a free lunch in the sense that we just, you know, sell you insurance that always works and you never lose money. Just to be clear on that, I
- [19:30]
Barry Ritholtz
do recall Was it the first quarter of 2020 during the pandemic, this exploded upwards like 25, 30%. Am I remembering that right?
- [19:40]
Wes Gray
Yes. It's designed where if the market blows up and the VIX explodes this thing, I mean, I can't guarantee anything, but it should, with very high expectations, make a lot of money if that fact pattern is true. Yeah. So if Trump says something crazy or North Korea nukes us tomorrow and the Vix goes to 100 and the market's down by 50, chaos will probably be doing pretty good.
- [20:06]
Barry Ritholtz
And the last one I want to ask because I love all of these unusual box chaos sort of things that are not the typical etf. Hide high inflation and deflation. I love the symbol. Hey, you need a place to hide during an inflation spike or deflation. Hide is, is the place. Tell us a little bit about that etf.
- [20:28]
Wes Gray
Yeah, same idea. We call this poor man's managed futures because it's 29 basis point and we're trying to deliver that kind of exposure if you're familiar with it. But basic idea is like listen you for your diversifier, you want something that could protect you if there's hyperinflation or potentially protect you if there's deflation, but we don't know what it's going to be. So all that product does is says, hey, we're going to focus on bonds which, which can help you in deflation. We'll focus on commodities which will help you in inflation. And then we have real estate as kind of an in betweener and we just trend follow those exposures. So if the bonds are doing great because we're trending towards deflation, own those. If, you know, if inflation's look crazy great, we're going to own commodities to get ahead of that curve. And then if nothing's got any movement, we're just going to own cash and hide literally. So it's just, you know, hyperinflation or deflation protection in one product so you don't have to think too hard.
- [21:26]
Barry Ritholtz
So to wrap up, for those of you who have a core index approach, but want some satellite ideas to surround the passive index, consider ETFs that focus either on specific factor strategies or specific option strategies that could work to your advantage both in terms of diversification and non correlation to what the core market is doing. I'm Barry Ritholtz. You're listening to Bloomberg's at the Money.
- [22:04]
Tom Keene
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