At The Money: Finding Alpha via Unique ETF Strategies

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You.

But still have found what I'm looking for.

But still have found what I'm looking for.

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 Rittholtz, 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 West Gray of alpha architect.

He's a quant who also specializes in ETF constructions,

West also runs ETF architect.

So let's start very basically West.

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?

Yes, so let me frame it because alpha is obviously a loaded word.

It can mean a lot of things to a lot of people.

On one extreme, we got Jim Simons,

you know, bus now 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 your vein guard beta.

Right?

But let's be honest, we're not going to...

It's not the alpha in the Rentex sense.

It's the alpha in unique, different boutique helps you shape your portfolio outcomes.

And just to clarify,

if we ought 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 Mendelian funds.

They're...

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, 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 vein guard can't do, for example.

Like, how do I differ...

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&B 500.

And usually that's going to be related to diversification benefits,

portfolio insurance benefits, and what have you.

So it's the poor man's alpha.

It's not the two and 20 alpha,

but that's just the reality of being in a product with a lot of scale and serving the public.

So it's funny, you say that.

When I think of alpha, I typically just think of factor exposure,

value, momentum, quality, etc.

How much of ETF-based alpha, poor man's alpha, is really

heavily focused on factor exposure?

Yeah, I would say pretty much all of it is.

And if it hasn't been factor exposure yet, it will be because people just need to invent

the factor that then explains that aspect of your performance.

And obviously if you're in a transparent wrapper like an ETF,

everything can be explained with factors at some level.

It's just a matter of, did we think about that factor yet?

And so again, the alpha idea is like, we want to deliver you these 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.

So I have an academic question for you.

And you're kind of an academic.

So you're the right person to ask.

You know, you studied with Gene Pharma.

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, 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, it can underperform your benchmark and you'll look like the biggest

edit 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.

But that doesn't mean everybody is going to go all in on buying like the value factor, right?

They're going to go by 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 that doesn't mean it's like easy to do because you know, you got to have discipline.

You got to have long time horizon.

You got to stick to the plan.

You got to stick to the program.

You know, it's kind of like dieting and like being in shape.

Like we all know how to get ripped.

Eat, exercise, and sleep appropriately.

Don't eat bond bonds. 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 arbitrage the way.

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 a 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?

Well, exactly.

And there's been fall on research.

I think someone here 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 maximum pain.

Before the gains are there, and that's just the nature of how markets

clear how they work.

So is what it is.

And I can't explain it.

But like I said, humans are going to human in the past,

in the present, and in the future.

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 manages.

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.

Yeah, so I mean, I think at the outset,

the best rule is just never trust any past performance,

especially hypothetical, but even live past performance.

The reality is what you should understand is what is the process fundamentally?

And then obviously, why has this work and why will it continue to work?

So for example, if someone shows me a back test that says,

hey, I made 50% returns a year with no risk,

and you don't have a 250 IQ like the Rentech guys,

which nobody else does, I'm going to say,

well, that's great.

It's in the back test.

And I'll grant you, let's just assume it's true.

That's pretty straightforward.

Why would it exist in the future?

So unless you got a great story about how terrible this is,

simultaneous to how great it is,

it's just not believable or credible, right?

And so that's my benchmark is don't believe any back test,

especially if it shows a great thing,

unless it also shows why it's so bad.

Why is there so much career risk?

Why is this underperformed the benchmark year and year out,

potentially for decades to get me fired?

And I 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.

But there's a trade off.

It's not like it's an easy thing to deal with in the future.

So that's what I'd say.

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?

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, too.

They're like, no one's biased.

Well, they want tenure, but they're not.

But they want form-fitting.

Exactly.

They're advocating alpha.

Yes, their currency is ego, prestige, getting published,

which is it's not show you this back test to go buy my product.

So just because of the incentive problem tied to back tests

from an asset manager, it's kind of like,

there's a study on how to this drug

from sponsored by Pfizer research.

I just can't believe it at the outset, right?

It's similar in I think in our business

where if it's a back test and unfortunately it was produced

by an actual firm that sells the product,

you just have to discount it damn near 99%.

And go look for other evidence from

like, quote unquote, people who are less biased.

And unfortunately, 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.

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.

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 long haul.

So naturally because I'm not in the investment management industry

which we'll talk about in a second,

like these products are designed like that

to deliver these kind of academic factor-looking things.

Like, hey, top 1000, let's go buy the top 5 or 10% on momentum

and call it a day, month of 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 creative.

Now, that's not what normal people do.

I learned what normal people do is you start with the S&P 500 index

and then you do little tilts plus or minus

because why would you want to do those academic factor things

because you're going to get your booty fired real quick

because you're going to deviate like a madman

from those underlying core benchmarks.

And that's just the lot that we chose.

But that also means you have a very high active score

and you're not a closet indexer.

Yes, we are not a 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.

So let's talk about what I think is your largest ETF.

It's based on a box spread that option riders

have been using for a long time

to generate low-cost lending situation against stocks.

B&WXX is the Alpha Architect 1-3 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.

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.

So we're targeting one to three month duration.

You know, obviously if you're going to do treasury bills

you can do one to three month duration there.

The key goal is how do we beat that?

And we have done this and the idea is like

it's just that funding market has a little bit less slack

under some other reasons why it outperforms.

But we're just trying to capture that net of fees

and net of taxes in box.

And then box A there's also a trend component.

But it's the same idea.

How do we how do we access these funding markets

and fixed income markets but deliver them in such a way

that ideally we can outperform

and you know, potentially have other benefits along the way.

Let's talk about two really interesting funds.

I love the stock symbol chaos, C-A-O-S.

The alpha architect tell risk.

I'm assuming that's exactly what it sounds like.

You are you are managing the potential

for there to be a market crash.

Yes, so one of the with a twist.

And again, there is no free lunch in options

and broad market exposures.

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 tell risk fund?

Well, we bleed out to zero over time

because I'm buying puts all the time.

So what chaos represents is a trade off

where we say listen, we're going to buy the protection.

So if the market bombs out,

it's going to make money.

However, we're going to be selling put spreads to fund that

and we're going to invest your collateral

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 chaos is just saying,

hey, we'll deliver the deep tell risk,

but we're going to have to pay for it by eating risk

in like the the small draw downs.

But that's what pays for our insurance.

And we're just trying to deliver all that

in a tax-fishing, you know, fee-efficient manner.

So, you know, people kind of have teller's protection

but without the bleed.

But again, it's just it reiterates,

not a free lunch in the sense that we just,

you know, sell you insurance that always works

and you never lose money just to be clear on that.

I do recall was it the first quarter of 2020

during the pandemic?

This exploded upwards like 25, 30%

am I remembering that right?

Yes, it's designed where if the market blows up

and the VIX explodes, this thing,

I mean, I can't guarantee anything,

but it's it should with very high expectations

make a lot of money if that fact pattern is true.

Yeah, so, you know, Trump says something crazy

and you know, North Korea nukes us tomorrow

and the VIX goes to 100 and the markets down by 50 chaos

will probably be doing pretty good.

And the last one I want to ask,

because I love all of these unusual box chaos,

sort of things that are not the typical ETF,

hide, high inflation and deflation.

I love the symbol, hey, you need a place to hide

during an inflation spike or deflation.

Hide is the place to us a little bit about that ETF.

Yeah, same idea.

We call this poor man's managed futures

because it's 29 basis point

and we're trying to deliver that kind of exposure

if you're familiar with it.

But basic idea is like, listen for your diverse fire,

you want something that could protect you

if there's hyperinflation or potentially protect you

if there's deflation, but we don't know what it's gonna be.

So all that product does is says, hey,

we're gonna focus on bonds which can help you in deflation.

We'll focus on commodities,

which will help you in inflation.

And then we have real estate as kind of an in-betweener.

And we just trend follow those exposures.

So if the bonds are doing great

because we're trending towards deflation, own those.

If inflation's look crazy, great.

We're gonna own commodities to get ahead of that curve.

And then if nothing's got any movement,

we're just gonna own cash and hide literally.

So it's just hyperinflation or deflation protection

in one product so you don't have to think too hard.

So to wrap up, for those of you

who have a core index approach

but want some satellite ideas

to surround the passive index,

consider ETFs that focus either on specific factor strategies

or specific option strategies that could work

to your advantage, both in terms of diversification

and non-correlation to what the core market is doing.

I'm Barry Rittultz,

you're listening to Bloomberg's at the money.

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