At The Money: Finding Alpha via Unique ETF Strategies

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1:00Wes Gray:Index funds have dominated capital flows since the great financial crisis. One of the rare exceptions is the pursuit of alpha via quant funds. These create very specific return characteristics that aim at somewhat different goals than the big broad indexes. I'm Barry Ritholtz, and on today's edition of At The Money, we're going to discuss how to pursue alpha through exchange-traded funds. To help us unpack all of this and what it means for your portfolio, let's bring in Wes Gray of Alpha Architect. He's a quant who also specializes in ETF constructions. Wes also runs ETF Architect. So let's start very basically, Wes.

1:48Wes Gray:When you talk about alpha in an ETF wrapper, what do you actually mean? Are we talking about excess returns over cap weighted beta or is it something else?

1:59Barry Ritholtz:Yes. So let me frame it because alpha is obviously a loaded word and can mean a lot of things to a lot of people. On one extreme, you got Jim Simons, you know, busting out 50 % returns with no risk. But guess what? You are never going to be offered this ever in your life, period. Because if I could do that, I would just manage my own money and become a billionaire, right? The alpha for the rest of us, at least in my mind, is it's basically delivering unique differentiated strategies after fee and after taxes that help you shape or differentiate your portfolio beyond the core of what you already have there in the form of like your Vanguard beta, right?

2:37Barry Ritholtz:But let's be honest, we're not gonna, it's not the alpha in the rent-tech sense, it's the alpha in unique, different boutique helps you shape your portfolio outcomes.

2:47Wes Gray:And just to clarify, if we are to believe Greg Zuckerman's book on Jim Simons, it was 62 % a year. And they did kick out everybody except the founding partners in the Medallion Funds. It didn't scale much beyond a few billion dollars, but still 62 % annually for 30 years. Nobody's even in second place. It's amazing. So let's delve a little deeper into alpha. How do you think of it? Is it behavioral? Is it structural? Is it informational? Or is it simply, here's where the model generates returns above what the market is doing on average? Yeah.

3:32Barry Ritholtz:So if we're going to talk about kind of alpha or the kind of stuff that we want to focus on in the context of the ETF wrapper that's public and has some capacity. I think it really boils down to boring things like the Vanguard can't do, for example. Like, how do I how do I deliver something low cost, great tax outcomes? That's also very unique, trades a lot and is going to change or shape your portfolio in ways that could be favorable for you beyond just buying S &P 500. And usually that's going to be related to diversification benefits, portfolio insurance benefits and what have you. So, you know, it's the poor man's alpha.

4:12Barry Ritholtz:It's not the it's not the two and 20 alpha. But that's just the reality of, you know, being in a product with a lot of scale and serving the public.

4:20Wes Gray:So it's funny you say that when I think of alpha, I typically just think of factor exposure, value, momentum, quality, et cetera. how much of ETF based alpha poor man's alpha is really heavily focused on factor exposure?

4:41Barry Ritholtz:Yeah, I would say pretty much all of it is. And if it hasn't been factor exposure yet, it will be because people just need to invent the factor that then explains that aspect of your performance. And obviously, if you're in a transparent wrapper like an ETF, everything can to be explained with factors at some level. It's just a matter of, did we think about that factor yet? And so, again, the alpha idea is like, we want to deliver you these unique market factors, but we want to make sure you capture all those efficiently, low costs and with good taxes. That's kind of the goal of ETF alpha.

5:16Wes Gray:So I have an academic question for you, and you're kind of an academic, so you're the right person to ask. You studied with Gene Fama. All of these factors are public and well-known. And in an ETF where it's transparent and disclosed, why doesn't this alpha just get arbitraged away? How does it still persist if everybody knows about it? Yeah.

5:42Barry Ritholtz:So I think humans are going to human. Let's just take the most basic example, the value factor. Buy cheap stuff everybody hates. Like we all know that over 100 years or 200 years in every market and every data set you can ever find, there's typically some sort of edge to buying cheap stuff that everyone hates. But then there's a dirty secret. For 10, 20 year stretches, is it can underperform your benchmark and you'll look like the biggest idiot on the planet. Everybody knows it has a long game historical edge. Everyone knows if you buy the cheap house in the neighborhood versus the most expensive, you're probably going to make money on average over the long haul.

6:24Barry Ritholtz:But that doesn't mean everybody is going to go all in on buying like the value factor, right? They're going to go buy Bitcoin. They're going to go do momentum. They're going to do all kinds of other things. So I think a lot of like the quote unquote alpha, it's like alpha in plain sight, but it's, that doesn't mean it's like easy to do because it, you know, you got to have discipline. You got to have long time horizon. You got to stick to the plan. You got to stick to the program. Uh, you know, it's, it's kind of like dieting and like being in shape. Like we all know how to get ripped, eat, exercise and sleep appropriately.

6:59Barry Ritholtz:Don't eat bonbons, don't eat McDonald's. But the alpha is there. We all know what you're supposed to do, but it doesn't mean everybody does it. It's the same exact problem with investing in these quote unquote alpha factors and why they don't get arbitraged away.

7:14Wes Gray:You know, it's funny. I'm going to paraphrase my favorite white paper of yours that you put out quite a while ago. Even God would get fired as an active value investor or fund manager. How is that possible? I love how you sum up so many different parts in the title of that. But if God's going to get fired as a value investor, what chance do the rest of us have?

7:41Barry Ritholtz:Well, exactly. And there's been fallen research. I think someone here's shop actually did it, where what if we were God, the tactical asset allocating manager. Same problem. Like you could underperform the benchmark for a long period, even though you're literally perfect. And you're like Biff, if you remember back to the future, he's got like the little almanac. It's just that the reality is markets are volatile and they generally work in a way that they're going to push you to maximal pain before the gains are there. And that's just the nature of how markets clear and how they work. So it is what it is, and I can't explain it, but like I said, humans are going to human in the past, in the present, and in the future.

8:24Wes Gray:So I have a couple of technical questions to ask you, and then I want to dive into some of the more really interesting ETFs, Alpha Architect, Managers. Because before we get to that, the perennial challenge with everybody who is a quant and everybody who works with factor investing is that they do these back tests and there's a tendency to either overfit. I mean, we've never seen a back test that we didn't love. The problem is if the future looks exactly like the past, well, then the back test is great. But most of the time that doesn't happen. How do you prevent that sort of overfitting? How do you prevent, oh my God, here's the perfect back test and not understand why that model isn't really going to work in the future?

9:18Yeah.

9:19Barry Ritholtz:So, I mean, I think at the outset, the best rule is just never trust any past performance, especially hypothetical, but even live past performance. The reality is what you should understand is what is the process fundamentally. And then obviously, why, why has this work and why will it continue to work? So for example, if, if someone shows me a back test that says, Hey, I made 50 % returns a year with like no risk and you don't have a 250 IQ, like, you know, the rent tech guys, which nobody else does. I'm going to say, well, that's great. It's in the back test and I'll grant you, let's just assume it's true.

9:56Barry Ritholtz:That's pretty straightforward. Why would it exist in the future. So unless you got a great story about how terrible this is simultaneous to how great it is, it's just not believable or credible. Right. And so that's my benchmark is don't believe any back test, especially if it shows a great thing, unless it also shows why it's so bad. Why is there so much career risk? Why is this underperformed the benchmark year in, year out, potentially for decades to get me fired and to want to jump off a cliff? Like I want to know that information because now I'm like thinking, oh, that back test might actually be legit then.

10:33Barry Ritholtz:But there's a trade-off. It's not like it's an easy thing to deal with in the future. So, you know, that's what I'd say.

10:39Wes Gray:Let's talk about some other risks from back tests, drawdowns, tracking error, trail risk, crowding. What other things do investors tend to underestimate or quants underestimate when they're looking at a model?

10:55Barry Ritholtz:Just pick them all. They underestimate everything. And the reason is because of incentives. So generally speaking, I only focus on academic research and peer reviewed journals, not because academics are the best or smartest or most practical, but they have the least warped incentives in a sense that they're also warped to like no one's.

11:18Wes Gray:Well, they want tenure, but they're not form fitting. Exactly. They're not fabricating alpha.

11:23Barry Ritholtz:Yes, their currency is like ego, prestige, like getting published, which is it's not show you this back test to go buy my product. So so just because of the incentive problem tied to like back test from an asset manager, it's you know, it's just it's like kind of like there's a there's a study on how do this drug from like sponsored by Pfizer research. Like, I just can't believe it at the outset. Right. Like it's similar in I think in our business where if it's a back test and unfortunately it was produced by an actual firm that sells the product, you just have to discount it damn near ninety nine percent.

12:03Barry Ritholtz:And, you know, go look for like other evidence from like, quote unquote, people who are less biased. And, you know, unfortunately, that that's really boils down to academic researchers, but they have their own biases as well. But as far as I know, that's the best you can find out there.

12:19Wes Gray:So let's talk about some of the funds that you help put together and help manage, starting with both momentum and value. QMOM and IMOM are US-based or international momentum strategies. And then QVAL and IVAL is US-based or international value strategies. These seem like such core factor models. Tell us a little bit about these four products and who tends to be the investors in these.

12:51Barry Ritholtz:Yeah. So generally speaking, what's the genesis of these products and why are they very different, but also very bad potentially for people? So I was an academic, right? I'm a PhD sitting around here spinning the data tapes and I just want to figure out how to invest my own money. and I read all these papers, they're like, great, take the thousand largest stocks, you buy the top 10 % on book to market, and this works over the long haul. So naturally, because I'm not in the investment management industry, which we'll talk about here in a second, like these products are designed like that to deliver these kind of academic-y factor looking things.

13:29Barry Ritholtz:Like, hey, top 1 ,000, let's go buy the top 5 % or 10 % on momentum and call it a day, monthly rebounds. I'm oversimplifying, but that's the idea. And I like that because it's grounded in the actual formation of how academic portfolios are actually created. Now, that's not what normal people do. I learned what normal people do is you start with the S &P 500 index and then you do little tilts plus or minus. Because why would you want to do those academic factor things? Because you're going to get your booty fired real quick because you're going to deviate like a madman from those underlying core benchmarks.

14:06Barry Ritholtz:And that's just the lot that we chose.

14:11Wes Gray:But that also means you have a very high active score and you're not a closet indexer.

14:17Barry Ritholtz:Yes, it's we're not closet indexers and we have very high active share and we're definitely doing something different and unique. But we don't like to sell our products because it's really important that people buy our products to understand what they're getting into because of this whole problem that they can outperform. and we look like heroes, they can underperform, we look like zeros and everything in between. It really does require kind of this 10-year horizon and a lot of understanding of the process and why it works.

14:46Wes Gray:So let's talk about what I think is your largest ETF. It's based on a box spread that option riders have been using for a long time to generate a low-cost lending situation against stocks. BOXX is the Alpha Architect one to three month box ETF. That's coming up on$10 billion. And then a little more intermediate duration underlying box A. Tell us about these two strategies. They seem really interesting.

15:21Barry Ritholtz:Yeah. So the fundamental idea here is that we can access the market price risk-free rate through the box spread market, which we can have a whole another podcast on how the heck that works and what it is. But just think about like, instead of going through the treasury market where I access what the government's going to give me effectively, I can go through the box spread market and access the implied risk-free rate amongst like broker dealers, banks and traders and everyone else. Which is much lower. Yes. And so what box is trying to do is how do we deliver excess returns, net of fees and taxes and all that good stuff over the equivalent duration.

16:00Barry Ritholtz:So we're, we're targeting one to three month duration. You know, obviously if you're going to do treasury bills, you could do one to three month duration there. The, the key goal is how do we beat that? And we, and we have done this. And the idea is like, it's just that funding market has a little bit less slack and there's some other reasons why it outperforms, but we're just trying to capture that net of fees and net of taxes in box. And in box A, there's also a trend component, but it's the same idea. How do we access these funding markets and fixed income markets, but deliver them in such a way that ideally we can outperform and potentially have other benefits along the way?

16:38Wes Gray:Let's talk about two really interesting funds. I love the stock symbol CHAOS, C-A-O-S, the Alpha Architect TelRisk. I'm assuming that's exactly what it sounds like. You are managing the potential for there to be a market crash.

16:59Barry Ritholtz:Yes. So with a twist, and again, there is no free lunch in options and broad market exposure. So I'm not here to say that this is a alpha generator in some sense, but what that product is doing is most tell risk funds, like, why do you buy a tell risk fund? I want to get protected if the market blows up. Well, what's the downside of a teller is fun. Well, we bleed out to zero over time because I'm buying puts all the time. So what chaos represents is a trade-off where we say, listen, we're going to buy the protection. So if the market bombs out, it's going to make money. However, we're going to be selling put spreads to fund that.

17:41Barry Ritholtz:And we're going to invest your collaterals as efficiently as possible. And what does that mean? Well, that means that we're not protecting you in like, say the zero to 20 % range in like a slow bleed out, you're also going to lose money, right? So, so chaos is just saying, Hey, we'll deliver the deep tail risk, but we're going to have to pay for it by eating risk in like the, the small drawdowns, but that's what pays for our insurance. And then we're just trying to deliver all that in a tax efficient, you know, fee efficient manner. So, you know, people kind of have tell risk protection, but without the bleed.

18:12Barry Ritholtz:But again, just to reiterate, it's not a free lunch in the sense that we just sell you insurance that always works and you never lose money. Just to be clear on that.