We Study Billionaires - The Investor’s Podcast Network - TIP 048 : Investing in ETFs with Dr. Wesley Gray (Investing Podcast)

Starting point is 00:00:00 We study billionaires, and this is episode 48 of The Investors Podcast. Broadcasting from Bel Air, Maryland. This is the Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish, and Stig Broderson. Hey, everyone, how you doing out there?

Starting point is 00:00:30 and welcome to this week's exciting show. This is Preston Pish, and I'm your host for The Investors Podcast. And as usual, I'm accompanied by my co-host, Stig Broderson, out in Denmark. And we have a very accomplished guest with us this week, and his name is Dr. Wesley Gray. And before I talk about Dr. Gray's background, I want to tell you a quick story that happened to me earlier this week. I got an email from one of the members of our audience, and his name is Matt Ziegler. And Matt is a very talented investor himself, and we exchanged emails from time to time in the past. Well, Matt sent me this message and he said, you really need to get this guy, Wes Gray, on your show.

Starting point is 00:01:06 And in the email, he said, he's friends with Toby, so you should be able to get him on the show. He wrote this book called Quantitative Value. When I read the email from Matt, I was laughing and I was thrilled at the same time because when I wrote him back, I said, we're interviewing Wes this weekend. I was like totally pumped that somebody would be on the same recommendation and just that he had this idea of bringing Wes on the show. and we were just so pumped to be able to match the expectations of our audience. So this is a two-part interview, and we'll break this down into two episodes. So this is going to be part one, and the next week we'll air part two.

Starting point is 00:01:39 And we're just going to be dividing the total interview here that we're having right now into two parts. So here's a little bit about Wes. So Wes earned his MBA and his PhD in finance from the University of Chicago's Booth Business School and graduated magna cum laude with a bachelor's of science and economics from the Wharton Business School. So two of the best business schools in the entire planet is where Wes got his degrees from. Currently, he's an assistant professor of finance at Drexel University's LeBoe College of Business, where his research is focused on empirical asset pricing and behavioral finance. He also teaches graduate level investment management and a seminar on hedge fund strategies and operations.

Starting point is 00:02:18 And so in addition to all those things, Wes also has his own company and it's called Alpha Architect. And we'll have links to all that stuff in our show notes. But, Wes, we just really want to welcome you to the show. You come with just a wealth of information. I know you're a value investing guy with this quant background, and I think our audience is really going to be looking forward to hearing some of your responses to our questions. Sure, guys. Appreciate you having me on and look forward to the discussion. All right. So let's kick this off and let's talk about the comment that Matt and my friend had in the email.

Starting point is 00:02:49 And so you co-wrote this book with our buddy, Toby Carlisle, and the name of the book is Quantitative Val. And I'm curious how the two of you met and what prompted you guys to write this book. Sure. Well, it's kind of a wild story. So I had been discussing with Toby for a long time because we'd both been writing blogs about, you know, value investing and what have you. And we were at the Value Investing Congress in New York, which is a big event where people pitch ideas or what have you.

Starting point is 00:03:18 He was there because I guess he helped sponsor the event. He got his free ticket that way. I was actually there with a client. One of our clients, he's a really rich guy out of Cleveland. He's like, hey, you should go to this value investing Congress saying it's really cool. I was like, yeah, I'd love to go, but I don't have 3 or 4K lying around to go listen to people pitch ideas. He's like, don't worry about it. It's on my tab.

Starting point is 00:03:44 So I went out there with this guy, Bob. And while we're there, I'm like, hey, you know, I want to introduce you this guy named Toby. he's a really cool guy. I've been reading his blog. You might find him interesting. So we go out to steak dinner that night. And, you know, Toby and I are just talking there. It's me, Toby, Bob, and then Bob's son and I think one of my early business partners.

Starting point is 00:04:07 And, you know, we're just talking about what we do. I'm like, yeah, you know, I always want to just write a book. I've been doing so much research and thinking about, you know, value investing on the empirical side and also the practical side. And Toby's like, yeah, yeah, you know, I always wanted to write a book that kind of capsulates, you know, my thoughts on value investing. And then as we kept backinging forthing what we wanted to write a book about, you know, more and more we're like, dude, we want to write the same book. Maybe, maybe what we could do is, is I can be the quanka on this and we'll do all kind of the, you know, the analysis, whatever. and you can be the, because he's lawyer by background and he's got an excellent way with the pen. I was like, you can be kind of like the guy that storyboards it out, and it'd be a great compliment.

Starting point is 00:04:59 And we're like, yeah, let's do it. So that's kind of the genesis of how it all started. It was literally over a dinner at, you know, right after the value investing Congress. So the facts are yours and the eloquence is his. Yeah, I would say that's probably. The eloquids price squared is Toby. I went to crappy California high school, so public high school. So I've been, my English skills have been a work in progress.

Starting point is 00:05:29 You can't say that anymore because we did announce where you got your master's, your undergrad, and your doctorate from. Yeah, yeah. No, that's true. But that doesn't mean I knew how to write or do English because I managed to dodge as many those classes as possible and just focus on statin finance and math or what have you. But over time, now I'm on my, actually, I'm going to have a fourth book coming out here pretty quick. So clearly I've gotten over my writer's block. But at the time, tell our audience about it.

Starting point is 00:06:00 Let's hear. Yeah, yeah, sure. So we did. So I wrote this book even before Quantay-Valle, this book called Embedded. So that was kind of book number one. That was about my time being embedded with Iraqis back in 2006. And then QV came out, quantitative value, which is basically a systematic, you know, deep dive into, if I wanted to capture the value premium in the most effective way possible, but pull out, you know, the monkey brain we all have, how would I go about doing it? That's basically what quantitative value is about. And then this next book that's actually coming out here in literally three or four weeks is called DIY financial advisor. And what that book is about is it's not a, it's not like investing for dummies book. It's certainly still a semi-pro level,

Starting point is 00:06:53 maybe arguably a pro level. That more talks about the asset allocation piece. So if I were to put together a total global endowment or retirement portfolio, but I wanted to do it in such a way that, you know, I could explain this to normal people and we don't have to talk about, you know, covariance matrices, getting inverted or whatever. That's what that book's about. And then the final book that we're working on a manuscript right now is even though I'm personally obviously a huge fan of value, I'm also a huge fan of just, you know, what works over the long haul. And, you know, we like momentum a lot as well. And so this next book after, or basically the last book probably, is called quantitative momentum.

Starting point is 00:07:38 Same thesis as quantitative value. How are we going to design the most effective way to exploit the momentum premium, again, by taking out Mr. Monkey Brain and trying to fully automate this? So that's, and I'm probably done writing books for, oh, for the rest of my life after that. Are those last two books your own writing? Are you doing those with Toby or somebody else? No, they're, yeah, so DIY Financial Advisor, it's published by Wiley. That's actually with two of my business partners, Jack Vogel, who's he's also a PhD guy, actually one of my former PhD students of Drexel.

Starting point is 00:08:18 And then one of my other business partners, David Folk, who's, he's just, yeah, he's an NBA Wharton guy, really smart, eloquent. He's kind of the Toby in the relationship in the sense that he's the guy that's actually a really good writer, really good communicator. and sometimes PhD guys need some help with that. So he's on there. He's also obviously really smart guy. And then quantitative momentum is Jack and I again. So we're just, we're grinding on that. It'll be kind of geeked out a little bit.

Starting point is 00:08:50 So just so you know, Wes, the interview here, I'm going to be asking questions that are a lot more current market conditions-based. And then Stig's going to be talking to you a lot more about what you do with your business and ETF, just so the audience knows as we go through these questions. So I'm going to throw the first question here over to Stig and fire away, buddy. First, I just want to say I love the expression, being the Toby in the relationship. I don't know. So, Wes, one of the reasons why I really like to talk about ECFs is because to me they're much more efficient that mutual funds, which is I guess they're still more popular.

Starting point is 00:09:29 But in the past, that is basically what people that have not been paid individual stocks, they have been buying. So they have been doing mutual funds. But there is a lot of costs. There are a lot of processes involved with the mutual fund. Not only do they have to record who is buying it, clearly also has to buy it. They have to sell it. If the investor doesn't want to invest in the mutual fund anymore, there needs to, I mean, there's new transactions that has to be done. Now, the whole structure for an ETF is a bit different.

Starting point is 00:10:02 And I think that's also one of the reason why it's not as costly for the investor to invest in ETF. Could you perhaps explain the mechanism behind the ETFs and why it might be more efficient? Sure. I mean, that pretty much is why we got in the ETF business. So there's really kind of three primary benefits of an ETF. And this will explain a lot about. why at the face of the ETFs seem like the best thing since sliced bread. And yet all the 800 pound gorillas, a lot of them are not doing ETFs,

Starting point is 00:10:38 which you would think like, well, wait a second, this is client friendly. It's better for the consumer. What's going on here? So the biggest reason for us, at least, is taxes. So when we're out there managing money and manage accounts, doing whatever we can on the tax engineering front, we start to learn about the whole ETF structure and we're like, holy cow, this is a eureka moment. Because we're an active investor, which means we trade those securities in and out, not all the time, but sometimes.

Starting point is 00:11:12 And, you know, that is going to generate a huge performance fee from Uncle Sam. The more we can punt that out into the future, as Warren Buffett kind of showed, you know, the magic of deferred tax compounding is pretty incredible. So we basically said, hey, this ETF structure from a tax standpoint where we're allowed to essentially do activity in the fund but punt the capital gains out to the future and not have to distribute them on a 1099, that's incredible. So that was benefit one. Benefit two is there, you know, again, going back to your discussion about mutual funds there, a mutual fund complex usually has to keep, you know, let's say one, two, maybe three percent. cash on hand because you need to have a liquidity buffer in case some client says, oh, give me my money back and you don't feel like blowing out your portfolio. And why is that bad?

Starting point is 00:12:07 Well, now I'm paying some idiot, you know, a fee on two to three percent of cash. He's not deploying the money. He's not actually doing anything on it. And it's just, it's an externality problem where even it's trying to help the other investors, but meanwhile, it's screwing the investors inside the fund. Whereas an ETF, you don't have to do that. You can buy and sell in the secondary market. Or for us, if you want to trade in big size and go through the primary market,

Starting point is 00:12:35 you deliver us in-kind shares and we deliver you out-kind shares. So there's no cash involved. There's no issues for the fund investors. It's a much cleaner design. And then the third one, which is the biggest reason why we think ETFs are a massive disruptor in the fund management space. is the way sales work. So going back to your point there about the convoluted way that one has to get into a mutual fund and get out of a mutual fund, it all works through what they call a transfer

Starting point is 00:13:11 agent system. So for example, if I'm a sales guy and I say, hey, Preston, dude, I got the greatest you know, you know, cake on the planet, you should buy this thing. And you say, you know what, I'm going to buy this mutual fund. And let's say it's Stiggs Mutual. fund. Preston's going to go over to Stig, fill out the paperwork, you know, put 10K in Stig's mutual fund. Guess what I'm going to then do. I'm going to go to Stig and say, Stig, hey, go on your transfer agent files and there's this guy named Preston who gave you 10K, give me my cut, you know, give me my trailer, they call it, or give me my fee or give me my kickback. That, the whole mutual fund complex is based on that ability to cleanly and transparently intermediate.

Starting point is 00:13:57 which means sales guys and distribution guys are way more important to the process. Now, let's look at an ETF. An ETF transfer agent file consists of what they call authorized participants or the people we trade with, which are banks. So the people I know who buy and sell our ETF are, you know, people like Deutsche Bank, Nomura, J.P. Morgan, Goldman Sachs, etc. I wouldn't, if Pressmore to buy my ETF, I have no way of knowing that. unless he literally gives me a screenshot of like his, you know, e-trade account or something, which means if I no longer have a way to basically pay people, it lends its ETF structures lend themselves to one of two things.

Starting point is 00:14:46 One, revolutionized sales culture. It's got to be now become a commune salary-based sales force that you just get paid to like, you know, sell the product. but we can't pay to play because we don't know if you sold a billion dollars or million dollars. So that's one thing. Or two, disintermediate. Go direct consumers. So like you guys, right, blogs and podcasts and really good content, you kind of own the client mind share.

Starting point is 00:15:15 That's one way you can indirectly, you know, get sales without having a deal with like a massive sales force, sales force. And we do a similar model. So bottom line is the entire industry and most 800 pound gorilla's in active management are not investment shops. They are sales intermediation shops. They don't add value. They sell stuff. The minute you take that out of the equation, they're going to sit back and be like, wait a second, our whole business model is destroyed.

Starting point is 00:15:45 This whole ETF thing, we need to figure out what's going on here. So I think that's what pretty much explains a lot of the dynamic in industry right now. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is.

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Starting point is 00:20:08 And you know what? If you call any of these major companies, and they're trying to push a mutual fund. And they're telling you, oh, yeah, the market could go higher, even though it's August of 2015. Yeah. And, you know, it's like you described that in great detail. And I think that it illuminates a lot that's kind of hidden behind the curtain for a lot of people.

Starting point is 00:20:28 And they don't really see that side of basically the affiliate marketing side of investing. Just real quick to emphasize that point, because a lot of people don't see it. but we get hit up by people all the time they want to figure out how to quote unquote monetize us because we're a great sell because we got all these PhDs and all these great things. And they walk in the door and they're like, they don't even know about the ETF structure really how and why it works. And they're like, wait a second. So what you're telling me is we can't get paid.

Starting point is 00:21:00 And I'm like, yeah, you can't get paid. So get the hell out of my office. And the more people understand that financial services are all about. the middleman and all about distribution, the more they learn how skeezy this industry is, and the more they want to go towards, you know, disintermediate solutions. So I just want to emphasize that point. Here's an idea. You actually have to create the asset to make money. Yeah, yeah, exactly. You've got to actually create value. You can't just be like some like huckster in the middle. Yeah, yeah, how about that for a business model? All right, Wes. So I want to change gears and

Starting point is 00:21:39 talk a little bit about the current market conditions. And like we said, this is August of 2015. So a lot of our audience is from the future when they're listening to this stuff. So just to kind to give you some context of where we're at. So right now, I'm of the opinion that we're starting to see the deflationary pressures take over. And I'm really excited to talk to you because I know you've had all these hardcore classes. You understand macro where a lot of people were just micro-investors. So I think the deflationary pressures are starting to take over. I also think that the Fed is going to actually raise rates before the end of the year. I actually believe them, which I think there's a lot of people out there that don't.

Starting point is 00:22:11 Yeah. So, and if they do that, that's going to only increase these deflationary pressures. Additionally, you got the dollar is getting stronger by the day, which is increasing those deflationary pressures beyond that. You got the American trade gap is getting deeper, which is making those deflationary pressures even stronger. So with all that said, do you agree with my opinion? And if so, what are some of the triggers people really need to pay close attention to moving

Starting point is 00:22:35 forward? And we all know that you got Carl Icon, billionaire Carl. icon, billionaire, Bill Gross, all these guys saying that the bubble here is the junk bond market. Do you agree with my very bearish position? And if not, what aspects are you looking at? Well, so a lot of thoughts just came up in my head. So first off, you know, I've been going, I haven't been going in last few years, but I used to go to Grants, Interest Rate Observer Conference. But every time I went to that, from 2009, 2010, 2011. 2012, I heard stories about how the world is going to blow up, how bonds are the worst thing on

Starting point is 00:23:17 the planet, gold's going to go to infinity. And these are from insanely smart people that have insanely well thought out theses and stories. And guess what? All of it was bold. None of it worked. Now, that said, everything you just said, personally, intuitively, I all agree with. But I have move beyond when it comes to market timing on basing things on subjective kind of thought processing because I can't find any evidence that any expert who actually thinks they know what they're talking about can actually predict anything when it comes to macro, you know, whether we're inflation, deflation, et cetera. Now, we work for a billionaire and I've been talking to them actually about this very thing a few years ago and I'm not going to give you the full debriefers.

Starting point is 00:24:08 refund the email, but the email starts off with this line, hocus, pocus, my ass. And he is speaking in reference to my diatribe hate email of why he would want to use long-term trend-falling rules, like literally just looking at an asset price, an asset's current price, relative to that asset's long-term trend. And using that simple, stupid rule as a way to basically time how you get in and out of different areas of the marketplace, whether it's commodities, bonds, what have you. I just went off on the guy, I said, this is stupid. And it literally responds, hocus, pocus my ass.

Starting point is 00:24:55 And he has like this 20 laundry list of names of people that said, this was going to happen. It didn't happen. So here's what I would say. I agree with anything, everything you mentioned. having reconciled and investigated our billionaire buddy's idea here, basically focus on trend falling, which is again also antithesis to like every gut reaction of every value investor on the planet. The bottom line is that if you focused on evidence-based, robust, minimally complex, which again leads to that robust,

Starting point is 00:25:32 is ways to time markets, I highly recommend people follow trends. So if as long, even though it's not intuitive. So as long as a market is trending and above some long-term base rate, you just hold the thing.

Starting point is 00:25:50 The minute it goes below that long-term trend, get out of it. That stupid, simple concept is, is basically not that simple, but pretty dang close, is how we think about market timing now. And frankly, I just don't, I don't even try to think about macro anymore. I've been smoked too many times and heard too many smart people just say something. Now, I was like, I've got to do this. And then they're 180% wrong.

Starting point is 00:26:19 So based on that statement, okay, we've seen the trend since 2015 is not a good one. So what would your opinions be on that? And I totally agree with you on the market timing. And I'm real curious to see your book as you're talking about asset allocation because that's what all these big guys say, hey, you can't time the market, but you can't change your asset allocation. So based on that trend and based on your firm understanding of asset allocation, what do you got to say for the audience? Sure, yeah. So commodities have not been good for six, seven months now and they're still not good. So commodities until that trend gets back, I would say, don't be in that.

Starting point is 00:26:57 S&P, I mean, it keeps going higher. And every time I hear someone say the CAPE ratios at 99 percentile get out, which they've been saying for three years now, you know, I say, hey, the trend is strong. Until that trend really breaks and it hasn't, we've had like small, short-term vol, you know, domestic equity is still on trend. International equity, however, you know,

Starting point is 00:27:21 it basically fell out of bed last year early. It's been chopping around. You know, you could argue. it's close to being back on trend. In many metrics, it actually is. I mean, we're long in it right now. Bonds have, again, been kind of hit or miss as well. But, yeah, I'd say so domestic equity, long and strong until the trend says otherwise.

Starting point is 00:27:45 International also tend to be long. Commodies out, bonds. It's kind of been hit or miss. Real estate, hit or miss, too. I guess I see it differently on the trend for that, for the, domestic equities. I mean, it's off. I made a video back and I want to say March of 2015, sending out warnings that, hey, this is not looking good. And since that video came out when the market was at 18.3, it's down to what, 173 now. So it's a thousand points off of that. So I don't

Starting point is 00:28:14 necessarily see the trend is still increasing at this point. I'm sorry. The long term trends is what matters. Short term trends don't tend to be effective. It's all about long term trends. And to give you the most extreme example, long-term trend-falling helped you in, for example, Greece, right? It got you out of that meddlem. Now, if you look at China, it got you into China, and you've also ridden a 30% drawdown, but you're still in that market because the long-term trend, the current market price are still above that long-term trend, so you're still sticking with it. So just because you do trend falling as a market timing device, it's not. in the business of preventing you from 10, 20% drawdowns. It's in the business of preventing

Starting point is 00:29:02 you from the 50% drawdowns, which is why it's just, you'd still be long S&P, even though you're exactly right. You made a good short-term call. I just can't find ways to systematically do that that I have confidence in. Cool. Spoken like a real value guy. I like that. Okay, so Wes, I got to forward a question. The reason why I'm saying I'm forwarding is because I get this question a lot. And this question is about how to value an ETF. Because whenever you look up an ETF online, you simply got bombarded with different key ratios. So if I was to value an ETF, which ratios? So how should I approach estimating the intrinsic value for that? Sure. Well, so I mean, in general, if you're,

Starting point is 00:29:50 remember, ETF is just a holding for a bunch of underlying securities that all have different intrinsic values that obviously we're trying to front run. What I would say is when investigating whether I'd want to own an ETF, there's two elements. One, focus on that person's process and then focus on how that portfolio is formed. So, for example, let's take a value process. Let's pretend that someone actually had a good value investing-based process that's trying to identify, let's say, the DCF of a firm. and, you know, compare that to the true intrinsic value of the firm, and whenever the stock is way

Starting point is 00:30:31 less than intrinsic value, you buy whenever it's way above, you sell. Okay, so the process we argue is good. We are fundamentally buying securities that are undervalue. Then it comes back to the formation. So if you look at the marketplace, and this is not just the case for ETFs, but across the world, a lot of people suffer from what we call diversification. So you may have the greatest process in the world to identify said undervalued securities. But if you hold 300 stocks in the portfolio, you know, it's like Munger says, you know, the diversification element, it's like it's become madness now. Like, focus on your edge, own up to the tracking error and the fact that you're going to be not beating the index and beating the index in the short run and, you know,

Starting point is 00:31:21 and follow that, that model. So I think, I think for an E-10, And the ETF specifically, because all it's doing is buying underlying securities, it's really important that you understand the manager's approach to how they go about it because that's going to be, his approach is going to be reflected in how and why he buys securities. And then obviously look at how and why he forms his portfolio as he does. And in any end, the intrinsic value of an ETF is the NAV. I mean, they basically trade plus or minus, you know, 20, 30 bips around. an AV. So that is the intrinsic value. The real question I think you're asking is maybe about the

Starting point is 00:32:00 underlying securities then. Yeah. Yes and no, because I think that if I look at an ETF and I might be looking at, I'm not saying it's P500 because that might be easier, but let's just say it's in P500, you might say, okay, so the intrinsic value is just the assets and that's basically what I'm buying. It might be a small premium discount, but basically that is what I'm buying. Then you will have like hardcore value guys like me and press. You're saying, well, that's not the value. The market is overvalue, so that's not the value. How do I estimate the intrinsic value on that?

Starting point is 00:32:32 And what we would usually say is, well, you need to, if you have a stock, you need to discount all the future cash flows and then you come to a given price. Yeah. But then you have, like, I can do that for Coca-Cola, but what if I have 500 stocks? I got you, got, you got. Yeah, I'm tracking. So what, one of the things that we've done a ton of research on is on what we call valuation-based timing.

Starting point is 00:32:56 So can you look at fundamentals, not at the individual stock level, but at the macro market level to help you make calls on the market, right? Like, because you want to, because we all know, I'm sure you guys are aware, you know, old Schiller's research where if you just look at, you know, current valuations, they predict very highly future returns, which makes sense. if prices are really high, by construction, expected returns should be low. Similarly, if prices are really low, expected returns should be really high. It's almost like mechanical in finance. So the issue, though, is that when you look at that evidence, you're like, okay, great. So, you know,

Starting point is 00:33:40 the market's insanely expensive right now. So I guess I'm going to sit on my hands for 10 years and wait for it to blow up. You know, the reality of it is that's not how the world works. So we've asked the question, how can we tactically use these kind of valuation fundamental market-wide metrics to help us be more effective at timing, you know, market exposure? And we've looked at things like extreme valuations. For example, if the market ever goes above the 95th percentile, you know, go to cash or some, you know, some derivative of that doesn't work. We've also looked at things where say, well, what if we look at, you know, the valuation on the market, like, say, earnings yield, so like PE, but inverted, minus, say, 10-year rates, you know, because that's kind of your,

Starting point is 00:34:28 your cost of capital, you could argue might be like your 10-year treasury rate. So if stock's really expensive, but the 10-year is, I don't know, 2%, and earning yield is 5%, even though 5% on absolute basis might be insanely expensive, you know, on a relative basis, maybe it's a good deal. Okay, that doesn't work either. Like, again, going back to buy and hold seems be more effective and going to trend falling beats this stuff big time. The only way that we've found that were fundamentals seem to work, but of course, it required a little bit of data torture, is if you take market-wide valuations, create an earnings yield version, of it like inverted so it's like e over p and minus off realized inflation that spread is actually pretty

Starting point is 00:35:22 dang good as far as like as a tactical way to identify when this is going to be effective or not so the inverse p for the schiller ratio or any you can use any valuation metric you just want to make sure it's like in yield format and you compare that to the realized inflation like just use CPI, that spread is actually pretty dang effective relative to buy and hold or other things as far as like no one went to kind of time just overall indecy. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business.

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Starting point is 00:39:03 charges and expenses. This and other information can be found in the income funds prospectus at Fundrise.com slash income. This is a paid advertisement. All right, back to the show. That's awesome because that's what we've really been promoting to our audience through all the episodes of our podcast. Go ahead, Stig. Yeah, so another question that I ask is, if you look up in the financial database, you would see the price to earnings is, and you'll probably also see what the price to the free cash flow is. Now, very often those two numbers are different. And also know that you were specifically looking at stocks where you're filtering out,

Starting point is 00:39:41 but you call earnings manipulators. So it seems to be that earnings are a lot easier to manipulate than cash. Cash is just hard to do that with. So how do you look at if you value in ETF, looking at priced earnings or priced free cash flow? So this is a great question. Jack and I actually have published papers on this and where we just say, you know what, you know, there's great stories for why free cash flow may make more sense.

Starting point is 00:40:09 There's great stories for why, you know, price to earnings make more sense, maybe enterprise multiples. We're going to literally just data mine and use a supercomputer to look at every perturbation evaluation metric that one can even fathom and just see in sample or during this period, what actually works and what actually doesn't work, at least over the past 40, 50 years we have data. Well, it turns out, and this is surprising until you dig into it, is that price to free cash flow is actually horrific. Reason being is cap-x is so noisy on firms. It's too noisy to actually give you an appropriate signal.

Starting point is 00:40:53 So a lot of times it moves you one way or the other. It's just ineffective. It's not bad. It's better than just say buying SP 500, but buying cheap firms on price-free cash flow is definitely not ideal. And now we say, well, what about things like price to earnings or, you know, we like enterprise multiples. I think Toby calls it the acquires multiple or what have you. You could use book to market and all these other things. It turns out that when you're being intellectually honest, trying to look for what's robust, what tends to work through thick and thin, maybe not all the time, but on average, enterprise multiples seem to be the most effective.

Starting point is 00:41:32 And I would argue the reason for that is because that is the most business-like way of looking at a firm, right? We're looking at, I got to buy the whole damn thing, the debt, the equity, pay off minority interest. I got to put the cash back of my hand and I get this, you know, general operating income that I can split between debt and equity. and we think that's how private equity guys view the world. We think that's how business guys view the world. And it just turns out that is the most effective way to kind of sort, quote unquote, value. I've got a question for you, Wes. Sure.

Starting point is 00:42:08 So Stig and I've been studying Ray Dalio a lot, and I'm sure you're familiar with Ray. Sure. And he's a macro guy, and he's been able to sidestep all these major downturns. And what he says that he's using in order to really kind of understand that is he's using really two main variables. He's looking at the inflation and where that's at. And then he's looking at the GDP growth. And whenever he sees a country, let's call the U.S., when he sees that the inflation is completely flat or decreasing significantly, and he sees the GDP decreasing significantly, that's where he's moving his money into more of a cash position because he's getting ready to

Starting point is 00:42:48 basically change locations on that four-piece quadrant. When you take those two variables, it turns into a quadrant of four. And he's getting ready to move into a different quadrant where equities aren't going to be nearly as good. And so when you look at the current conditions, have you guys, I guess I'm curious, have you guys studied using those two variables and trying to understand the way that he's going about moving his assets around based on those variables? Sure. So we know a lot about that guy's process because they're all based on what they call risk parity, right? And so if you look at the past, Let me just tell you a little dirty secret about Bridgewater.

Starting point is 00:43:27 Tell us all. And that's not to mean that's not what they're going to do in the Ford. But historically, they've been focused on a very effective concept, just at a real high level, like intellectual. It's called risk parity. Idea being, if you guys are unfamiliar, audience is unfamiliar, real simply, is if I run a traditional 60-40 portfolio, 60 stocks, 40 bonds, the problem is stocks are way the hell more volatile than bonds. So from a risk standpoint, my portfolio is getting, say, let's just make this up, 80% of the risk from the stocks and only 20% from the bonds. So we can use some math to try to balance that out. Where maybe from a risk parity structure,

Starting point is 00:44:13 we should be owning 80% bonds, 20% stocks, because now on a portfolio basis, 50% of my portfolio risk comes from stocks, 50% comes from bonds. Now, let's think about what asset over the past 30 years has whooped ass more than any asset class out there. 30 year treasury bond. If you started doing risk parity concepts in 1980, you're going to basically have a portfolio that is going to be leverage treasury bonds and have small exposures to equity in other assets. You can take a a brain-dead portfolio that has leveraged treasury bonds mixed with a little bit of equity and essentially replicate the track record of Bridgewater. So now we got to ask ourselves, is that track record because those guys are actually smart,

Starting point is 00:45:06 know what the heck they're doing, or do they happen to run upon a golden goose called the 30-year treasury bond levered that laid a golden egg? We've looked at risk parity in an asset allocation context, and the many you pull out Treasury bond exposure. There's no evidence in our opinion that's actually effective. So what happens in asset management businesses? Well, you build a track record doing something, you became a brand. You get hundreds of billions of dollars. Do you guys really think that someone managing hundreds of billions of dollars can continue to provide outsized performance in a relatively competitive market with charging two and 20 fees or whatever it is? I say there's no way

Starting point is 00:45:51 So I love what those guys do. It's a great brand, great business. They all made billions of dollars. But frankly, I think everything you just mentioned there about their little two-by-two matrix is a great story. It sells a lot of pension funds and endowments and consultants because it sounds great. I don't know of any empirical evidence that it actually works, period. So you're basically saying that because interest rates have continued to go down since 1980, whenever this 75-year cycle basically hit its culmination peak and has gone down is the reason that they've been able to, because they've levered it.

Starting point is 00:46:29 Yeah. They've been able to do so well. So now that we're at the bottom of that, or at least we think we are, you're saying that the next 20 to 30 years could be a real challenge for them because... What I'm saying is the following. Anyone, not just Bridgewater, but anyone in any strategy, we need an investigator over the past 30 years. and control for leverage bond exposure. And then ascertain whether this person's process is based on the fact that they just had exposure to leverage treasury bonds, or is it based on some underlying intellectual edge that is going to allow them to perform out of sample?

Starting point is 00:47:10 Now, I'm not saying that's not the case with Bridgewater. I'm just saying that is a due diligence point that one would want to investigate very clearly. and then these stories that they're throwing out there about their two by two matrix, I would want to get clear empirical evidence that it's not a story. It's actually something that, you know, in theory, could work in reality. Because you don't want to invest in stories. You want to invest in things that actually have evidence behind them, basically. So my understanding with the little bit of research that I've done is that he breaks up,

Starting point is 00:47:44 let's say the portfolio of 100% of whatever cash is in that portfolio, 25% is put into a growing inflated environment. 25% of the portfolio is putting into a deflationary GDP growing environment. So he's basically splitting 25% into each one of those four quadrants. Yeah. So for me, I guess when I look at that, there's only a small portion of his portfolio assuming that the story matches what they're actually doing, which I would tend to believe that it is.

Starting point is 00:48:16 I wouldn't necessarily say that he's been. highly leveraged on a 30-year treasury, then that would have encompassed his entire portfolio. In fact, he talks about how he has diversified the funds of his company worldwide. We're only a small portion, call it maybe 12.5% to 30% of all the money that he's managing is even domestically in the United States. Sure. And he calls that his holy grail to investing as being able to distribute all of that money worldwide. but I think we're getting off.

Starting point is 00:48:49 Yeah, yeah. And I'll do a recap on it. Totally agree. But you got to look at track records early and late. And now the question is out of sample, because their construct is very good. That's a very, very sensible way to diversify a portfolio. Don't diversify based on some covariance matrix that is totally noisy. You know, based on somewhere you got some allocation to different states of the world,

Starting point is 00:49:14 no matter what the state of the world ends up being. That's true diversification. My question to something like Bridgewater is can they beat a simple passive allocation to say some domestic equity, some international equity, some reeds, some bonds and some commodities with a simple trend falling rule on it? And it's not that they're not good and smart. My question is more now out of sample with all the IQs and all the brain powers and all the assets that they've been endowed with. can they really add value above that? And I'm going to argue no. But we'll see.

Starting point is 00:49:51 We've got an out of sample test and we'll compare their performance against, you know, some passive globally diversified or foe that has trend following rules on it. All right. I guess we're just going to have to short the 30 year treasury leverage for the next 30 years and we'll be set. Well, I didn't say that either. I didn't say that either. I'm totally joking. on it because we could go to Japan too. You know, ride the way.

Starting point is 00:50:16 But if it spikes against you, you might want to, you know, try something else. Wes, I'm just teasing you. I know, I know. So that concludes our first part interview with Wesley Gray. And we're really looking forward to playing the rest of our interview with him next week. So make sure you guys tune in next week to hear that. So thanks for listening. Thanks for listening to The Investors podcast.

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We Study Billionaires - The Investor’s Podcast Network - TIP 048 : Investing in ETFs with Dr. Wesley Gray (Investing Podcast)

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