Introduction

Patrick: [00:01:21] My guest this week is a version of me, a funnier, cooler version who also has a Ph.D. 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 that 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 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 five times. You are going to love it all.

Talk about the mindset that gets beat into you or brainwashed into you as a Marine. I’ve read a lot about Belleau Wood and Devil Dogs and sort of the mindset underneath it all. Compare that maybe to the rest of some other branches of the service and kind of how the mindset is or isn't an advantage if you think it. I don't assume you think it is.

Wes: [00:03:28] Yeah. Marine Corps’ kind of, their ethos is "do more with less". We’re the guys that always get the scraps. We got to be ordinary and mean and internal. I don’t know if that's a fair classification but in general, Marines is we like to think of ourselves as kind of survivalists and we can do more with less. I don’t know if that's true or not because when I was in… We had GWAC funds and they gave you as much money as you wanted. If you want to go shoot 10,000 rounds as long as you were training, you got it. 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.

Patrick: [00:04:12] Did that change your mindset? I always wondered how much of this is self-selection versus real transformation. Would your mind select that before or was it through change?

Wes: [00:04:24] I’ve always been like that, man. I grew up in the mountains in Colorado. I've always just been into adventure, survival. When I was a kid, we were pretty broke. I never really know it at the time but just I've always been in that mindset of don't spend money even if you have it. Just always be kind of like a Depression baby that was born in 1980. I think that kind of culture is also in the Marine Corps and at some level, it attracted me to the Marine Corps so I think the Marine Corps doesn't really change you a lot of times, at least, with my scenario. It just attracts whack jobs like myself to come into it and so then you get a whole fraternity of people that were already self-selected to be like this and then we all hang out together. It just makes it even worse. Yeah. Some people do come in the Marines and it does change them. I was already brainwashed coming in basically. I think it transformed. I was already weird beforehand, I would say.

Patrick: [00:05:24] What was your most memorable experience growing up in the mountains?

Wes: [00:05:26] It's funny because… You probably know this when you grew up but there is this mountain behind where I live there. At the time, I was called Adam's Rib Ranch. The Kummer's family bought it. It’s called Frost Creek. The whole thing is like a development now. There is this mountain behind us and my brothers and I, we’d always climb up this thing. It was like an epic adventure. It would take all day. That was the best thing ever. 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, Henry, you got to hear about this thing. It was so epic. This is where I did all my toughest things.” Of course, we’d go out there and it's like a hill, maybe a hill. It was just amazing. When I was a kid, that was so great in my mind. It’s like the most insane awesome thing you could ever do. We went back there and we’re like, “Oh, that’s pretty lame and it doesn't even matter. It wouldn’t even count.” Unfortunately, that was probably 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.

Patrick: [00:06:29] In the military, what experiences would you say are most related to what you’ve gone on to see in public markets? Maybe the same sorts of mistakes that people make. Arguably, these mistakes are what strategies like yours and ours prey on.

Wes: [00:06:43] Sure.

Patrick: [00:06:43] What are some parallels that you saw between your experiences there and here?

Wes: [00:06:46] I think Kahneman’s book, Thinking Fast and Slow, the whole system one, system two, the architecture of the brain, I think that defines life. In decision-making in the military, 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 thinking that system two mentality like rational calculated thinking, but obviously, that gets more and more difficult at the margin when you got 100 pounds a shit you're carrying around. It's 125 degrees, you're tired, you’re pissed off. In the military, it’s all about how do we contain system-one errors as best we can. Obviously, at investing, that's totally transferable where if you're not in that extreme as an environment but clearly investing your money, it’s pretty stressful and emotional. 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 and doing stupid stuff basically.

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 and doing stupid stuff basically.

Wes' Journey into Quant Investing

Patrick: [00:07:51] What were your early forays? I realized 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? What was the first stock you bought or owned, the first story in the market?

Wes: [00:08:06] I was on a path to total failure because of the first stock I bought was Swisher Sweets Cigars. 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 return on capital, low PE. This was probably in ’98. At the time, 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.” The earnings kept growing, super cheap on PE, bought at 650 like literally a month later, a buyout for like… It was like 900 or 950. I was like, “Oh, this is so easy, man. No wonder Buffett's a billionaire. This is all you got to do.”

That's unfortunately how I started with a ton of success which was lucky because then I started getting huge in-stock pickings, special situations, did that for years, and also got lucky in the sense that I wasn’t lucky to start around like the late ‘90s because my dad would call me up. Tell me to buy the Janus Global Twenty Fund every day. This is when Internet go-go was going on. I felt confident because I had my Swisher Sweet success, but then I kept not doing as good as the general market which is, by nature, be in a small-cap value player. As we all know, the story has now been told minus the Internet crash like small-cap value you could have thrown a dart at a wall and made 30 CAGRs for 10 years. You're not all in poorly because, towards the end of it, I kept doing more of the stock-picking stuff. Even to this day, I still sit on about a half-million-dollar capital loss carry forward. That's what moves me into I’m not Warren Buffett and I need to focus on systems and not basically fucking everything up. I went from the super overconfident and then all the way down to the bottom of the depths. Then luckily, I wasn't that rich. I ate my humble pie pretty early and thank God because now I haven't looked back now. I don't do stock picking at all.

Patrick: [00:10:15] What was the transition into the quantitative investing space? How did you discover it? What was the early research process like? How did you build conviction that this was the way to do things?

Wes: [00:10:27] It's another bad story. I actually launched a hedge fund that was going to be basically like kind of what Quantitative Value does but long-short in September ’08. I literally launched the hedge fund right when the whole thing was like blown up and of course, just by dumb luck, I go in hedged. In those months, I'm looking good relatively but at the time, I wasn’t doing short security names, it’s just using Russell 2000. Of course, because all of the naked shorting roles got blown out, even IW ingot called in so I couldn’t short anymore, so now I'm long and strong these quant value names which is like, “Oh, this is great,” but of course, this is now in December. I start going back to old Ben Graham ways where there are all these like biotechs, they’re selling for less than cash. All the traditional things that I've been doing for 10 years, I’m like, “Oh, guys, we got to switch. This is the best opportunity ever. All we got to do is go by these stubs. We’ll make all this money.” Literally, we talked to LPs. It was like $3 million with just our internal money and like a few rich guys we knew. We changed the whole system. We said, “Screw this quant thing. This is a once-in-a-lifetime.” Of course, long story short, we ended up basically getting R2K with twice the vol and then end up liquidating and transition the business because I had some bigger rich guys calling me. When we backtested what we would have done if we just followed the damn model, we obviously would outperform our own stupid ideas. That was my last straw where I’m like, “You know what? I’m done. I’m pure quant now. Just build the system and the process that you think makes sense when you’re in a system-two frame of mind. Then when you're in the battle on the fight, just follow the model.” You almost got to take a religious bent towards your own scientifically-minded system. I don’t do stock picking anymore.

Quantitative Investing Landscape

Patrick: [00:12:29] If you had to describe the… We’ll call it quantitative investor like landscape or map. How would you do that? What would you say are the major camps or applications of the basic idea which is get some things… There’s a group of stuff you can buy or sell. There is data on those things and there is future returns and you build models. There's a ton of ways to apply that basic scientific method idea. If you were describing to, let’s say, a sophisticated investor out there that came forward in a time machine from the ‘70s where no one was doing quant or very few known except that Thorp was doing quant, how would you describe what it looks like today? What are the major camps? Who were the pockets? Who are at the leading edge?

Wes: [00:13:14] Just like anything, it's good to define the term. I'm sure you guys get the issue all the time. Quant can mean anything from what I consider ourselves and I imagine you guys as well. We're just long-term investors that like to use quantitative tools to help us make good decisions for a long term and minimize the baggage of being a human. Then there's a whole another spectrum a quant which is the Caltech physics Ph.D. building like AI machine-learning algorithms on basically making markets. 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? I think the applications in a much higher frequency land 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 that's a game of super-high frequency information acquisition trying to be smarter than the next guy. I got to build good computers, uncertain it gets resolved. The media and I keep making thousands and thousands of bets. That's extreme quant. We don't play in that game. We don’t get any edge. We don't want to.

Then on the other extreme is you got people to say, “Hey, Warren Buffett has a pretty cool idea. Buy cheap stuff that's high quality and has low beta, it turns out too.” His real edge is just patience and the ability to sit back and not worry about what everyone else is saying about the world. I'm not strong enough to be Warren Buffett, tried and failed. I don't know if 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. Is this meant to say that my model is better than your model? It’s better than in AQR’s model or better than Joe Schmoe's model?” No. We all know the same data. We all know the same facts. I have 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 Asness because there's no edge in that. We can all run Compustat tapes that were blown in the face as you’ve mentioned you’ve done-

Patrick: [00:15:38] We’ve both done it.

Wes: [00:15:38] Yeah, we’ve all done it. I was even listed in the… Actually, Cliff… I was watching a YouTube video of him because he's the guy I really respect. I just love their firm and what have it. Someone asked him about machine learning. They’re like, “Hey, Cliff, what do you think about machine learning? He almost said the same thing that I wanted to say. “Super interesting. I haven't really seen anything in its application on what I do which is this lower turnover quantitative investing to capture these premiums over the long haul.” He's like, “We do value, we do momentum," and that’s what we do. We’re probably not changing it. I’m the same way. I literally get people with Ph.D.'s in every physics, math thing you can ever mention saying, “Hey, you guys were really cool. You’re awesome. I got this new machine-learning algorithm and I’m an equal-opportunity employer so I’ll just send them a bunch of data,” because I’ve already known what we've done on it. 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.

It’s one of those things where on one end, the quant super hardcore is great like an HFT. On the other end, you could give me 50 guys with 200 IQ, Caltech math PhD's and they're not going to convince me that their value algorithm is better than mine or yours or whoever's. That's not what matters.

Patrick: [00:17:09] 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 error, simple basic long-term stuff. We’re going to return there and spend time there. It would be fun to get your perspective because you have straddled all the worlds. You’ve been in the Chicago Ph.D. program. I think Fama was literally your thesis advisor. We could get into that story a little bit. You have a window into all types of quant including that crazy mega mind, thousand Ph.D., informational advantage market-making thing. I don’t want to assume… It’s easy to throw around terms. It would be great if you could explain in a little more detail what that means. What do you mean high-frequency, market-making, 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?

Wes: [00:18:06] A perfect example is one of our… One of the guys that see through our business came out of a firm called Gecko. We have a lot of clients that come through that channel through him. A lot of them, Gecko was like the original gangster in basically market-making, crush the world. They came into that KCG acquisition kind of a mesh with the different culture and then all original Gecko guys, for the most part, left. They're now all running their own little shops. One of our clients who’s a guy in Chicago that does this… These are systems that have probably got 100 mil capital max it can take but they can leverage it to infinity, and he's got 40 people that are all math, physics Ph.D.'s and they’re literally all working on one central machine-learning algorithm. Their whole thing is they’re literally making microsecond transactions essentially trying to understand supply and demand better than the next guy to make little small little return.

When I asked them, I was like, “What’re the returns you make?” He's like, “Well, we make 30%, 40% returns just like when RenTech does, but what people don’t understand is we’re not investors; we are traders. If I were to capitalize all the brain damage, all my computer systems, the servers, my ROA, return on assets is probably like buying S&P. I have a hell of a lot more fun because this is my passion, what I like doing.” I think their game is they’re in a true edge of outsmarting the next really smart guy and just being able to understand supply-demand better than the next and buying low and selling high is what they do. If you’re competing with supercomputers at the margin, if you're one-millionth of a second better than the next Ph.D. guy, that's everything. It’s a winner take all essentially and it’s also always changing too.

Their market is unlike what we do like value. Okay, there's some element of risk obviously. There's some element that people just hate like retail stocks right now because Amazon's going to 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 going to 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 going to be a limited scale opportunity where you’re always going to have to be innovating, always going to have to be smarter than the next guy. It's not Warren Buffett's frequency of change.

Patrick: [00:20:56] People are always curious about who populates these firms. Given that you came through the Chicago Ph.D. program, a lot of the alumni from that go to firms like this. Can you talk a little bit about the human capital arms race in this space like how is RenTech outpitching Two Sigma, outpitching whomever to get the top talent? What are the elements or variables that matter there from a creating standpoint?

Wes: [00:21:26] I know a few of the teams like Millennium and some of these big shops like that. One of the things is these have great infrastructure. To be honest, a lot of them aren't Chicago PhDs. A lot of them are just more like hard science types. You can go to a shop like Millennium and you'll say, “Hey, here's all the data pipes in the world. Here's all the legal infrastructure in the world. Oh, by the way, we charge whatever 350 and because our fee structure is so high, we can pay you internally like 0 in 20 or 0 in 30 and everyone is still winning.” The ability to be able to offer someone who's maybe a Ph.D. geek that’s got really cool ideas and say, “Hey, you’re almost like a postdoc coming into a science lab. You don't have to go race. You don't have to go fight for grant money. You can just come in here and do cool stuff. Oh, by the way, because our fee structure is so big and deep, we can also pay you a ton of money.” I think that's the initial attraction on all these guys. Then I think it boils down to culture because we all know guys who work at all these best shops, the decision usually comes down to what's the cultural fit? There are people that will be like, “Honestly, I'd rather work for you guys and make one-fiftieth because this is so much pressure. I'm losing my hair. I hate my life.” I really think the culture element is within those firms is probably what decides who goes where because, in the end, it's commodity what they’re going to provide for you. It's more like what’s your fit with that culture. You know probably Bridgewater. You think of people that love it or people that are like, “yeah, I like to go hang myself in the rafters now from hanging out at that place for longer than two months.” I think culture is like a big, soft element of recruiting that most people… You just can’t quantify it that well so that matters.

Patrick: [00:23:20] Obviously, we’ve both chosen a very different poker table to play at. Let’s go to our world which I’ll let you start by describing at a high level the basics of our findings. You already mentioned and a lot of us, we’re all going to copy that data, COMPUSTAT 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 on how you calculate things, how you… I want to get into portfolio construction because that's how… I think you and I agree that could be a huge differentiator that maybe describe for the 10 people listening that don’t know. You 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 mental model, but the characteristics that you found in your research to be most predictive or usually predictive of future returns in stocks.

Wes: [00:24:12] It's going to sound like a beaten drum and your dad wrote a whole freaking 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 the idea of value. Buy stuff that at 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. We know that winners, they get winning so do that. The last part is arguably the most important buy them cheap, buy them strong… and hold them long because everyone in this factor rat race and you know it, we know it, anyone who’s studied the data knows that if you're going to capture those factor premiums, it's going to be insanely painful especially if you do it how you and I do it where I think it’s a more intellectually honest way to do it which is much more concentrated and focused in the actual factor. It’s just that's the nature of it. It's going to be painful so it isn't a free lunch. I think in return for having endured that pain, you get some gain. I think those are the... 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.

...we have a saying, “Buy them cheap, buy them strong, and hold them long.” What does that mean? Buy cheap is basically encapsulating the idea of value. Buy stuff that at 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.

Portfolio Construction

Patrick: [00:25:36] One of the most interesting debates going out now is around portfolio construction. When you say pain, there’s 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. We got this goofy-fear-greed imbalance. Talk about your research on portfolio construction because the standard party line for quants is you got to be really broadly diversified and take basically no individual name exposure, neutralize every risk to everything so you got these platonic pure factor exposures and nothing else. This coalesces around the idea of Smart beta whichever everyone is familiar with. You and I have very different takes on this so talk about portfolio construction.

Wes: [00:26:31] Again, we use quantitative tools to capture what we think are important good insights from qualitative investors. Munger has that whole thing about the worst vacation and if you have an edge, why would you dilute it out. Again, being like to your other point, being different is the way you're going to add value or potentially subtract the ton of value. I understand the merits and doing the super sector-constrained control for every little thing. 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 fee, after taxes, and I don't frankly care that much about sector risk or volatility or what have you. I feel like that's the only way I can capture my edge which is being crazy and having a lot of patience. 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, it destroys any edge or ability to take pain.

We just build portfolios. I’m not saying they’re right or wrong. I’m saying for a particular mission, they make a lot of sense. They're also the worst idea on the planet Earth for probably a vast majority of investors. It’s much more appropriate to manage the risk because again, our portfolios, we don’t say you should put everything in one of these things. It has 50% retailers right now because that's a real risk. What if the whole damn thing blows up and Amazon 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 at a broader portfolio set where you're doing some element of efficient frontier portfolio diversification, you want me to have as much active risk as possible because that’s what you’re paying me to do. I know Asness retort will be like, “Yeah, well, a lot of that is not active risk. That’s just sector risk.” 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.” A perfect example is the Internet bubble. In 1999, you're going to force me to own some tech stocks that are “cheap” and 500 times earnings, 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.”

Patrick: [00:29:22] Best Buy.

Wes: [00:29:22] Best Buy, all this crap that they weed on. I'm sure you guys own a lot of it.

Patrick: [00:29:26] We own a lot of Best Buy.

Wes: [00:29:27] Yeah. You got to own the pain. You got to own the pain. You got to own the risk and it is risk. There's some misprice in there too but it’s a lot of risks but that's fine. If you got a horizon, you can bear the risk. We just build super risky portfolios and that's just what we do for them. We’re a boutique. We’re not saying this is for everyone but that's what we do, and I think you guys do it as well at some level.

Patrick: [00:29:50] Maybe this is something where you and I may have a slight disagreement, so let’s see if we can explore this a little bit more. What we found is that a lot of quantitative managers are sort of risk first. Risk mitigation is a key part of their process. You can define risk a lot of ways but tracking error is a very common one. The great pitch from some enormous asset managers that do factors is factor exposure but low tracking error, which to us is like you, a little bit oxymoronic. It can be right for the right investors for sure. Obviously, these asset managers are multiples the size of both yours and mine so there's an appetite for it. I'm curious how you think about risk within this category of highly active. One of the things we found is, step one needs to be get really concentrated in your key factors, but then within, let’s say, that's the cheapest decile stocks or something like that in large-cap stocks. Then within that group then you can do some stuff around risk management. Then let’s say that today, the cheapest is 50% of retailers, well, maybe it's 40%. As long as you’re within the best of category by value momentum kick out the worst crappy companies is step one, then you can shape and not take as much active sector risk. How do you think about that? Is there any risk management that you do or…

Wes: [00:31:23] 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 in momentum portfolio. 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 vol or “risk.” Risk may be associated with sector bets what have you. However, if those 40 stocks are part of a 200-stock portfolio especially full with momentum where a lot of times it's doing the convex bet that’s opposite of the Best Buy pain trade, I think as a global portfolio there which is really the in-state equity book, it's not that big a deal. 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 overexposing yourself at the margin to like the Best Buy bet. You can obviously hedge against that and maybe put some sensible rules in there which I also agree with like, “Let's not do 100%.” We have like 25% rules or whatever.

Patrick: [00:32:38] Yeah. We have exactly the same number.

Wes: [00:32:38] You don’t want to go totally insane. The thing that kills me is when people are like… It's almost like getting two 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 every factor element of it. That's what I just call over-engineering. It seems like the benefit versus brain damage, it's not a good quotient there. In general, if we can go simple and robust with reasonable constraints, it is good. I think we would agree actually. I’m more talking to the hyper quant types that it seems overengineered to me.

Patrick: [00:33:19] QVAL, at least, the last time I checked which is the standalone value ETF, I think it’s 40 holdings, right?

Wes: [00:33:25] Yeah.

Patrick: [00:33:25] Something in that ballpark.

Wes: [00:33:27] Yeah.

Patrick: [00:33:27] How do you think about that number versus 100 versus 10? What is that portfolio construction logic just behind like the site, the number of names, and the size and the positions in the portfolio?

Wes: [00:33:37] Yeah, sure. We all have to operate in some constraints for 40 act and what have you. In general, we can 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? 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 that 30 to 50 seems reasonable. Could you do a 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. I think it's more of the art and 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 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 pure blue meth drug they were trying to deliver out there. People can chop that up and add their baby powder on their own terms, but were going to personally smoke our own blue meth because we like it. That’s kind of how I’d say I think about portfolio construction.

Value and Momentum Factors

Patrick: [00:35:18] Gun to your head, you got a 20-year horizon. You get to pick one factor. You’re picking value or momentum?

Wes: [00:35:26] Okay, so the evidence would say momentum but because I'm a human and because I was raised on Ben Graham, value is just intuitive for me. When I incorporate the system-one risk with guns to my head and momentum stops working, I’m just going to give up on it value something that you could put 50 guns to my head. I will never even if it goes -99% return, I’ll still be holding my value stocks. Whereas momentum is something where I know the evidence is compelling and all the rationale for blah blah blah but it's not as intuitive, it just doesn't sit with my system one as well. I would be more inclined to blow that trade out when I'm in the worst pain and value. I’d stick with value because behaviorally I could write that to zero.

Patrick: [00:36:19] When you say that momentum, if you just wondered what the data, it would be momentum. Describe what that means.

Wes: [00:36:25] 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 is more compelling from just a straight-up empirical-based standpoint than value ever thought of being especially when you control for the risk and how it fits in a broader portfolio. I don’t think anyone denies that even. Fama and French Dissecting Anomalies paper, they say, “This is the premier anomaly.” We can actually look at books and market which is a classic value factor and of course, they pick that one because it sucks. You could make all kinds of storylines risk-based blah, blah, blah, 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. I think the evidence is there and because it is so counterintuitive in how it works and why it works, I just feel like it is a better long-term bet if you are like a scientist like computer, robot guy which I’m not. That's why I said value but if I was a robot, that's what I would do.

Patrick: [00:37:35] I feel like I spent like a 10th of my career explaining to people why I don't like price-to-book so maybe I’ll let you do it for me. When you say price-to-book stocks, why? Why relative to other value factors?

Wes: [00:37:48] Before we’re getting the weeds out, because you guys have tons of great research, unlike 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 hard-core capital that won't sell book-to-market stocks unless you put 50 guns to their head. Any time you get a factor, there is the thing… The market doesn’t matter; supply and demand do matter. 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 their investors and essentially arbitrage their factor away, it happens. In the same thing, if someone took our favorite which is enterprise multiple and you said, “Hey, we’re going to get $500 million of brainwashed capital that permits that will never leave,” that risk premium/mispricing premium will erode because it's not leaving. It's not factor timing just like if we did your guy’s stuff, shareholder yield, blow our water. Guess what? If you grew to $500 billion and you arbitrage the way your shareholder yield factor, you, over that time period, have done an incredible service to your investors because they've gained that whole benefit of arbitrage and that mispricing because they presumably were the permanent capital initially. They were like that the $1 billionth, not the $500 billionth, which at the margin is now just buying risk premium pure.

I just think it's probably been the hour of doubt not to mention that there are mechanical reasons you guys talk about with how book-to-market works with share repurchases, all these other things. It’s not a bad factor. It's going to capture just what DFA tells their people they’re going to capture, a risk premium pure. Great. If you want to try to maximize your value premium exploitation, you obviously are going to eat the risk component of it. 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.

Patrick: [00:39:54] 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? Flows affect factors, right? Obviously, if there's $500 billion and something and a million dollars and the other thing, you probably want to be in the million-dollar thing. What are the sorts of things that worry you about the strategies that we’ve spent our careers on which 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. What kind of things worry you and what would be the circumstances… We sit here insistent too right now being very rational like if you are to set a set of criteria at which you would say, “Okay, I actually need to get out of this strategy.” What would that look like?

Wes: [00:40:49] 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 use the scientific method here where we have competing hypotheses. We’re going to look at all this data look at out of sample, in sample, different time periods, different markets, and we've done that for hundreds of years now on value momentum. Amen. Now, if I'm a Bayesian updater, we need so much time to go out a sample for me to change my prior at this point. I'm basically not changing. 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. The way I look at it is it’s still, in the end, it's all about supply-demand. Just going back to this DFA example, the art of this is if you see massive amounts of insanely patient disciplined capital that have not exposed principal-agent issues with recycling, short-term, chasing DFA-type money where we put billions upon hundreds of billions of dollars of super hard-core factor premium exploitation capital to play on something, you will arbitrage the thing away. I just don't see that. What do I see? I see more intermediation, more stupidity, more data access, more transparency which you would think would make a better decision-makers at the margin. 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?

Also, when they have all the data in the world at their fingertips. This is not going to make people more rational, patient capital 20-year hold investors. It's going to actually create availability bias and forced decision-making which is the decision-making you don't want which is short-term-minded. I think we’re entering a world where ironically all the information access, more data, more technology that “helps” people make better investment decisions is end up going to 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 going to screw it up.

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 until the day I die. There may be new things like trends or other things that I’ll explore interesting, but those core concepts ain’t changing just because there’s not enough time for me to be alive to make enough out of sample to convince me otherwise. But what would change me is, again, going back to the dynamic of the market and understanding what creates this saying in the first place? Usually delegated asset management, principal-agent problems, and then just look for basically little mini warm Buffets starting to pop up that stick to these factors. There’s ETF strategist. 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 VOR. That's the exact capital that… actually permanent capital exploits in the value premium. You just see more of that, not less of that. I think it would be insane to think at least based on a short-term forecast and knowing psychology of the marketplace and how your institutions are framing and pitching themselves right now to think that that's creating more patient factor capital. That's the way I look at it.

Patrick: [00:44:38] How do you think about new researches? Most of these, we’ll call it like fundamental quant strategies. Really, it's data coming from its price plus the financial statements more or less. There's other stuff too 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 and you mentioned the idea of education being a central mission of yours. 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 engage with the data and tinkering around?

Wes: [00:45:17] Every morning… I know you read tons of books which is awesome. I just read unfortunately because I’m just a finance geek, I just read source journal literature like my books. I don't practice the Munger mental model thing. My mental model is finance crap all day, every day just because I like it personally. I love reading research, love, and desire like no other to find new ideas and hope that they change my mind. That’s what I’m passionate about and that excites me anytime I get something new. I'm always reading because I always want to hunt for that new Easter egg but that said, haven't been doing this for a while now like there hasn't been… Ever since we’ve kind of summed up everything we knew about the value and everything we knew about momentum, we always test stuff all the time. The problem is the bar to entry is so much higher now because we always have to consider getting us more art and science of the chance of overfeeding, over-optimization data mining where anytime you already have the baseline idea, buy them cheap. Am I going to argue that our model is better than your model? They’re all about the same. Buy cheap. Who cares? Just have discipline and you'll probably win. We like ours is better than your stuff and that's great. I think, honestly, the stuff that comes out on the new model is marketing because every time we look at every idea, re-engineer, tested, and we say, “Hey, does this add value at the margin of what we already have? Unfortunately, and you guys probably know it too, inevitably it doesn't. Then you got to sit back and ask the incentives of the marketplace usually sales guys, “Why do you keep adding all his new crap onto this model?” It's because there's a thing called complexity and it sells.

People quickly move from being an evidence-based investor to a story-based investor and you’ve probably seen it. All of our friends or my friends all run these things but you go to a big shop and they got like 90 PhDs over there and their model hasn't changed in 50 years. You got to say, “Why do you got these 90 PhDs over there?” On the outside view, they’ll be like, “Oh, yeah. There’s always doing research, finding new ideas to make our model awesome,” and then you give them a few beers and like, “Dude, when the consultants come here, we can’t just tell them we’re doing this model, man. We got to like tell them we’re doing something.” I got to point to these 90 PhDs with all other Chicago PhDs because you got to look like we’re doing something here. That's just more like the marketing part of the business and I totally understand it. I don't think they're actually adding value anymore because that's why Warren Buffet has like, him he reads like his 10K's in his underwear in Omaha. He doesn’t need 500 staff and he does perfectly fine. 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. 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. I just do it because I intellectually like it frankly.

Patrick: [00:48:46] We only 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 really doing, there's nothing there. That's probably 95% of research so it's a big cutting room floor.

Wes: [00:49:02] What we used to do which we all probably do because I need to contain my own system-one issues is 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 what we think is the best way we can do that. Then there's this whole fun game of like the fun research where you try to be smarter than the next 200-IQ guy and we've done that in the past. The issue is those things take a ton of resources, a ton of brain damage, and they’re really cool and really exciting because you train them all day but it’s just not our business focus. If I ever got rich enough or I just didn’t really care, I would do that more just for the fun of it knowing fully well I’ve been better off just buying my ETFs probably but it's just a lot more fun to do the action-packed things. It’s all probably create like a little unit down the road where we just do like prop trading things just to placate my own need to be engaged in cool guy stuff.

The Passive-Active Debate

Patrick: [00:50:05] If you had to give your money to some other active manager so you can’t choose Vanguard which is the boring answer that everyone gives these days.

Wes: [00:50:15] I want to give it to them honestly.

Patrick: [00:50:17] To Vanguard?

Wes: [00:50:18] I think they’re going to have mean reversion at some point. I love the idea and the concept, tax-efficient, cheap investing, but there is no firm that still exists a hundred years ago. If you get too damn big and too damn powerful, 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.

Patrick: [00:50:44] How would that play out though? What would be the seeds of their demise? I spent a decent amount of time with some really great people there.

Wes: [00:50:52] Oh, it’s amazing people.

Patrick: [00:50:53] It’s an amazing culture and tone was set early on by Jack and it's been continued by some really great leadership. They're about to get another CEO. Think through that thought exercise like what might that mean reversion look like. This is a question everyone has which is, what does this massive one-directional trade from everything else into Vanguard? You see some people saying usually it's high-fee active managers but consider it with a grain of salt but usually, it’s saying this is creating distortions and perversions and fundamentals matter less today. The internals of the market is weird as a result. How do you think about that? How do you think about... I don't really agree with that but I’m curious how you think about it.

Wes: [00:51:34] Here's what I would say. I don't think they're really screw anything up in the market, but I'll tell you what I think about Vanguard and the same argument would be applied to 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. You just go talk over here. Things get corrupted just like Amazon. That's why I love the Amazon trait. Everyone just assumes Amazon is going to take over the world because they are and they should. Here's the problem. When they take over the world, do you think governments going to put less regulation on or more regulation? 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. I think if you just assume that these things are going to 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. I think all these things come to an end at some point. 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. I hope they keep dominating but just knowing the culture of the world and how power seems to attract corrupt people that end up screwing 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 hundred years from now. Someone will screw it up; it's just inevitable.

Patrick: [00:53:22] It's an interesting example of like the inside-outside view from Thinking Fast and Slow where the inside view on both these firms, Amazon is 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 or is the outside view as to your point like go look at the biggest companies from 100 years ago; it’s just not around. There are also these interesting arguments like the government regulation thing. It makes you think of standard oil or something where they’re cornering markets and gouging customers whereas Amazon is very different. Their model has been, “No. Let’s actually deliver lower and lower prices.” It will be interesting to see how the hell is a regulator going to explain that?

Wes: [00:54:01] Here's what interesting. The government will screw that up or in those certain models and this is like… Google is 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 is a good example. My business models, I’m going to get insane, massive scale basically burning money until the cats come home, and then I guess investors just assume at some point they’re going to magically have all those economic moats because people don't want to leave and I guess they'll going to raise prices a little better or something. Here's the problem. They don’t understand that the main curve is highly elastic because the minute they’re no longer the low-cost producer in their prime, it’s pretty cool. 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 our economic moat to like do a standard oil monopoly play.” Guess what’s going to happen? Everyone’s going to be like, “Oh, wait a second. Let’s go back to Walmart, man. It’s right down the road and it's a lot cheaper than you guys.” It's like a phantom economic moat. It's there in theory but then the second question is can you exploit the moat you're built? Maybe they’re so good and then get so many magnitudes better that even if they keep their cost structure, they can somehow create massive P&L on it but I'm not really sure. That's without even considering that I imagine, well, the government already has. Remember they used to have like the no-state-tax thing? They had to manage that like all these firms, always if you get too big and too successful, you end up having to fight non-market forces.

Patrick: [00:55:43] We’re getting 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? 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. If you had to give your money to any number of outside managers, active managers, who do you really respect out there?

Wes: [00:56:02] What would I be trying to achieve? The same thing I’m trying to achieve now?

Patrick: [00:56:06] Yes.

Wes: [00:56:06] Honestly, I like… This sounds totally pathetic but I actually do like what you guys do in like your dad said. You guy's tax problem would cause me some angst there.” I don’t even know. Who else does like super-concentrated highly disciplined, transparent quant?

Patrick: [00:56:22] Not many.

Wes: [00:56:23] That's what I want. Whoever does that is who I’d give all my money to and if they could help me like build tax deferral or even better than that. I just don't know… Yeah, I don’t know. I like what you guys do. Whoever would fit… If you can just give me a transparent, super focused, well-established like AQR thing but they concentrated way down and they could figure out how to get tax fraud, use them too. I like those guys. It’s tough, man.

Patrick: [00:56:51] Tough, man.

Wes: [00:56:51] Yeah. That’s why we built our own firm.

Patrick: [00:56:54] Yeah. It’s good news that not too many people are doing this. That how we wanted it, right?

Wes: [00:56:58] Yeah, exactly.

The Alpha Architect Business Model

Patrick: [00:56:59] Talk about the business then. 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 having some super-secret sauce. The secret sauce is often the clients, the right clients. Talk about the business behind it, the organizational alpha as our friend, Ben, likes to call it. I like that term. Tell me about Alpha Architect.

Wes: [00:57:35] There’s this famous paper, Shleifer-Vishny ‘97. It’s called Limits of Arbitrage and you probably know LSV, those guides, the two of the names in there went off to create this $100-billion monster. That paper, in my opinion, is the theory of how the asset management market works. What does it basically say? It says delegated asset management creates a problem because there's a situation where there are really smart people that manage money come up with whiz-bang cool ideas, they were going to work over the long haul. What happens is they couple those strategies with capital that doesn't understand that. Inevitably, when they say, “Wow. In 10 years from now, this strategy is going to be amazing, but oh, by the way, in the short run, it 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 always have turnover, do spaghetti against the wall. That would be like the black crow model. We’ll do 200 funds a year and inevitably some are going to 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 going to be a Caltech 500 IQ, Ph.D. doing HFT, or information acquisition edge or we’re just trying to win in that game which I don’t want to play, I want to do an 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 that no ever win. Instead of focusing so much, I’m trying to be the smartest guy to figure how to do valuable momentum where the hell it is. Let's stop competing on that. Let's focus on the investor education or building or creating 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 going to be smarter and build cool models. Our mission is we're going to empower investors through education in order to build sustainable investors. That's why we have that mission because the only way we’re going to exploit that long-term edge is not us being smart; it's us finding 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.

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 other thing is we have a segment on individuals who are taxable. 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. 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. The great thing about taxable investors is to the extent that you can get a deferral mechanism in place, re-create like this tax liability for them to be able to move out of a true… basically make a bad decision. You could also… kind of what we've structured is to mechanically get people to a position where one that got to come in with all guns blazing, “I am in. I'm wholeness for 20 years.” Then also build structures where even if at a certain point five years from now, they’re like, “God, this is stupid. I got to pay the taxes to get out of it. I got to stick to it.”

If we can mechanically just keep you being successful either through education or structures or whatever, we’re going to win. We just want to get people to be better, long-duration factor investors 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 flow because you got to understand what we’re trying to help you with. If you don't, we can't really talk to you. It’s not going to work long-term like go get marketed too. We’re marketing but we’re trying to solve the Shleifer-Vishny problem basically and now is our best attempt at it.

Patrick: [01:02:35] Talk about the profile of that investor. You do a great job with the education obviously. I think you and I both have probably written the 170 white papers or whatever. You can write and educate until you’re blue in the face. At the end of the day, you still need the right person or family or whatever. What does that investor tend to look like? Are there common traits?

Wes: [01:02:57] There are common traits, at least, for the folks we deal with. We have this acronym called EDUCATED which stands for a bunch of stuff. The best way to think about it is engineer types that are very 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.” Yeah, I understand. I can actually do it in the end or I don’t want to, but I want to understand what's going on and why this works. What is this system?

Those types of people are perfect because they actually care about the process and they want to know the weeds, and one of our core beliefs is in transparency so we’re willing to facilitate. We just need people like that. We also like business owner types because if you think about the private versus public owner mentality, public CEOs or public ownership is inevitable. 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 cheap bastards because they usually start 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, want in control, wanting to understand, and want to be cognizant of the fees and who they're dealing with. We just attract people like that which means we’re not in the hot money game. We’re in the two-three years of figuring all this out, how you guys working but that's fine. We don't want hot money because it will come in and be out the next day. We want people to understand what they're doing, why we’re doing it, and 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 only gets us…

Patrick: [01:05:00] I think that’s the key.

Wes: [01:05:00] But you have clients that totally don't get it, you also break the chain which is we were talking about beforehand as we’re starting to get more and more intermediary channel. It's a segment but there is a segment of advisers out there. We’re talking about the DFA advisors who are super hyper-focused on the process, client education, and they were in the small-value trade. Talk about a hair-raiser and they did it. There is a segment of advisers out there who work on behalf of clients where they figured out a mojo and a symbiotic relationship where the intermediary was really smart and their clients through their intermediary and that relationship they built over the years are able to basically be sustainable capital, you think. We’re building FinTech tools to help them be successful and that but the intermediary world is hard because of the Shleifer-Vishny problem. Because we've always been direct consumer because you can go to a rich guy who owns that capital and he's like, “Well, yeah, I don’t have a principal-agent problem because I am the principal and the agent, man. I get it. Good. This is my money. I want to compound. I’m not worried about my career here.”

Patrick: [01:06:18] You mentioned earlier that all this information, data, technology, et cetera, is just forcing more decisions. The other way to think about that is the more layers of people and processes and checklists and whatever else is between you and the end money, the more decisions there can be to screw the whole thing up for everyone involved.

Wes: [01:06:37] Yeah. There are more conflicts of interest coming in.

Patrick: [01:06:39] That’s right.

Wes: [01:06:39] As you know, there's a lot of… Pat, actually, our CCO had a great analogy on the poker game whereas if you go to a poker table, Buffett is always like, “Hey, if you don't know who the patsy is, well, screw it because you’re the patsy.” 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, you’re also going to lose to him and you're still a loser. The issue is you got to go on 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 and they’ve saddled him with like 50 constraints like, “Hey, you can only bet on spade cards. You can only bet when you have double aces.” 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 is my opportunity because I see that smart guy who I will never be his constraints, I can find some edge in that middle ground which is things where he can’t exploit because there’s some structural problem. To your point, the more hands around the pot, either more careers that get involved, the more principal-agent conflicts that are created and we’re no longer in a game of after fee, after-tax compounding our faces off for 20 years. We got other incentives.

Our CCO had a great analogy on the poker game whereas if you go to a poker table, Buffett is always like, “Hey, if you don't know who the patsy is, well, screw it because you’re the patsy.” 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, you’re also going to lose to him and you're still a loser.

Patrick: [01:08:14] Let’s go a little bit farther on this analogy. We talked earlier about all this money going passive. I’ve talked to Michael Mauboussin 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 backtest effectively exploiting those losers and their dumb decisions that a lot of those have gone to Vanguard and are no longer toning up their money into the pot. Do think that that's right or do you think that there are enough weak hands in the collective market for these strategies to work for the next 10 or 20 years?

Wes: [01:08:51] Here's what I’d say. Everyone knows the whole sharp math, right? 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 the actively day trading it, all that math is totally out the window. If you could tell me with the straight face that this whole movement, the passive, 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, 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.” 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.

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. I honestly don't know how it's going to end, but I know it's not going to end well. Again, I’m not smart enough to figure out. I don’t think anybody is. We don't know where the bubble is going to pop out. Again, you can't have some people perceiving something that works all the time that has zero cost and comes in infinite supply and… That’s just all we’re going to do because that’s the best thing and tell me that sort of mentality is a mentality that leads to good macro equilibrium outcomes; it doesn’t. That's not to say passive is not bad, all the theories are not correct, but they always hinge on assumption that this is permanently-deployed capital since we took all that stock off the market so now it’s just me and you dicking around over the active scraps.

Patrick: [01:11:30] I find it very interesting that the performance chase that always happens right now, it just happens to be the S&P 500. It has outperformed everything in the world. 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 that all the smart, responsible people are doing. At the end of the day, you’re buying the thing that’s done the best. Of course, fees matter. We never want to downplay that but costs are real and they may compound. I think that was Jack's fundamental insight. It wasn't so much be passive; it was below cost.

Wes: [01:12:09] Yeah. Be affordable or know what you’re buying. You got to make one other point to give a shout out to the action investors, all the guys, they make a good point about. The stock selection thing is one element but when everyone is buying these passive Vanguard funds, the theory of all this is the global market portfolio. Active asset allocation decisions, a lot of times, have way bigger portfolio effects than whether I pick Best Buy or whatever. People can buy S&P but that is so divergent from the passive global market portfolio. 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 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.

Patrick: [01:13:03] We’ll realize this in hindsight only.

Wes: [01:13:04] Yeah, exactly. We’ll all figure it out that 60-40 was stupid over the next 30 years and 30 years from now, but we'll see what they’ve cooked up next.

Patrick: [01:13:13] What is the most memorable individual day of your career?

Wes: [01:13:17] Which one, in finance?

Patrick: [01:13:20] How about one of each?

Wes: [01:13:21] Okay, so in military, this is because I still remember this. This sounds cheesy but the Infantry Officer course which is basically a hazex. I got put in charge as a platoon commander. We had an excise at Bridgeport and literally, I didn't sleep for five days straight and we did this what they call me administrative march out of there and I literally couldn’t. I have not slept for like four or five days straight and never ate. I remember getting on that seven-ton at the end of that and thinking I just thank God for water, breath, just being alive, and not having to deal with that bullshit anymore. I would just never forget that. This is like the best day of my life. Can I just sit down and close my eyes and have some water? I just remember that like versus combat things like training, that one little training episode, and be able to finally have that done was like my happiest, best moment of my life in the Marine Corps so it's a weird one in my mind.

Now, as far as investing, I want to tell you that one too. It has nothing to do with quant. It has to do when part of my freaking capital loss that I still got to write in my books is I used to be totally crazy like put like Buffett style 50% some penny stock where I thought I had some sort of inside edge or something and then I can't even name the names so it's so embarrassing. It was this penny stock, I own like 4.99 so I didn’t have the 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. You do everything legally to be on the scoop.

I was all in on this damn thing and I became friends with the CEO. Again, you got to know him, blah, blah, blah. He's a, turns out this was false, “West Point graduation,” so we had the military connection going on, whole ball of wax, totally ate this thing hook, line, and sinker. I remember it was over the summer and I knew they were in a situation where they were renegotiating their debt. It was a situation where my inside baseball was like, “Oh, that is…” because it's a cloud-based business, there is free cash flowing, the debts totally going to get negotiated, and it’s done. I get this 8k and I'm looking at the saying and I'm reading it. It sounds really great like, “Oh, they’ve negotiated the debt,” but the stock is down 90%. I’m like, “Wait a second.” Of course, again, I had done everything. It turns out the CEO guy, he was overconfident of his own information set which was then being conveyed to us, and it turns out that basically the debtholders smoked him out and all of us along the path. It was a total permanent loss of capital. Then one of the other guys, we had little syndicated penny stock traders I just do with all these rich guys that were bored basically. He actually hired a private investigator. It turns out the CEO guy was a total fraud like never even went to West Point. It was just a scam basically and we had all just bought in hook, line, and sinker like believed in this guy. That was just my moment when 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 bust for many, many, for all intents and purposes, and I was just like, “I am just done.” That’s why I just always remember that. I just don't trust any humans anymore. Yeah, it’s just that I don't do it anymore, only computers.

Patrick: [01:17:18] It will be a good transition from that to this one. What is the kindest thing that anyone has ever done for you?

Wes: [01:17:24] I would be remiss if I didn’t mention the standards. My mom and my parents obviously, did good but that's cheesy because everyone says that even though it's true. My wife, for dealing with me and having my three kids. Those are all the standards. I might have two, another military one but again, it's going to sound weird. Unfortunately, again, it’s going to go back to IOC, Infantry Officer Course.

We had this guy that I’ll never forget and Captain Rettinger. He was the captain in charge of running IOC. At the time, this is serious because people are getting pulled out of IOC to go in-country combat so it was like a pretty hard-core time. This guy was like the hardest, meanest, biggest asshole on the planet. You're like just a straight-up not… I want to call it hazex. Everything in the end I realized, after the fact, was there for a reason. 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.” That was his mentality but we’re all still kind of like living in the 21st century. His harshness which at the time because I was a total buyer on that, I personally was like into it and I hated it at the same time. The reason I say it was the kindest thing is because I really felt he made us so freaking hard and so intense that when you actually did the real thing, you never had even breached in the system one. I was always insistent too even in combat zones like whatever. We’re just doing SOPs. I’d say it’s the kindest thing because I just feel like that's a good reason why not just me, but I think a lot of Marines that went through 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. He wasn’t trying to be your friend. He was trying to, we learned the aftereffect, make you really good at your job. I just thought that was really nice of the guy, to be honest for kicking my ass which is a weird, nice thing.

Patrick: [01:19:39] I always love that idea that you don't rise to the occasion. You sink to the level of your preparation.

Wes: [01:19:44] True.

Patrick: [01:19:45] It basically seems that that's what that was. It's overdoing it but preparing you for hard situations. I think your mission in educating investors, we share the same mission is kind of like a light. I don’t think you can harden prospective investors to nearly the same degree. Obviously, you can’t.

Wes: [01:20:03] Yeah, we got this.

Patrick: [01:20:03] The best thing you can do is just grind away at education. I think transparency is a big part of that.

Wes: [01:20:10] And highlight the words.

Patrick: [01:20:11] Yup, highlight the words.

Wes: [01:20:12] Always post about how many… You could have this tenure on your performance. It happens all the time. Just almost Captain Rettinger 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. If you still come through my traps and all my hexes and you're still willing to be standing at his door, now you at least got a small chance of being successful. A small chance is better than zero. I'm going to figure it out but I think if all of us could figure this out in a small scale because we get too good at it, we end up screwing up our own trade, and then we got to go be like everyone else. In the short run here, if we could do that, we’d probably have a huge win on our hands.

Patrick: [01:20:59] I love it. I think this hour and a half is a good step in that direction so I appreciate the time. This was a blast.

Wes: [01:21:05] Thank you for having me, Pat.