Audio · 2017-07-25 · 1h 25m · 6 moments

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 o ✦ AI generated

Apple Podcasts ↗

GUEST Wes Gray

timeline · colored by role

Claim◆

The edge in quantitative investing is not building a better model; the edge is coupling educated capital that understands why your mousetrap works with the strategy itself.

Wes argues that since all quant firms have access to the same data and can run the same Compustat tapes, there is no sustainable edge in building a better mousetrap. The real advantage is finding and educating investors who will stick with the strategy through painful periods.

transcript

Wes Gray: 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 was why our firm's mission and impact is we empower investors through education. Our mission is not we're going to build cooler models than Patrick O'Shaughnessy or Cliff Azanis, because there's no edge in that. We can all run CompuStat tapes till we're blue in the face, as you mentioned.

Data

Machine learning and complex algorithms have not been shown to improve upon simple predictive regression approaches for long-term, low-turnover quantitative factor investing.

Wes routinely tests machine learning pitches from PhDs by giving them data and strict robustness requirements, and to date none have outperformed a basic predictive regression approach for his style of long-term factor investing.

transcript

Wes Gray: 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 got this new machine learning algorithm'... I'll say, 'Here's a bunch of data. You go crazy. And here's all the robustness requirements you got to show me. Prove to me that it works any better than just predictive regression approach.' And to date, I have not seen it.

explains mechanism · 1

Claim◆

The optimal portfolio construction for factor investing is concentrated (30-50 holdings) with high active risk, not broadly diversified sector-neutral approaches, because the edge comes from being different and enduring pain.

Wes argues that concentrated portfolios with 30-50 holdings maximize active risk exposure without being reckless, and that excessive sector-neutral constraints dilute the factor premium. The real value-add comes from being willing to hold the unloved, painful bets that diversified mandates avoid.

transcript

Wes Gray: 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 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? 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.

supports · 1

Claim

Value investing is more behaviorally sustainable than momentum for most humans, even though the empirical evidence for momentum is stronger.

When asked to choose one factor for a 20-year horizon, Wes picks value over momentum despite acknowledging momentum's superior empirical evidence. He explains that value is intuitive and he would ride it to zero, whereas momentum's counterintuitive nature would cause him to abandon it during drawdowns.

transcript

Wes Gray: The evidence would say momentum, but because I'm a human and because I was raised on Ben Graham, value's just intuitive for me. So when I incorporate the system one risk, that when I add guns to my head and momentum stops working, I'm just going to give up on it. Value's something that you could put 50 guns to my head and I will never... Even if it goes negative 99% return, I'll still be holding my value stocks.

Prediction

The proliferation of data, technology, and trading apps like Robinhood is making investors worse, not better, by amplifying short-term decision-making and availability bias, which paradoxically preserves the edge for disciplined long-term factor investors.

Wes argues that contrary to expectations, more information and technology do not create more rational, patient investors. Instead, they trigger availability bias and force more frequent decisions, which humans are biologically wired to make poorly. This environment actually sustains the mispricings that disciplined factor investors exploit.

transcript

Wes Gray: What do I see? I see more intermediation, more stupidity, more data access, more transparency, which you would think would make better decision makers at the margin. But what do you think happens when someone has the Robin Hood app on their phone when they can click a button and buy or sell something? This is not going to make people more rational, patient capital, twenty-year-old investors it's going to actually create availability bias and force decision-making, which is the decision-making you don't want, which is short-term minded.

extends · 2provides context · 1supports · 1

Prediction◆

The passive investing boom is being framed as a performance-chasing vehicle rather than a permanent portfolio allocation, making it fragile and unlikely to end well as a macro equilibrium.

Wes argues that passive investing is marketed as 'a way to beat active managers' rather than as a permanent portfolio allocation tool. This performance-chasing framing, combined with the assumption of infinite supply and zero cost, creates a fragile macro dynamic that historically has never ended well.

transcript

Wes Gray: It's being couched again as a performance chasing vehicle and the best way to invest because it gives you the best returns... 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.

extends · 1

Highlight slides

The Real Edge in Quant Investing✦ from: The edge in quantitative investing is not building a better model; the edge is coupling educated capital that understands why your mousetrap works with the strategy itself.Mission: Educated Capital, Not Better Models✦ from: The edge in quantitative investing is not building a better model; the edge is coupling educated capital that understands why your mousetrap works with the strategy itself.Concentrated Portfolios Maximize Factor Exposure✦ from: The optimal portfolio construction for factor investing is concentrated (30-50 holdings) with high active risk, not broadly diversified sector-neutral approaches, because the edge comes from being different and enduring pain.Why Not 100 or 500?✦ from: The optimal portfolio construction for factor investing is concentrated (30-50 holdings) with high active risk, not broadly diversified sector-neutral approaches, because the edge comes from being different and enduring pain.Passive investing: performance-chasing, not allocation✦ from: The passive investing boom is being framed as a performance-chasing vehicle rather than a permanent portfolio allocation, making it fragile and unlikely to end well as a macro equilibrium.A fragile macro equilibrium✦ from: The passive investing boom is being framed as a performance-chasing vehicle rather than a permanent portfolio allocation, making it fragile and unlikely to end well as a macro equilibrium.Historical precedent: never ends well✦ from: The passive investing boom is being framed as a performance-chasing vehicle rather than a permanent portfolio allocation, making it fragile and unlikely to end well as a macro equilibrium.

Related episodes

Video · a16z Podcast

The edge in quantitative investing is not building a better model; the edge is coupling educated capital that understands why your mousetrap works with the strategy itself.

Machine learning and complex algorithms have not been shown to improve upon simple predictive regression approaches for long-term, low-turnover quantitative factor investing.

The optimal portfolio construction for factor investing is concentrated (30-50 holdings) with high active risk, not broadly diversified sector-neutral approaches, because the edge comes from being different and enduring pain.

Value investing is more behaviorally sustainable than momentum for most humans, even though the empirical evidence for momentum is stronger.

The proliferation of data, technology, and trading apps like Robinhood is making investors worse, not better, by amplifying short-term decision-making and availability bias, which paradoxically preserves the edge for disciplined long-term factor investors.

The passive investing boom is being framed as a performance-chasing vehicle rather than a permanent portfolio allocation, making it fragile and unlikely to end well as a macro equilibrium.

Ben Horowitz on the Global Race for Tech, Power, and Influence

Chris Camillo: I put 70% of my portfolio in this ONE stock

He won a Nobel here for AlphaFold. Then he left. - John Jumper