Wes Gray - Compound Your Face Off - [Invest Like the Best, EP.47]

My guest this week is a version of me—a funnier, cooler version who has a PhD and served as an active duty marine. Lots of you will already be familiar with Wes Gray, and those of you who are not are in for a treat. Wes is the founder of Alpha Architect, a firm which manages quantitative equity strategies for clients using factors like value and momentum. He also advocates for a more concentrated, pure approach to factor investing, which listeners know is music to my ears. While we share a lot of the same views on markets and investing, you will still find this refreshing. The conversation was easy to structure--I just took all the questions clients and prospective investors always ask of me and my firm, and turned them on Wes. These range from very specific questions on quant investing to big existential ones. I listened to this on a long drive home and laughed out loud in the car at least 5 times. You are going to love it all. I close this introduction by offering you an opportunity which is not for the faint of heart. On September 16th, I will be joining Wes and his crew on a 28-mile trek called “March for the Fallen” which is a small but important way of honoring those who have given their lives in service of our country. Wes and I invite you to join as well. If you are interested, check out the post on Wes’s site with all the details. I will link to it in the shownotes at investorfieldguide.com/wes. If you are still interested, then email me with the subject heading “March for the Fallen.” I told you Wes is a much cooler version of me, and true to form he will be doing the hike with a 40-pound rucksack. I will be doing the version without a rucksack. Either way, it will be a day of comradery and remembrance that we won’t soon forget. Join us. Books Referenced The Devil Dogs at Belleau Wood: U. S. Marines in World War I Thinking, Fast and Slow Online References The Limits of Arbitrage Show Notes 3:07 – (First question) – Exploring the mindset that is ingrained into Marines 3:16 – The Devil Dogs at Belleau Wood: U. S. Marines in World War I 5:27 – Most memorable experience growing up in the mountains of Colorado 6:29 – What experiences in the military have transferred to what Wes sees in the public markets 6:48 – Thinking, Fast and Slow 7:51 – Wes’s first foray into stocks 10:51 – What was the transition into the quantitative investing space 12:29 – How Wes would describe quantitative investing and what the landscape looks like today 17:10 – What is the nature of the strategies Wes uses, like high-frequency and market-making, and what makes them stand out in those 20:57 – What about the human capital arms race in this space and how different firms are attracting the top talent 23:21 – What the approach is for Wes and what his research suggests is the best predictor of performance in stocks 25:36 – Wes’s approach to portfolio construction 33:19 – What is the thinking behind the number of and the size of names in the QVAL ETF 36:20 – Why the data suggests momentum is the better pick 37:36 – Why price-to-book sucks relative to other value factors 39:55 – What things worry Wes about the future of this strategy 44:39 – How does Wes think about research and what to explore next. 50:05 – Who would Wes have manage his money since he thinks Vanguard is not the best choice 57:01 – Exploring his firm Alpha Architect, how it started and has evolved since launch 57:39 – The Limits of Arbitrage 1:08:15 – How the influx of people to passive investments are impacting the overall market, especially for active investment strategies 1:13:13 – Wes’s most memorable day of his career both in the military and as an investor 1:17:19– Kindest thing anyone has ever done for Wes Learn More For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on twitter at @patrick_oshag

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

  I know firsthand how complex the tech stack is for asset management firms. And seemingly every new tool and data source makes the problem even worse, adding more complexity, more headcount and more risk. RidgeLine offers a better way forward. One unified platform that automates away the complexity across portfolio accounting, reconciliation, reporting, trading, compliance and more, all at scale. RidgeLine is revolutionizing investment management, helping ambitious firms scale faster, operate smarter and stay ahead of the curve. See what RidgeLine can unlock for your firm. Schedule a demo at ridgeline.ai.

• 0:32Patrick O'Shaughnessy?

  This podcast is sponsored by CFA Institute, the global association of investment professionals whose mission is to lead the investment profession by promoting the highest standards of ethics, education and professional excellence for the ultimate benefit of society. CFA Institute serves a global community of investment professionals, working to build an investment industry where investors' interests come first, financial markets function at their best and economies grow. The Chartered Financial Analyst credential is the most respected and recognized investment management designation in the world. The views expressed in this podcast do not necessarily represent the views of CFA Institute. Hello and welcome everyone. I'm Patrick O'Neal and this is Invest Like the Best.

• 1:15Patrick O'Shaughnessy?

  This show is an open-ended exploration of markets, ideas, methods, stories and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com.

• 1:31Speaker 02

  Patrick O'Neal is a Principal and Portfolio Manager at O'Neal Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Neal Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Neal Asset Management may maintain positions in the securities discussed in this podcast.

• 1:54Patrick O'Shaughnessy?

  My guest this week is a version of me, a funnier, cooler version, who also has a PhD and has served as an active-duty Marine. Lots of you will already be familiar with Wes Gray, and those of you who are not are in for a treat. Wes is the founder of Alpha Architect, a firm which manages quantitative equity strategies for clients using factors like value and momentum. He also advocates a more concentrated, pure approach to factor investing, which listeners know is music to my ears. While we share a lot of the same views on markets and investing, you will still find this refreshing. The conversation was easy to structure. I just took all the questions clients and prospective investors always ask of me in my firm and turned them on Wes. These range from very specific questions

• 2:35Patrick O'Shaughnessy?

  on quant investing to big existential ones. I listened to this on the log drive home and laughed out loud in the car at least five times. You're gonna love it all. I close this introduction by offering you an opportunity which is not for the faint of heart. On September 16th, I will be joining Wes and his crew on a 28-mile trek called March for the Fallen, which is a small but important way of honoring those who have given their lives in service of our country. Wes and I invite you to join as well. If you're interested, check out the post on Wes's site with all the details. I will link to it in the show notes, which you can find at investorfieldguide.com/wes. If you are still interested, then email me with the subject heading March for the Fallen. I told

• 3:19Patrick O'Shaughnessy?

  you Wes is a cooler version of me, and true to form, he will be doing the hike with a 40-pound rucksack. I will be doing the version without a rucksack. Either way, it will be a day of camaraderie and remembrance that we won't soon forget. Join us. Okay, now on to my awesome conversation with fellow quant fanatic Wes Gray. Talk about the mindset that gets beat into you, or maybe brainwashed into you as a Marine. I've read a lot about Bella Wood, and Devil Dogs, and sort of the mindset underneath it all. Compare that maybe to the rest, some other branches of the service, and kind of how the mindset is or isn't an advantage, if you think, I don't want to assume you think it is.

• 4:00Speaker 03

  Yeah, Marine Corps is like, kind of there. Do more with less. We're the guys that always get the scraps. We've got to be honorary and mean and internal. And I don't know if that's a fair classification, but in general, Marines, we like to think of ourselves as kind of survivalist and we can do more with less. So I think that's, I don't know if that's true or not, because when I was in, we had GWOT funds and they gave you as much money as you wanted. And if you wanted to go shoot 10,000 rounds, as long as you were training, you got it. But still that mentality and that culture of doing more with less and winning at all costs, I think still permeates Marine Corps versus the bigger, more bureaucratic services, for sure.

• 4:44Patrick O'Shaughnessy?

  Did that change your mindset? So how much, I always wonder, like, how much of this is self-selection versus like real transformation? So was your mindset like that before, or was it?

• 4:55Speaker 03

  Yeah, I've always been like that, man. I grew up in the mountains in Colorado, and so I've always just been into adventure, survival. When I was a kid, we were pretty broke. I didn't really know it at the time, but just I've always been in that mindset of, you know, don't spend money, even if you have it, just always be, you know, kind of like a depression baby that was born in 1980. And so I think that kind of culture is just also in the Marine Corps, and at some level, kind of attracted me to the Marine Corps. So I think Marine Corps doesn't really change you a lot of times, at least in my scenarios. It just attracts whack jobs like myself to come into it. And so then you get a whole fraternity of people that were kind of already self-selected to be like this,

• 5:39Speaker 03

  and then we all hang out together, and it just makes it even worse, you know? And some people do come in the Marines, I think it does change them. But I was, like, I was already brainwashed coming in, basically. I didn't get transformed. I was already weird beforehand, I would say.

• 5:56Patrick O'Shaughnessy?

  What was your most memorable experience growing up in the mountains?

• 5:59Speaker 03

  It's funny, because you probably know this when you grew up, but there was this mountain behind where I live there. At the time, it's called Adams River Ranch. The Coors family bought it. It's called Frost Creek, and the whole thing is like a development now. But there's this mountain. Behind us and my brothers and I, we'd always climb up this thing. It was like an epic adventure, take all day. Thought it was the best thing ever. And then we went back probably about 10 years. I brought my best friend out there. And I was looking for this mountain and I'm like, man, Henrik, you gotta hear about this thing. It was so epic like. This is where I did all my like toughest things. And of course, we go out there and it's like a hill, maybe a hill.

• 6:40Speaker 03

  And it was just amazing when I was a kid, like that was so great. In my mind, it was like the most insane, awesome thing you could ever do. And we went back there, we're like, oh, that's pretty lame and doesn't even matter, wouldn't even count. So unfortunately, that was probably the best or the most memorable thing I did growing up there was just climbing mountains and doing crazy things, but it wasn't that cool after the fact.

• 7:01Patrick O'Shaughnessy?

  In the military, what, what experiences would you say are most related to kind of what you've gone on to see in public markets? So maybe the same sorts of mistakes that people make, arguably these mistakes are what strategies like yours and ours prey on.

• 7:15Speaker 03

  Sure.

• 7:15Patrick O'Shaughnessy?

  So, so what are some parallels that you saw?

• 7:17Speaker 03

  Yeah, I think, um, you know, Kahneman's book, Thinking Fast and Slow, the whole system one, system two architectures of brain. I think that defines life in, in decision making and in the military, it's, it's just magnified because all your training, everything you do is set up, how do you minimize system one errors? And try our best to think in that system two mentality of like rational, calculated thinking. But obviously that gets more and more difficult at the margin when you got a hundred pounds of shit you're carrying around. It's 125 degrees, you're tired, you're pissed off and the military is just, it's all about how do we contain system one errors as best we can.

• 7:59Speaker 03

  And, and you know, obviously in investing, that's totally transferable where if you're not in that extreme as an environment, but clearly investing your money is pretty stressful and emotional. And I still think that the best investors are not really those that can make the best stock pick, but more they're able to contain the damage from bad decision making and being overconfident, doing stupid stuff.

• 8:23Patrick O'Shaughnessy?

  What were your early forays? I realize I don't think you and I have ever actually talked about this despite a million investing conversations we've had. What were your earliest forays into stocks into the stock market? Was it, how did you first, what was the first stock you bought or owned?

• 8:36Speaker 03

  Yeah, yeah, so.

• 8:37Patrick O'Shaughnessy?

  First story in the market?

• 8:38Speaker 03

  Yeah, I mean, I was on a path to total failure because the first stock I bought was Swisher Sweet cigars. And I know, I'll even remember, I remember exactly, it was 650 the stock price and I'd been brainwashing like Warren Buffett stuff and Ben Graham. So it was all about, you know, return on capital, low PE. This was probably like 98 and at the time, it like, I think I even read the value line back in the days of the paper one. It was amazing, like huge return on capital, huge return on assets for multiple years. You know, the, the earnings kept growing, it was super cheap on PE. Bought it at 650, like literally a month later, a buyout for like, it was like nine or 950. And I was like, oh, this is so easy, man.

• 9:21Speaker 03

  No wonder Buffett's a billionaire, this is all you gotta do. And so that, that's unfortunately how I started with like a ton of success. Which was kind of lucky because then I started getting huge and like stock picking, special situations, did that for years. And kind of also got lucky in the sense that I wasn't lucky starting around like the late 90s. Cause you know, my dad would call me up, tell me to buy the Janus Global 20 Fund every day. You know, this is when internet go-go was going on. So I kind of, I felt confident because I had my Swisher Sweet success. But then, you know, I kept not doing as good as the general market. But just by nature, being a small cap value player. And as we all know, the, the story's now been told.

• 10:03Speaker 03

  Minus the internet crash, like small cap value, you could have thrown a dart at a wall and made 30 Keggers for 10 years. But you're not all in poorly because towards the end of it, I kept doing more of the stock picking stuff. And even to this day, I still sit on about a half a million dollar capital loss carry forward. And that, that's kind of what, what moved me into a, I'm not Warren Buffett and I need to focus on systems and not basically fucking everything up. Yeah, I went from the super overconfident. And then all the way down to the bottom of the depths. And then luckily, I wasn't that rich. I kind of ate my humble pie pretty early. And thank God, because now, you know, I haven't looked back now. I don't do stock picking at all.

• 10:48Patrick O'Shaughnessy?

  So what was the transition into the quantitative investing space? So how did you kind of discover it? What was the early research process like? How did you build conviction that this was the way to do things?

• 10:58Speaker 03

  Well, it's another, it's another bad story. But, you know, so I actually launched a hedge fund. It was going to be basically like, kind of what quantitative value does, but long short in September 08. So I literally launched a hedge fund right when the whole thing was like blown up. And of course, just by dumb luck, I go in hedged. So, you know, in those months, I'm looking good relatively. But at the time, I wasn't doing short in individual security names. I was just using Russell 2000. And of course, because all the naked shorting rules got blown up. Even IWN got like called in, so I couldn't short anymore. So now I'm long and strong, these quant value names, which I was like, oh, this is great.

• 11:41Speaker 03

  But of course, this is now in December. I start going back to the old Ben Graham ways where there's all these like biotechs that are selling for less than cash. Like all the traditional things that I've been doing for like 10 years. And I'm like, oh, guys, we gotta switch. This is the best opportunity ever. All we gotta do is go buy these stubs. We'll make all this money. And so literally, we talked to LPs, which was, it was like $3 million, but just our internal money and like, you know, a few rich guys we knew. And we changed the whole system, said, screw this quant thing. This is a once in a lifetime. And of course, long story short, we end up basically getting R2K with like twice the vol.

• 12:22Speaker 03

  And then end up liquidating and transitioning the business because I had some bigger rich guys call me. But and when we backtested what we would have done if we just followed the damn model, we obviously would have outperformed like our own stupid ideas. So that was my last straw where I'm like, you know what? I'm done. Like it's, I'm pure quant now. Just build a system and a process that you think makes sense when you're in a system two frame of mind. And then when you're in the battle and the fight, just follow the model. And you just, you almost got to take a religious bent towards your own kind of scientifically minded system. So. Yeah, I don't do stock pick anymore.

• 13:01Patrick O'Shaughnessy?

  If you had to sort of describe the, we'll call it quantitative investor like landscape or map, how would you do that? Like, what would you say are the major camps or applications of the basic idea, which is, you know, get some, get some things, there's a group of stuff you can buy or sell. There's data on those things and there's future returns and you kind of, you build models. But there's a ton of ways to apply that basic kind of scientific method idea. So if you were describing to, let's say, a sophisticated investor out there that came forward in a time machine from the seventies when no one was doing quant, or very few, no one except Ed Thorp was doing quant. How would you describe what it looks like today? Like, what are the major camps? Who are the pockets? Who are at the leading edge?

• 13:46Speaker 03

  Yeah, so, just like anything, it's good to define the term. And I'm sure you guys get the issue all the time, like, quant can mean anything from what I consider ourselves, and I imagine you guys as well, where we are just long-term investors that like to use quantitative tools to help us make good decisions for the long term and minimize the baggage of being a human. And then there's a whole nother spectrum of quant, which is the Caltech physics PhD building like AI machine learning algorithms on basically making markets. And I think it's really important for people to just know, when you say quant, what do you mean and what are you trying to achieve? And so I think the applications in the much higher frequency land,

• 14:31Speaker 03

  because we know a lot of them, like the prop trading world or market making, that's where I think a lot of like the biggest brains in the world are super useful. Because, because that's a game of super high frequency information acquisition, trying to be smarter than next guy, I gotta build good computers. Uncertainty gets resolved immediately and I keep making thousands and thousands of bets. That's extreme quant. We don't play in that game. We don't got any edge. We don't want to. And then on the other extreme is you got people that say, hey, Warren Buffett has a pretty cool idea. Buy cheap stuff that's high quality and has low beta, it turns out, too. But his real edge is just patience and Ability to sit back and not worry about what everyone else is saying about the world. And I'm not smart enough to be Warren Buffett, tried and failed.

• 15:17Speaker 03

  But I, I don't know if I'm smart enough, but I think I can capture the essence of what he's trying to achieve. Using quantitative tools and that works for me. And is this meant to say that my model is better than your model is better than AQR's model or better than Joe Schmo's model? No, we, we all know the same data. We all know the same facts. That I've determined the edge is not in building a better mousetrap. The edge is in coupling educated capital that understands why your mousetrap works. And pairing the two together, which, which was why our firm's mission and impact is. We empower investors through education.

• 15:58Speaker 03

  Our mission is not, we're going to build cooler models than Patrick O'Shaughnessy or Cliff Azanas. Because there's no edge in that. We, we can all run CompuStat tapes till we're blue in the face. As you mentioned, you've done. Yeah. Yeah, we've all done it and, and, and I was even listening to actually Cliff, I was watching a YouTube video of him. Cause, cause he's a guy, you know, really respect and, you know, just love their firm and what have you. And someone asked him about like machine learning. They're like, hey, Cliff, what do you think about machine learning? And, and he almost said the same thing that, that I wanted to say. Super interesting, you know, haven't really seen anything in its application of what I do. Which is kind of this lower turnover, kind of quantitative investing to capture these premiums over the long haul.

• 16:42Speaker 03

  He's like, we do value, we do momentum. And that's what we do and we're probably not changing it. And, and I'm the same way, like I literally get people with PhDs in every physics math. Thing you could ever mention saying, hey, you guys are really cool. You're awesome. I, I got this new machine learning algorithm and I'm, you know, equal opportunity employer. So I'll just send them a bunch of data. Cause I've already know what we've done on it and I'll say, here's a bunch of data. You go crazy and, and here's all the robustness requirements you gotta show me. Prove to me that it works any better than just predictive regression approach. And, and to date I have not seen it. It's one of those things where it's on one end of quant, super hardcore is great,

• 17:26Speaker 03

  like an HFT. On the other end, I don't, you could give me 50 guys with 200 IQ, Caltech, math PhDs, and they're not going to convince me that their value algorithm is better than mine, or yours, or whomever's. That's not what matters.

• 17:42Patrick O'Shaughnessy?

  We're going to spend most of the rest of the time parsing our world, which is, I'll say, like, the more just automated fundamental type investing, more or less. Killing system one air, simple, basic, long-term stuff. So, we're going to return there and spend time there. But it'd be fun to get your perspective, because you have straddled all the worlds. You've been in the Chicago PhD program. I think Fama was literally your thesis advisor, so we could get into that story a little bit. But you have sort of a window into all types of quant, including that crazy, you know, mega mind, thousand PhD, informational advantage, market making thing. I don't want to assume it's easy to throw around terms. So, it'd be great if you could explain in a little more detail,

• 18:24Patrick O'Shaughnessy?

  like, what that means. So, what do you mean, high-frequency market making? Like, what is the nature of these strategies? What exactly is it that they're trying to do? And how are the good ones, or the best ones, better than the second and third-tier ones?

• 18:38Speaker 03

  Yeah. So, well, a perfect example is one of our, well, one of the guys that seeded our business came out of a firm called Getco, and we have a lot of clients that kind of come through that channel through him. And a lot of them, you know, Getco was like the original gangster in Pixie Market Making, right? Crushed the world. They came into that KCG acquisition, kind of meshed with a different culture, and then all the original Getco guys, for the most part, left. And they're now all running their own little shops. And one of our clients, who's a guy on Chicago that does this, and it just, these are a system, it's probably got 100 mil capital max it can take, but they can leverage it, you know, to infinity. And he's got 40

• 19:22Speaker 03

  People that are all math, physics PhDs, and they're literally all working on one central machine learning algorithm. And their whole thing is they're literally making microsecond transactions, just essentially trying to understand supply and demand better than the next guy, to make little, small, little return. And when I asked him, I was like, "Well, what's your returns you make?" He's like, "Well, we make 30, 40% returns, just like RenTech does." But what people don't understand is we're not investors. We are traders. And if I were to capitalize all the brain damage, all my computer systems, the servers,

• 20:04Speaker 03

  my R O A, return on assets, is probably like buying S and P, but I have a hell of a lot more fun, because this is my passion, what I like doing. And, you know, so I think their game is they're in the true edge of outsmarting the next really smart guy, and just being able to understand supply, demand better than the next. And, you know, buying low and selling high is what they do. It's just, that's, you know, if you're competing with supercomputers, at the margin, if you're one millionth of a second better than the next PhD guy, that's everything. It's kind of a winner-take-all, essentially. So, and it's also always changing, too. Their market's unlike what we do, like value. Okay, there's some element of risk, obviously.

• 20:48Speaker 03

  There's some element that people just hate, like retail stocks right now, because Amazon's gonna kill them. The edge of the bet is, they always throw the baby out with the bathwater. No amount of technology, or brain damage, or 500 IQ people is gonna change my mind about that. Whereas in their world, it is the case that a smart, like, I do think machine learning, mainly because you can learn much faster, with much more frequency, I think that those technologies can make that better at the margin. But it's always gonna be a limited-scale opportunity where... Yeah, you're always gonna have to be innovating, always gonna have to be smarter than next guy. It's not Warren Buffett, you know, frequency of change.

• 21:29Patrick O'Shaughnessy?

  People are always curious about who populates these firms, right? And given that you came through the Chicago PhD program, you know, a lot of the alumni from that go to firms like this. So can you talk a little bit about like the human capital arms race in this space? Like how is Rentech, you know, out pitching 2 Sigma, out pitching whomever to get the top talent? Like what is the, what are the kind of the elements or variables that matter there from a recruiting standpoint?

• 21:58Speaker 03

  Yes, so I know a few of the teams like Millennium and some of these big shops like that. One of the things is they just have great infrastructure. And to be honest, a lot of them aren't Chicago PhDs. A lot of them are just, you know, more like hard science types. But you can go to a shop like that, like Millennium, and they'll say, hey, here's all the data pipes in the world, here's all the legal infrastructure in the world, and oh, by the way, we charge whatever, three and 50. And because our fee structure is so high, we can pay you internally like 0 and 20 or 0 and 30, and everyone's still winning. And the ability to be able to offer someone who's, you know, maybe a PhD geek that's got really cool ideas, and say, hey, you're almost like a postdoc coming into a science lab.

• 22:43Speaker 03

  You don't have to go raise, you don't have to go fight for grant money. You can just come in here and do cool stuff. And oh, by the way, because our fee structure is so big and deep, we can also pay you a ton of money. And then, and so I think that's the initial attraction on all these guys. And then I think it boils down to culture. Because most of the folks, you know, we all know guys that work at all these best shops. The decision usually comes down to what's the cultural fit. And there's people that will be like, honestly, I'd rather work for you guys and make 1/50, because this is so much pressure, I'm losing my hair, I hate my life. And I really think the culture element is what, within those firms, is probably what decides who goes where.

• 23:26Speaker 03

  Because in the end, they're all, it's kind of commodity what they're gonna provide for you. It's more like what's your fit with that culture? Like, you know, probably Bridgewater, you either get people that love it, or people that are like, yeah, I like to go hang myself from the rafters now, from hanging out at that place for longer than two months. So I think culture is like a big, kind of, soft element of recruiting that most people... You just can't quantify it that well, but it matters.

• 23:52Patrick O'Shaughnessy?

  So obviously, we've both chosen a very different poker table to play at. So let's go to our world, which I'll let you start by describing at a high level, the basics of our findings. So you already mentioned that a lot of us, we're all looking at copy stat data, world scope data, MSCI data, whatever. And obviously, if you do fairly simple work, you're going to reach fairly similar conclusions. That's not to say that you can't differentiate yourself in how you calculate things, how you, I want to get into portfolio construction because that's how, I think you and I agree, that can be a huge differentiator. But maybe describe for the, you know, the 10 people listening that don't already know who you are, given that we're kind of operating in similar circles here. Maybe describe at a high level what the approach is and the characteristics that, you mentioned Buffett before, so that's one kind of mental model.

• 24:37Patrick O'Shaughnessy?

  But the characteristics that you found in your research to be most predictive or usefully predictive of future returns in stocks.

• 24:44Speaker 03

  Yeah, I mean, it's going to sound like a beaten drum and your dad wrote a whole fricking book about it, but we have a saying, buy them cheap, buy them strong and hold them long. What does that mean? Buy cheap is basically encapsulating an idea of value. Buy stuff that the market at that time, basically everyone hates and just hold your nose and have a long horizon. And then buy strong refers to momentum is you just, we know that winners, we get winning. So do that. But the last part is arguably the most important. Buy them cheap, buy them strong, dot, dot, dot, and hold them long.

• 25:25Speaker 03

  Because everyone in this factor rat race, and you know, we know, and anyone who's studied the data knows that if you're gonna capture those factor premiums, it's gonna be insanely painful. Especially if you do it how you and I do it, where I think it's the more intellectually honest way to do it, which is much more concentrated and focused in the actual factor. It's just, it's just, that's the nature of it. It's going to be painful. So it isn't a free lunch, but I think in return for not, for having to endure that pain, you get some gain. And I think those are the, buy them, buy them cheap, buy them strong and hold them long is about my summary of all the research out there for the last 200 years on this thing.

• 26:08Patrick O'Shaughnessy?

  So one of the most interesting debates going on now is around portfolio construction. And when you say pain, there's kind of only one type of portfolio that can deliver real intense pain, which is a high active share, highly differentiated one. Because by nature, the more different you are, the more potential there is to do really badly, which always hurts much more than doing really well feels great. So we've got this goofy, you know, fear, greed imbalance. So talk about your research on portfolio construction, because the standard party line for quants is you've got to be really broadly diversified and take basically no individual name exposure, neutralize every risk to everything.

• 26:49Patrick O'Shaughnessy?

  So you've got these like platonic pure factor exposures and nothing else. And this kind of coalesces around the idea of smart beta, which everyone's familiar with. So you and I have very different takes on this, so talk about portfolio construction.

• 27:02Speaker 03

  Yeah, so again, we use quantitative tools to capture what we think are important, good insights from qualitative investors. You know, Munger has that whole thing about, you know, diversification, and if you have an edge, why would you dilute it out? And again, being like to your other point, being different is the way you're going to add value or potentially subtract a ton of value. So I understand the merits in doing like the super sector constrained, control for every little thing, and that's, that's cool for a certain buyer. We build products for our own money. I'm in the business of trying to compound my face off for 20, 30 year horizon, after

• 27:43Speaker 03

  fee, after taxes, and I don't frankly care that much about sector risk or volatility or what have you. And, and I feel like that's the only way I can capture my edge, which is being crazy and have a lot of patience, right? Because if everyone in the world has to sector neutralize to placate this institutional mandate, like just if you think about it, are you going to have more or less edge when you have to look more and more like the Vanguard Fund? Almost mechanically, if you think of this as the poker game, if more and more have to play poker like all the other poker players, almost mechanically destroys any edge or ability to take paint. So we just build portfolios.

• 28:27Speaker 03

  I'm not saying they're right or wrong. I'm saying for a particular mission. They make a lot of sense, but they're also the worst idea on the planet Earth for probably a vast majority of investors, and it's much more appropriate to kind of manage the risk. Because again, our portfolios, we don't say you should put everything in like one of these things that has like 50% retailers right now, because that's a real risk. What if the whole damn thing blows up and Amazon like takes over the world? I'm not discounting that as a real risk, but if you're paying me to deliver you the value premium, and presumably that's being wrapped in a broader portfolio set where, you know, you're doing some element of efficient frontier portfolio diversification, you want me to

• 29:12Speaker 03

  have as much active risk as possible, because that's what you're paying me to do. And you know, I know Aziz's rhetoric be like, "Oh yeah, well, a lot of that's not active risk, that's just sector risk." Well, I'd say, "Yeah, you show me how to easily and with low brain damage and low cost, separate out the value premium from sectors." I don't think you could do it that well. And a perfect example is like the internet bubble. So in 1999, you're going to force me to own some tech stocks that are quote-unquote "cheap" at like 500 times earnings, you know, that's not the value premium. The value premium is buying pain and hate and discontent, i.e. right now, buying everything that Amazon is going to destroy, quote-unquote.

• 29:54Patrick O'Shaughnessy?

  Best Buy.

• 29:55Speaker 03

  Best Buy, all this crap that we own, and I'm sure you guys own a lot of it.

• 29:59Patrick O'Shaughnessy?

  We have a lot of Best Buy.

• 30:00Speaker 03

  Yeah, you gotta own the pain, you gotta own the risk, and it is risk. There's some misprice in there too, but it's a lot of risk. But that's fine, if you've got Horizon, you can bear risk. And so, we just build super risky portfolios, and that's just what we do for them. We're a boutique, you know, we're not saying it's for everyone, but that's what we do. And I think you guys do it as well, at some level.

• 30:23Patrick O'Shaughnessy?

  Maybe this is something where you and I may have slight disagreements, so let's see if we can explore this a little bit more. So, what we found is that...

• 30:32Patrick O'Shaughnessy?

  A lot of quantitative managers are sort of risk first or risk mitigation is a key, key part of their process. And you can define risk a lot of ways, but tracking error is a very common one. So the sort of great pitch from some enormous asset managers that do factors is factor exposure, but low tracking error, which to us is kind of like you, a little bit oxymoronic. It can be right for the right investors for sure. Obviously, you know, these, these asset managers are multiples the size of both yours and mine. So, so, so there's an appetite for it. But I'm curious how you think about risk within this category of highly active. So what, one of the things we've found is step one needs to be get really concentrated

• 31:17Patrick O'Shaughnessy?

  in your key factors. But then within, let's say that's the cheapest decile of stocks or something like that in large cap stocks. But then within that group, then you can do some stuff around risk management. So, so then if, let's say that today, you know, the cheapest is 50% retailers. Well, maybe it's 40% and that as long as you're within the kind of best of category by value momentum, you know, kick out the worst crappy companies is kind of step one. Then you can kind of shape and, and not take as much active sector risk. So how do you think about that? So like, is, is there any risk management that you do or?

• 31:55Speaker 03

  So here's the problem. I'm leaving out some context here because the other way, we're always, when we think about like value, for example, it's always in the broader context that we know we're going to do this in a global value and momentum portfolio. So when I want to go get my value risk, I'm going to go get the most whoop it on crazy, highest expectation thing I can get. And obviously it's going to have a lot of vault and quote unquote risk. And you know, risk that may be associated with sector bets, what have you. However, if those 40 stocks are part of a 200 stock portfolio, especially pulled with momentum, where a lot of times it's doing kind of like the convex bet that's opposite of the best buy pain trade.

• 32:38Speaker 03

  I think as a global portfolio there, which is really the in-state equity book. It's not that big a deal. But to the extent that you were just buying our little value exposure, and that was your all-in with your entire life's net worth, you're going to be probably over-exposing yourself at the margin to like the best buy bet. And you can obviously hedge against that and, and you know, maybe put some sensible rules in there, which I also agree with, like, let's not do 100%. You know, we have like 25% rules or whatever.

• 33:10Patrick O'Shaughnessy?

  Yeah.

• 33:11Speaker 03

  So you don't want to go like totally insane. But, but the thing that kills me is when people are like, it, it's almost like getting too scientific where like every sector is going to have the exact exposure and we're going to have these 10 longs, these 10 shorts. We're going to rip out the, every factor, element of it. And, and that's what I just call like over-engineering. And it seems like the benefit versus brain damage is just, it's not a good quotient there. So in, in general, if you can go simple and robust with reasonable constraints is good. So I think we would agree, actually. I'm more, I'm more talking to the hyper-quant types that it's like seems over-engineered to me.

• 33:51Patrick O'Shaughnessy?

  So, so QVal, at least last time I checked, which is the standalone value ETF, I think it's 40 holdings, right? Something in that ballpark? So how do you think about that number versus 100 versus 10? What is the portfolio construction logic just behind like the side, the number of names and the sizing of the positions in the portfolio?

• 34:09Speaker 03

  Yeah, sure. So, so we, we all have to operate in some constraints for like 40 act or what have you. But, but in general, we kind of look at it as, you always have that trade-off between expected return and volatility or some measure of volatility. And we all know the chart. How many positions do you really need to hold to get the benefit of diversification? Especially if you consider that these investors are probably going to hold other things. And we just feel that if you're going to try to bottom ticket and give people as much active risk exposure as possible, without being insane or running afoul of, you know, these different rules we have to operate within the regulated space, we think like kind of that 30 to 50 seems reasonable. And could you do 100?

• 34:54Speaker 03

  Sure, that's not bad. That's at the margin better than 500 where you got sector neutral everything and you're not really buying the factor. So I think it's more of the art and the science of it. We're just trying to get it as focused as absolutely humanly possible, where the results back 40 versus 55 versus 23.2 positions, no. But you know, 30 to 50 seems like a good ballpark to maximize the active risk without getting stupid about it by holding like a five-stock value factor portfolio. We feel like we can get the diversification we need, but still deliver the high-octane kind of pure blue meth drug that we're trying

• 35:36Speaker 03

  to deliver out there. And then, you know, people can chop that up and add their baby powder on their own terms, but you know, we're going to personally, you know, smoke our own blue meth because we like it. It's kind of how I'd say I think about portfolio construction.

• 35:51Patrick O'Shaughnessy?

  Gun to your head, you got 20-year horizon, you get to pick one factor, you're picking value or momentum?

• 35:58Speaker 03

  Okay, so the evidence would say momentum. But because I'm a human, and because I was raised on Ben Graham, I, value is just intuitive for me. So when I incorporate the system one risk, that when I had guns to my head and momentum stops working, I'm just going to give up on it. Value is something that you could put 50 guns to my head, I will never, even if it goes negative 99% return, I'll still be holding my value stocks. Whereas momentum's something where I know the evidence is compelling, I know all the rationale for it, blah, blah, blah, but it's just, it's not as intuitive. It just doesn't sit with my system one as

• 36:40Speaker 03

  well. So I would be more inclined to blow that trade out, you know, when I'm in worse pain in value. So I'd stick with value because behaviorally, I could ride that to zero.

• 36:52Patrick O'Shaughnessy?

  When you say that momentum, if you just went with the data, it would be momentum. Describe what that means.

• 36:57Speaker 03

  So what that means is, when you look across all the robustness studies, all the asset classes, all the time periods, this idea of momentum, buying relative strength...

• 37:09Speaker 03

  is more compelling from just a straight up empirical based standpoint than value ever thought of being, especially when you control for like the risk and kind of how it fits in like a broader portfolio. And I don't think anyone denies that, even you know, Fomin French in the dissect anomalies paper, they say this is the premier anomaly. Like, we can actually look at book to market, which you know, classic value factor, and of course, they picked that one because it sucks. But you know, you could, you can kind of make all kinds of story why it's risk based, blah, blah, blah. But, but they say momentum. And oh, by the way, our prior is we got to make the world efficient market hypothesis here. We even can't explain this. This is absurd. And, and so I think the evidence is there. And because it is so

• 37:53Speaker 03

  counterintuitive in how it works and why it works, I, I just feel like it is a better long-term bet if you were like a scientist, like computer, robot guy, which I'm not. That's why I said value. But, but if I was a robot, that's what I would do.

• 38:08Patrick O'Shaughnessy?

  I feel like I spend like a tenth of my career explaining to people why I don't like price to book. So maybe I'll let you do it for me. So, so when you say price to book sucks, why? Why, why relative to other value factors?

• 38:20Speaker 03

  Well, I mean, before we get into weeds though, because you guys have like tons of great research on like the mechanical reasons why, I'll give you the simplest reason why. There's this little shop called DFA that has now, I don't know, $600 billion of hardcore capital that won't sell book to market stocks if, unless you put 50 guns to their head. So anytime you get a factor, you know, there is the thing, you know, the market does matter, supply and demand does matter. So if you have a factor that is the sole focus of a firm that has actually created insanely disciplined investors and done a great thing for, for their investors, and essentially arbitrage their factor away, it'll, it happens. So, and

• 39:05Speaker 03

  same thing, if someone took, you know, our favorite, which is enterprise multiple, and you said, hey, we're going to get a bunch of, we're going to get $500 million of brainwash capital that's permanent, that will never leave, that risk premium slash mispricing premium well erode. Because it's not leaving, it's not timing, factor timing, just like if we did your guys' stuff, shareholder yield, blow out of the water. But guess what? If you grew to $500 billion and you arbitrage away your shareholder yield factor, you over that time period have done an incredible service to your investors because you've, they've gained that whole benefit of arbitrage net mispricing because they presumably were the permanent capital initially,

• 39:47Speaker 03

  and they were like the 1 billionth dollar, not the 500 billionth dollar, which at the margin is now just buying risk premium, pure. So I just think it's probably been arb'd out. Not to mention that, you know, there's mechanical reasons. You guys talk about with how book to market works with share repurchases, all these other things. So it's not a bad factor. It's going to capture just what DFA tells their people are going to capture, a risk premium, pure. Great. But if you want to try to maximize your value premium exploitation, you're obviously going to eat the risk component of it. But if we can add a little bit of mispricing sizzle in there, why wouldn't we do that as opposed to the book to market version?

• 40:27Patrick O'Shaughnessy?

  It raises an interesting question, which is one of the key questions, I guess, any manager that seems to have an edge has to answer, which is how do you know when this is going to stop working? And flows affect factors, right? Obviously, if there's $500 billion in something and $1 million in the other thing, you probably want to be in the million dollar thing. So what are the sorts of things that worry you about the strategies that we've spent our careers on, which, you know, 10 years ago, honestly, even five years ago, it feels like, were much lesser known, much less popular. There wasn't a Wall Street Journal week-long series written about these strategies. So what kind of things worry you? And is there any, what would be the circumstances? So we sit here in system two

• 41:11Patrick O'Shaughnessy?

  right now, being very rational. Like, if you had to set a set of criteria at which you would say, okay, I'm actually need to get out of this strategy, what would that look like?

• 41:21Speaker 03

  So I would say the biggest one, and this is, again, the art and the science of it, because as yourself, you probably know, when you look and you're trying to be scientific-minded, we're going to have the scientific, or we're going to use a scientific method here, where we have Competing hypotheses, we're gonna look at all this data, look at out of sample, in sample, different time pairs, different markets, and we've done that for hundreds of years now on value momentum. I'm in. So now, if I'm a Bayesian updater, like, we need so much time to go out of sample for me to change my prior at this point. I'm basically not changing. And I can't even live a long, long enough time for me to change that core ethos on the science. But then it gets back to the art.

• 42:06Speaker 03

  And the way I look at it is, it's still in the end, it's all about supply-demand. And just going back to this DFA example, the art of this is if you see massive amounts of insanely patient, disciplined capital that's not exposed to principal agent issues with, like, recycling, short-term chasing, DFA-type money, where we put billions upon hundreds of billions of dollars of super hardcore factor-premium exploitation capital to play on something, you will arbitrage the thing away. Period. But I just don't see that. What do I see? I see more intermediation, more stupidity, more data access, more transparency, which

• 42:50Speaker 03

  you would think would make better decision-makers at the margin. But what do you think happens when someone has the Robinhood app on their phone, when they can click a button and buy or sell something? Also, when they have all the data in the world at their fingertips. This is not gonna make people more rational, patient, capital, 20-year-hold investors. It's gonna actually create availability bias and force decision-making, which is the decision-making you don't want, which is short-term-minded. And so I think we're entering a world where ironically, all the information access, more data, more, more technology that quote-unquote "helps people make better investment decisions"

• 43:32Speaker 03

  is end up gonna make people just make more decisions, which, we all know if there's a chance that a decision-maker has a flaw of making a decision, because we're all humans, there's a lot of system one in there, the more times you take that bet, the higher probability you're gonna screw it up. So, so I, the art of it is, I'm not changing my mind. Buy them cheap, buy them strong, hold them long is going to be in my ethos till the day I die. There may be new things like trend or other things I'll explore, interesting. But those core concepts ain't changing. And it just because there's not enough time in for me to be alive to make enough out of sample to convince me otherwise.

• 44:13Speaker 03

  But what would change me is again, going back to the dynamic of the market and understanding what crates he's saying in the first place. Usually delegated asset management, principal agent problems. And then just look for basically little mini Warren Buffet's starting to pop up that that stick to these factors. There's ETF strategists. What do they do? Factor time mechanically. It's not permanent capital. They're literally going to be blowing out of value because now they're going to low vol or do that's the exact kind of capital that actually permanent capital exploits in the value premium. And there's you just see more of that, not less of that. So I mean, I think it's would be insane to think, at least based on a short-term forecast

• 44:57Speaker 03

  and knowing psychology of, you know, the marketplace and how, you know, institutions are framing and pitching themselves right now, to think that that's creating more patient factor capital. I mean, that's the way I look at it.

• 45:10Patrick O'Shaughnessy?

  How do you think about new research? So most of these, we'll call it like fundamental quant strategies, really, I mean, it's it's data coming from its price plus, you know, the financial statements, more or less. There's other stuff too, but but that's the basis of most of what people like you and I do. How do you think about new ideas to explore, new research? You guys write a ton, you know, mentioned the idea of education being a central mission of yours. So how do you think about what to explore next? Maybe give some examples today, like what are the sorts of things that have you interested and engaged with the data and, you know, tinkering around?

• 45:49Speaker 03

  Yes, so, you know, every morning. All I mean, all I do, like, I know you read like tons of books, which is awesome. I just read, unfortunately, because like I'm just a finance geek. I just read source journal literature, it's kind of like my books. So I don't practice the Munger like mental model thing. Like, my mental model is finance crap all day, every day, just because I like it personally. So, I love reading research, love and desire like no other to find new ideas and hope that they change my mind. That's, I'm passionate about that, and that excites me anytime I get something new. And I'm always reading because I always want to hunt for that new Easter egg.

• 46:29Speaker 03

  But, that said, you know, having been doing this for a while now, like, I, there hasn't been, ever since we've kind of like summed up everything we knew about value and everything we knew about momentum, we always test stuff, all the time. But the problem is, the bar to entry is so much higher now. Because, because we always have to, you know, kind of consider, again, this is more art and science, of the chance of overfitting, over-optimization, data mining, where anytime you already have kind of the baseline idea, buy them cheap. Am I going to argue that our model is better than your model? Prob, they're all about the same, buy cheap, who cares? Just have discipline, you probably win.

• 47:13Speaker 03

  We think ours is better than, you know, your stuff. That, and that's great. I think, honestly, the stuff that comes out on the new models is marketing. Because every time, we look at every idea, re-engineer it, you know, test it, and we say, "Hey, does this add value at the margin of what we already have?" And unfortunately, and you guys probably know it too, inevitably, it doesn't. So then you gotta sit back and ask the incentives of the marketplace, usually sales guys, "Well, why are you keep adding all this new crap onto this model?" And it's because there's a thing called complexity, and it sells, right? So, people quickly move from being an evidence-based investor to a story-based investor,

• 47:58Speaker 03

  and you've probably seen it, you know, all our friends, or my friends, like, all run these things. But you go to like a big shop, and they got like 90 PhDs over there. And their model hasn't changed in 50 years. And you gotta say, well, why do you got these 90 PhDs over there? And on the outside view, they'll be like, oh, yeah, they're always doing research, finding new ideas to make our model awesome. And then, then you like give them a few beers, they're like, dude, when the consultants come here, we can't just tell them we're doing this model, man. We gotta like tell them we're doing something. And so we gotta point to these 90 PhDs over here, you know, with all their Chicago PhDs, because, because it's gotta look like we're doing something here. You know, but, but the reality, that's just more like the marketing part of the business.

• 48:40Speaker 03

  And I totally understand it, but I, I don't think they're actually adding value anymore. Because we've already, like, that's why Warren Buffett has like him, and he reads his like 10 Ks in his underwear in Omaha. He doesn't need 500 staff and he does perfectly fine. I, I mean, and we see family offices all the time where they have a staff of like two. Because that's all you really need to get the job done. And, and, yeah, so I don't, we're always doing research. I love it, passionate about it. But the cold, honest truth is I'm not sure it adds much more value to what we already got. But I just do it because I intellectually like it, frankly.

• 49:19Patrick O'Shaughnessy?

  We always say that it can be an incredibly frustrating exercise because you'll often find things that work in isolation. But the second you go and add them into what you're already doing, there's, there's nothing there. And that's probably 95% of, of research. So it's a big cutting room floor.

• 49:35Speaker 03

  And, and what, so what we used to do, which I'll probably do because I need to contain my own system one issues, is, you know, because it's way more exciting to do like prop strategies and cool guy stuff, is right now we're in the investment realm. We're trying to build systems to allow you to compound after tax, you know, what we think is the best way we can do that. But then there's this whole fun game of like the fun research where you're trying to be smarter than the next 200 IQ guy. And we've done that in the past. But the issue is those things take ton of resources, ton of brain damage. And they're really cool and really exciting because you're trading them all day. But it's just not our business focus. So i- if I ever got rich enough, right?

• 50:18Speaker 03

  Really care. Yeah, I would do that more just for the fun of it. Knowing full well, I'd been better off just buying my ETFs probably. But it's just a lot more fun to do the action-packed things. And so I'll probably create like a little unit down the road. Where we just do like prop trading things, ju- just to placate my own need to like be engaged in cool guy stuff.

• 50:37Patrick O'Shaughnessy?

  If you had to give your money to some other active manager.

• 50:43Speaker 03

  Yeah.

• 50:43Patrick O'Shaughnessy?

  So you can't choose Vanguard, which is what the boring answer that everyone gives these days.

• 50:47Speaker 03

  I wouldn't give it to him, honestly.

• 50:49Patrick O'Shaughnessy?

  To Vanguard.

• 50:50Speaker 03

  I think they're gonna have mean reversion at some point. Uh, I love the idea and the concept. You know, tax vision, cheap investing, but all there is no firm that was that it still exists that, you know, hundred years ago. And if you get too damn big and too damn powerful, you know, governments get involved, other people get involved. Cultures change and you just can't keep something going on forever, in my opinion. I do love Vanguard, but.

• 51:16Patrick O'Shaughnessy?

  So how how would that play out though? So what would be the the seeds of their demise? You know, I've I've spent a decent amount of time with Some really great people there.

• 51:24Speaker 03

  Yeah, oh, it's amazing.

• 51:25Patrick O'Shaughnessy?

  It's an amazing culture and tone was set early on by by Jack and and it's been continued by some really great leadership. They're about to get another CEO.

• 51:33Speaker 03

  Yeah.

• 51:33Patrick O'Shaughnessy?

  So think think through that thought exercise, like what might that mean reversion look like? This is on everyone. This is a question everyone has, which is What this this massive one directional trade from everything else into Vanguard? Uh, you see some people saying usually it's, you know, high fee active managers, but so consider the grain of salt. But usually it's saying this is creating distortions and perversions and fundamentals matter less today. And the internals of the market are weird as a result. So how do you think about that? Like, how do you think about? I don't really agree with that, but.

• 52:04Speaker 03

  Yeah, I don't really.

• 52:05Patrick O'Shaughnessy?

  Think about it.

• 52:05Speaker 03

  Yes. So so here's what I'd say. I don't think they're really screwing anything up in the market. But I'll tell you what I think about Vanguard and the same argument would be applied to like an Amazon. If you get too good and too powerful, it's not the market that screws things up, it's the government. What do you think happens when a senator knows that a one-stop-shop owns 20% of all of corporate America and I don't have to go haggle with everyone now, I can just go talk over here? Things get corrupted, just like Amazon. That's why I love the Amazon trade. Everyone just assumes Amazon's gonna take over the world, because they are and they should. But here's the problem: when they take over the world, do you think government's gonna

• 52:50Speaker 03

  put less regulation on them or more regulation? And what do you think happens when bureaucrats start interfering with marketplaces? The margins, everything that was great about that wonderful business model gets totally destroyed. And so I think if you just assume that these things are gonna go forever exponential, they can't eat the whole world, because eventually it starts running into other forces that are outside the marketplace that mechanically suck. And I think, you know, all these things come to an end at some point. So it's not that... Vanguard in particular is an amazing firm, they're probably the most respected firm that I like. I like everything about them, their culture, and I hope they keep dominating, but just,

• 53:34Speaker 03

  you know, knowing the culture of the world and how power seems to attract corrupt people, they end up screwing everything up, that I imagine with 100% probability will happen in the next 200 years. Just like Amazon, I guarantee will not be around in its current amazing form in 100 years from now. Someone will screw it up, it's just inevitable.

• 53:55Patrick O'Shaughnessy?

  It's an interesting example of like the inside-outside view from Thinking Fast and Slow, where like the inside view on both these firms, Amazon's actually a good parallel for Vanguard, is that they're invincible and can do no harm, and it's so easy to project like a perfect future. Whereas the outside view is, to your point, like, go look at the biggest companies from 100 years ago, like, it's just not around. There's all sorts of interesting arguments, like, you know, the government regulation thing. You know, that makes you think like Standard Oil or something where they're cornering markets and gouging customers. Whereas Amazon's very different, right? Like their model has been, no, let's actually deliver lower and lower prices. So it'll be interesting to see like, how the hell is the regulator gonna explain that?

• 54:34Speaker 03

  And here's what's interesting, yeah. So the government will screw that up, or in those sort of models, and this is like, so Google's a firm I probably most respect. I actually really like those guys, like what they do, their culture of like, do no evil. I think they're amazing, but the problem is, when you become a brand that's known for doing that, and like, Amazon's a good example. So my business model is I'm gonna get insane massive scale, basically burning money till the cats come home, and then I guess investors just assume at some point they're gonna magically have all this economic moat because people don't wanna leave, and I guess they'll get to raise prices a little bit or something. But here's the problem. They don't understand that that demand curve is highly elastic.

• 55:18Speaker 03

  Because the minute they're no longer the low-cost producer and their, you know, prime's pretty cool, but guess what? Everyone else is starting to get that too now. The minute they say, oh crap, now we own the market, let's leverage your economic moat to like, do a Standard Oil monopoly play. Well, guess what's gonna happen? Everyone's gonna be like, oh, wait a second, like, oh, let's go back to Walmart, man. It's right down the road and it's a lot cheaper than you guys. So it's like a phantom economic moat. It's there in theory, but then the same question is, can you exploit the moat you built? And maybe they're so good and then get so many magnitudes better, that even if they keep their cost structure, they can somehow create like massive P&L on it. But I'm just, I'm not really sure. And that's

• 56:00Speaker 03

  without even considering that, I imagine, well, government already has. Remember they used to have like, the no state tax thing? They had to manage that. Like, all these firms, you always, if you get too big and too successful, you end up having to fight non-market forces.

• 56:15Patrick O'Shaughnessy?

  So we got way far away from my question, which was, if you had to give money to another active manager... Who would it be? Who else out there does work? And it doesn't have to be quant. Actually, I'd be very curious if you give a non-quant answer. Maybe I should change the question. But if you had to give your money to any number of outside managers, active managers, who do you really respect out there?

• 56:35Speaker 03

  What would I be trying to achieve? The same thing I'm trying to achieve now?

• 56:38Patrick O'Shaughnessy?

  Yes.

• 56:39Speaker 03

  I mean, honestly, I like, this sounds totally pathetic, but I actually do like what you guys do. And like your dad said, the only issue is you guys' tax problem would cause me some angst there. But I mean, I don't even know who else does like super concentrated, highly disciplined, transparent quant.

• 56:55Patrick O'Shaughnessy?

  Not many.

• 56:56Speaker 03

  That's what I want. So whoever does that is who I'd give all my money to. And if they could help me like build tax deferral, even better in it. I just don't know. Yeah, I don't know. I mean, I like what you guys do. Whoever would fit that, if you can just give me a transparent, super focused, well-established, like an AQR thing, but they concentrate it way down, and they could figure out how to get tax deferral, I'd use them too. I like those guys. It's tough, man.

• 57:23Patrick O'Shaughnessy?

  Tough, man.

• 57:24Speaker 03

  Yeah. And that's why we built our own firm.

• 57:26Patrick O'Shaughnessy?

  Yeah, it's good news that not too many people are doing this. That's how we want it, right?

• 57:30Speaker 03

  Yeah, yeah, exactly.

• 57:32Patrick O'Shaughnessy?

  Talk about the business then. So talk about Alpha Architect. How the firm has evolved, how it started, what the client base is like, the marketing versus sales mindset. I love hearing about the businesses behind this because you said earlier that the real edge is pairing the right investors with the strategy, more than just like having some super secret sauce. The secret sauce is often the clients, the right clients. So talk about the business behind it, sort of the organizational alpha, as our friend Ben likes to call it, I like that term. Tell me about Alpha Architect.

• 58:07Speaker 03

  So there's this famous paper, Shifer Vishney 97, it's called Lims Arbitrage. And you probably know LSV, those guy, the two of the names in there, you know, went off to create this like $100 billion monster. And that paper... In my opinion, is the theory of how the asset management market works. And what does it basically say? It says delegated asset management creates a problem. Because there's a situation where there's really smart people that manage money, come up with whiz bang cool ideas, they're gonna work over the long haul. But what happens is they couple those strategies with capital that doesn't understand that.

• 58:49Speaker 03

  And inevitably, when they say, wow, in 10 years from now, this strategy's gonna be amazing. But oh, by the way, in the short run, it's could be the stupidest idea on the planet. Well, ex ante, all these really smart people are like, well, I could just do that and collect fees for a while until it blows up. So I'll just run 200 funds and I'll just have always have turnover, do spaghetti against the wall. So that'd be like the BlackRock model. We'll do 200 funds a year, you know, inevitably some are gonna work. We'll market those track records, we'll blow the other ones out, and you just do that model. The other model is you say, okay, if this is the problem, if I'm not gonna be a Caltech 500 IQ PhD doing HFT or information acquisition edge, where we're just trying to win in that game,

• 59:32Speaker 03

  which I don't wanna play, I wanna do the investing game. What I noticed is there's a structural problem where everyone knows about what works. But the problem is it's a long duration trade and it always gets coupled with short duration capital, which always leads to a lose-lose situation. The manager wins for a while, then he has bad performance, he gets fired, the clients hate him, and no one ever wins. So instead of focusing so much on trying to be the smartest guy to figure out how to do value or momentum, or whatever the hell it is, let's stop competing on that. Let's focus on the investor education and putting or building or creating

• 1:00:16Speaker 03

  or identifying the long duration capital that we can then pair with the long duration strategy. Which is why we didn't, again, our mission is not we're gonna be smart and everyone build cool models. Our mission is we're gonna empower investors to education in order to build sustainable investors.

• 1:00:39Speaker 03

  So that's why we have that mission. Because the only way we're going to exploit that long-term edge is not be us being smart. It's us find the capital, getting them mentally prepared and telling them how crappy this idea is going to be in the short run. So they have the ability to stick to it. That's stage one. The other thing is we have a segment on individuals who are taxable. So one of the things, if you look at real estate investors and why the hell are they so rich all the time? Is because a lot of times, my small little anecdote view on them is they hate taxes more than they like making money. Which makes them incredible investors because they never want to transact.

• 1:01:22Speaker 03

  So if you get a real estate investor and the real estate goes up, down, or they're feeling a lot of pain. If they didn't have that tax burden, you'd see way more transactions. But good real estate investors, the reason they get so damn rich is not because they're that smart. It's because they're stuck in this low basis asset and forced to hold it for like 20 years when other people are going in and out. So the great thing about taxable investors is to the extent that you can get a deferral mechanism in place. Where you create like this tax liability for them to be able to move out of a, basically make a bad decision. You could also, and kind of what we've structured is to mechanically get people in a position.

• 1:02:08Speaker 03

  Where one, they gotta come in with all guns blazing, "I am in, I am wholeness for 20 years." But then also build structures where even if at a certain point, five years from now, they're like, "God, this is stupid. I gotta pay the taxes to get out of it, I gotta stick to it." If we can mechanically just keep you being successful, either through education or structures or whatever, we're going to win. And so we just want to get people to be better, long-duration factor investors. And which is why that's our mission and that's why we're super segmented, we're super focused. And we don't have armies of sales guys because we almost need the inbound.

• 1:02:49Speaker 03

  Flow because you've got to understand what we're trying to help you with and if you don't, just we can't really talk to you. It's not going to work long-term. Like go, go get marketed to. And we're marketing, but that's, that we're trying to solve the Cypher Vision problem, basically. And that was our best attempt at it.

• 1:03:07Patrick O'Shaughnessy?

  Talk about the profile of that investor. So you do a great job with the education, obviously. I think you and I both have probably written 170, you know, white papers or whatever. So you can, you can write and educate till you're blue in the face, but at the end of the day, you still need the right person or family or whatever. So what does that, what does that investor tend to look like? Are there common traits?

• 1:03:29Speaker 03

  There are common traits, at least for the folks we deal with. So we have this acronym called Educated, which stands for a bunch of stuff. But basically, the best way to think about it is engineer types that are very like process-driven, don't trust anybody, like these Wall Street clowns. I'm smarter than them because I went to electrical engineering where they were like marketing guys chasing the girls. I know I can figure out what they're figuring out. I want to understand this process. And yeah, I understand, I can't actually do it in the end because I don't, or I don't want to. But I want to understand what's going on and why this works. What is this system? Those type of people are perfect because they actually care about the process and they want to know the weeds. And one of our

• 1:04:14Speaker 03

  core beliefs is in transparency, so we're willing to facilitate. So we just need people like that. We also like business owner types because if you think about like the private versus public owner mentality, public CEOs or public ownership, you just inevitably you get in the quarterly mentality. And it's just the world. If you talk to private business owners, they're always thinking 10, 20 years. It's just their culture. They're, they're cheap bastards because they usually started this company. They understand do more with less, understand what's the value proposition before I buy it. What's the process? They're just very methodical on Wanting to control, wanting to understand, and want to be cognizant of like the fees and who

• 1:04:57Speaker 03

  they're they're dealing with. So we just attract people like that, which means we're not in a hot money game. We're in like the two, three years of figuring all this out, how you guys work and and but but that's fine. We don't want hot money because it'll come in and be out the next day. Like we want people to understand what they're doing, why we're doing it. And we, if you want to ask 500 questions, we're not going to complain. We're going to be like double thumbs up. This is the right person. And then also structurally able to play the game. Because if you're an intermediary that totally gets us, but you have clients that totally don't get it, you also break the chain, which is what we were talking about beforehand. As we're starting

• 1:05:41Speaker 03

  to get more and more in an intermediary channel, it's a segment, but there is a segment of advisors out there, like we're talking like the DFA advisors, who are super, hyper focused on process, you know, client education and and they've, you know, they were in the small value trade. Talk about a hair razor and they did it. So so that like there there is a segment of advisors out there who work on behalf of clients where they've figured out a a mojo and a symbiotic relationship there where they're the intermediary is really smart and their clients through that intermediary and that relationship they've built over the years are able to basically be sustainable capital, I think. And and we're we're building fintech tools to help them be

• 1:06:26Speaker 03

  successful in that. But the intermediary world's hard because of the Schaefer-Vishny problem, whereas we've always been direct consumer because you can go to a rich guy who owns that capital and he's like, well, I'm not, yeah, I get I don't have a principal agent problem because I am the principal and and agent, man. Like, like, I'm not good. Like, I get it. Like, good, this is my money. I want to compound. I'm not worried about my career here.

• 1:06:50Patrick O'Shaughnessy?

  You you mentioned earlier that all this information, data, technology, etc., is just forcing more decisions. And and the other way to think about that is the more layers of people and processes and checklist. And whatever else are between you and the end money, the more decisions there can be to screw the whole thing up for everyone involved.

• 1:07:09Speaker 03

  Yeah, there's more conflicts of interest coming in.

• 1:07:11Patrick O'Shaughnessy?

  That's right.

• 1:07:12Speaker 03

  And there's, yeah, as you know, there's a lot of, Pat actually, our CCO had a great analogy on the, on the poker game. Whereas if you go to a poker table, you know, Buffett's always like, hey, if you don't know who the patsy is, well, it's screwed because, because you're the patsy. But you know, that's not enough. You also got to know who the best poker players are because if you go in, you're like, all right, that's the idiot over there. We're going to exploit him. But you don't recognize there's someone 50 times smarter and you're also going to lose to him and you're still a loser. And so the issue is you got to go in these games, you got to go, okay, who's the patsy? Roger that. Who's the biggest brain in the world? Roger that. I have no edge at this game. However, that biggest brain over there has 50 people that have given him money.

• 1:07:56Speaker 03

  And they've put saddled him with like 50 constraints, like, hey, you can only bet on spade cards. You can only bet when you have double aces. Like they start constraining that best poker player. Now me as you know, smarter than average, but not a genius. And I know who the idiot is. I can be like, oh, wow. Now's my opportunity. Cause I see that smart guy who I'll never be his constraints. I can find some edge in that middle ground, which is, you know, things where he can't exploit because of some structural problem. And to your point, the more hands are in the pot, i.e. the more careers that get involved, the more principal agent conflicts that are created.

• 1:08:40Speaker 03

  And, and we're no longer in a game of after fee, after tax, compounding our faces off for 20 years. We're, we've got other incentives.

• 1:08:47Patrick O'Shaughnessy?

  Let's go a little bit farther on this analogy. So we talked earlier about all this money going passive. And I've talked to Michael Mobison about this paradox of skill where one argument is that. In this transition to Vanguard, basically, a lot of those losers you just talked about, where we were previously, or in our backtests, effectively exploiting those losers and their dumb decisions, that a lot of those have gone to Vanguard and are no longer ponying up their money into the pot. Do you think that that's right? Or do you think that there still is enough, there are enough weak hands in the collective market for these strategies to work for the next 10 or 20 years?

• 1:09:23Speaker 03

  So here's what I'd say. So everyone knows the whole sharp math, right? So to the extent that money goes into the market portfolio and essentially takes that supply out because it doesn't trade it and it's permanent, all these arguments go through. The minute you have people investing in passive stuff and then actively day trading it, all that math is totally out the window. And if you could tell me with a straight face that this whole movement to passive is, this is permanent capital that's going to hold this trade for 50 years, and this really isn't essentially another short-term performance chasing thing,

• 1:10:05Speaker 03

  I'd say you're probably crazy. Because if you look at a lot of the way this is couched, passive investing, the way it should be couched is, don't buy the bullshit, get low-cost beta that's tax-efficient, this is your permanent allocation, let all these fancy smart guys compete with each other. That's not how it's couched. It's, look at this study of active managers, passive beats 95% of them, and most of the frame that I've heard is you'd use passive to beat the active guys. It's not you use passive as a portfolio tool to capture the average very efficiently, it's you use passive to beat these active guys.

• 1:10:48Speaker 03

  So it's being couched again as a performance chasing vehicle, and the best way to invest because it gives you the best returns, or whatever the thing is. But I just think that if you have tons of money chasing what seems to be always winning with infinite supply, and if you don't do it, you're an idiot, and we're going to stop paying attention to anything else, I don't know of any macro equilibrium in the history of the world where that's ever ended well. And I honestly don't know how it's going to end. But I know it's not going to end well. And again, I'm not smart enough to figure, I don't think anybody is, but we don't know where the bubble's gonna pop out, but you just, again, you can't have some people perceiving

• 1:11:31Speaker 03

  something that works all the time, that has zero cost, and comes in infinite supply, and where that's just all we're gonna do, because that's the best thing, and tell me that that sort of mentality is a mentality that leads to good macroeconomic outcomes. It doesn't. That's not to say passive's not bad, all the theories are not correct, but they always hinge on the assumption that this is permanently deployed capital, essentially took all that stock off the market, so now it's just me and you, like, dicking around over the active scraps.

• 1:12:03Patrick O'Shaughnessy?

  I find it very interesting that the performance chase that always happens, right now, it just happens to be the S&P 500, right? Like, it has outperformed everything in the world, and I don't think anyone that's buying it is really thinking about that. It's an incredibly easy trade, because it's cheap, and it seems like the thing all the smart, responsible people are doing, but at the end of the day, you're buying the thing that's done the best. And of course, fees matter, and we never want to downplay that, but costs are real, and they compound, and I think that was Jack's fundamental insight. It wasn't so much be passive, it was be low cost.

• 1:12:41Speaker 03

  Yeah, be affordable, know what you're buying. You gotta make one other point to give a shout out to the actually Investors All Guys. They make a good point about, okay, the stock selection thing is one element, but when everyone's buying these passive Vanguard funds, the theory of all this is the global market portfolio. And asset allocation decisions, a lot of times have way bigger portfolio effects than whether I pick Best Buy or whatever, and people can buy S&P, but that is so divergent from the passive global market portfolio, so you are taking an insanely active bet through what feels passive, and what you're being told is, oh, all the smart guys are competing away, but

• 1:13:24Speaker 03

  not really, because you're not the global market portfolio. You actually have massive, epically huge, active bets in that portfolio. They're really cheap, but they're super active, and they don't even know about it.

• 1:13:35Patrick O'Shaughnessy?

  And we'll realize this in hindsight only.

• 1:13:37Speaker 03

  Yeah, exactly. We'll all figure it out that 60-40 was stupid, you know, over the next 30 years and 30 years from now, but we'll see what they cook up next.

• 1:13:45Patrick O'Shaughnessy?

  What is the most memorable individual day of your career?

• 1:13:50Speaker 03

  Which one? In finance?

• 1:13:52Patrick O'Shaughnessy?

  How about one of each?

• 1:13:53Speaker 03

  Okay, so in military, I mean, this is because I still remember this, it sounds kinda cheesy, but the MSHA Officer Course, which is like basically a hazex, I got put in charge of the platoon commander. We had to do an exercise at Bridgeport and it was literally, I didn't sleep for five days straight. And we did this, what do they call it, administrative march out of there. And I literally couldn't, I was, I never not slept for like four or five days straight and never ate. And I remember getting on that seven ton at the end of that and thinking, I just thank God for water, bread, like just being alive and not having to deal with that bullshit anymore.

• 1:14:35Speaker 03

  And I'll just never forget that. This is like the best day of my life. Can I just sit down and close my eyes and like have some water? And I just remember that, like versus combat things, like training, that one little training episode and being able to finally have that done, was like my happiest, best moment of my life in the Marine Corps. So it's kind of a weird one, but it's just in my mind. Now, as far as in investing, well, I'll tell you that one too, has nothing to do with quant. It has to do when part of my frickin' capital loss, I still gotta write in my books, is, you know, I used to be totally crazy, like put like Buffett style, 50% in some penny stock where, you know, I thought I had some sort of inside edge or something.

• 1:15:19Speaker 03

  And I'm not gonna even name the names, it's so embarrassing, but, so it was this penny stock. I owned like 4.99, so I didn't have to file on it, but that doesn't mean I was rich. It means it was like a $10 million company. And I did everything you're supposed to do. Met the CEO, went down to visit, channel, everything that every old school value guy does, to get your edge in such a way that you're not doing anything illegal, but you obviously have some edge, because you know this thing better than anyone and you do everything legally to be on the scoop, right? I was all in on this damn thing and I became friends with the CEO. Again, you gotta know him, blah, blah, blah. You know, he's a quote unquote, turns out this was false, West Point grad,

• 1:16:04Speaker 03

  so we had the military connection going on. Whole ball of wax, totally ate this thing, hook, line, sinker, and... I remember it was like, it was over the summer and I knew they were in a situation where they're renegotiating their debt. Right? And it was a situation where my inside baseball was like, oh, that is, because it's a, it's a cloud-based business. They're free cash flowing, the debt's totally gonna get negotiated and it's done, right? So I get this 8K and I'm looking at this thing and I'm reading it. It sounds really great, like, oh, they've negotiated the debt. And everything, but the stock is down like 90%. And I'm like, wait a second. And of course, again, I've done everything.

• 1:16:45Speaker 03

  It turns out this guy, the CEO guy, he was overconfident in his own information set, which was then being conveyed to us. And it turns out that basically the debt holders smoked him out and all of us along the path. So it's just, it was a total like permanent loss of capital. And then we, then one of the other guys, we had a little syndicate of like penny stock traders, they used to do, all these rich guys that were bored, basically. He actually hired a private investigator. It turns out the CEO guy was like a total fraud, like never even went to West Point, like. It was, it was just a scam, basically. And, and we had all just bought in hook, line, sinker, like believing this guy.

• 1:17:24Speaker 03

  And, and that was just my moment when I, I went from, at the time, having like a pretty good amount of money for like whatever I was, like 25 or 26, to basically being, basically bust for many, many, for all suspected purposes here. And, and I was just like, I am just done. So, so I just always remember that. I just, I just don't trust any humans anymore. And I, yeah, it's just, I don't do it anymore. Only computers.

• 1:17:51Patrick O'Shaughnessy?

  It'll be a good transition from, from that to this one. So what is the kindest thing that anyone's ever done for you?

• 1:17:57Speaker 03

  I would be remiss if I didn't mention the standards, right? My, my mom and my parents, obviously they did good there, but that's cheesy because everyone says that, even though it's true. You know, my wife for, for dealing with me and having my three kids. So those are all the standards. But unfortunately, I'm gonna have to do another military one, but again, it's gonna sound weird. And unfortunately, again, it's gonna go back to IOC, empty officer course. But, but we had this guy there, I'll never forget him, Captain Redinger. And, and he was, he was the captain in charge of, of running IOC. And at the time, this is kind of serious because like people are getting like. Pulled out of IOC to go in country combat. So it was like pretty hardcore time.

• 1:18:38Speaker 03

  And this guy was like the hardest, meanest, biggest asshole like on the planet. You're like, like just a straight up, not, I want to call it hazards. Everything in the end, I realized after the fact was there for a reason. But it was, he was totally insane as far as like his warrior monk, like just, we're going to dement you. It's almost like you guys are like Vikings. Like that was his mentality. And, and but we're all still kind of like live in the 21st century. But, but his harshness, which, which at the time, because I was a total buyer on that. Like I personally was like into it and I hated it at the same time. And, and the reason I say it was the kindest thing is because I, I really felt he made us

• 1:19:23Speaker 03

  so fricking hard and so intense that like when you actually did the real thing, you never had to even breach in the system one. Like I was always in system two, even in like combat zones, like IED, whatever dude, we're just doing SOPs. And I'd say it's the kindest thing because I just feel like that that's a good reason why not just me, but I think a lot of Marines that went through that, that platoon training with that guy are alive today. Because he actually kicked our ass so hard that it was actually ironically like a really kind thing. Cause he wasn't trying to be your friend. He was trying to, what we learned after the fact, basically make you really good at your job.

• 1:20:05Speaker 03

  And I just thought that was really nice of the guy, to be honest, for kicking my ass. Uh, which is kind of a weird, nice thing.

• 1:20:12Patrick O'Shaughnessy?

  I always love that idea that you don't rise to the occasion, you sink to the level of your preparation. And it basically seems that that's what that was, right? It's, it's, it's overdoing it, but preparing you for hard situations. And I, I think your mission in educating investors, you know, we share the same mission, is kind of like a light. Obviously you can't, I don't think you can harden.

• 1:20:32Speaker 04

  Perspective investors to nearly the same degree. Obviously, you can't. But the best thing you can do is just grind away at education. I think transparency is a big part of that. So.

• 1:20:42Speaker 03

  And highlight the warts.

• 1:20:44Speaker 04

  Yep.

• 1:20:45Speaker 03

  Always post about how many you could have this 10-year underperformance. It happens all the time. Yeah, just almost Captain Redger style. Like, be nice by being mean. Explain why this sucks so bad. Why this is so terrible. Why you shouldn't do this. And why this is an inevitably terrible idea. And if you still come through my traps and all my hazaxes and you're still willing to be standing at this door, now you at least got a small chance of being successful. But a small chance is better than zero. And I'm not, I haven't figured it out, but I think if all of us could figure this out in a small scale, because if we get too good at it, we end up screwing up our own trade. And then we gotta go be like everyone else. But in the short run here, if we could do that, we'd probably have a huge win on our

• 1:21:30Speaker 03

  hands.

• 1:21:31Speaker 04

  I love it. Well, I think this hour and a half is a good step in that direction. So I appreciate the time. This was a blast.

• 1:21:37Speaker 03

  Thank you for having me, Pat.

• 1:21:42Speaker 04

  Hey, everyone. Patrick here again. To find more episodes of Invest Like the Best, go to investorfieldguide.com/podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide.com/bookclub. After you sign up, you'll receive a full investor curriculum right away and then three to four suggestions of new books every month. You can also follow me on Twitter, @Patrick_OShag, O-S-H-A-G. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.