S.01-E.01: How to use the greatest minds in academia to filter out the investment noise.
S.01-E.01: How to use the greatest minds in academia to filter out the investment noise.
Through his journey from a world class stock picker, up-and-coming hedge fund manager, PhD candidate and over-confident investor riding the bull market, suddenly watching his book melt down, Wes found a humility that changed the course of his investment life. Dr. Wesley Gray is sure to entertain as he tells us his adventures while building a scalable hybrid wealth and asset management firm based on the fundamentals of scientific investing.
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After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in the suburbs of Philadelphia with his wife and three children. Twitter
Rod: Good morning. My name's Rod Heard, I'm co-founder and CEO of SmartBe Wealth, Inc. And we're here today with my co-founder Art Johnson and our special guest Dr. Wesley Gray from Alpha Architect. Alpha Architect is our business partner and runs the index for the fund that we host on the neo exchange, called SBEA. And today we're hosting our first of a podcast series called Modern Investment Journeys.
We're gonna try and stay on the nontechnical side and on the human side of investing. I have a great conversation about what prompted many of us to move to the dark side and follow a quantitative investing strategy. Art, you want to introduce yourself?
Art: Hi, I'm Art Johnson. I'm the, uh, co-founder with Rod and Portfolio Manager at SmartBe Wealth in Calgary, Alberta, Canada.
I think what Rod is talking about is really important. We, wanted to call our podcast a journey. And we believe that a lot of the financial advice is more on the technical or insight level. And not a lot of it tells people actually how you actually practice these things. How do you keep strategies?
How do you build philosophies and how do you actually make something work with you? And I started as a quant portfolio manager in, kind of, 2000 and I was really fascinated, -more and curious about - not so much how interesting these strategies were to me, but actually how they actually could change people's lives.
But more importantly, how we could actually make people stick to some of this stuff, which is a little bit different. Like Rod, like Wes, like a lot of the people in our community. I dunno if we're all failed teachers or could have been teachers in our lives, but definitely that concept of being a teacher and a helper and a mentor, uh, hopefully plays out in this podcast.
And I think those are the things that we're trying to do rather than just be technical.
Rod: Thanks Art! For those of you that don't know Wes; Wes did his PhD at the University of Chicago, which is a renowned as the world's leading institution for quantitative finance. And he did his dissertation under, uh, Dr.Eugene Fama. Who won a Nobel prize in 2013 for his work on the efficient market hypothesis. Wes tells a great story about one of the other profs at University of Chicago, that was more on the behavioral finance side of things. Identifying that in market data. You can take advantage systematically of human behavior.
So, you know, Wes through his journey, um, has become one of the leading worldwide experts in quantitative finance, where we're really privileged to have him as a partner. Don't be fooled by his casual style or his, uh, sense of humor. Wes is definitely considered among his peers as one of the leading financial investment managers in North America.
Wes's approach has been a little bit different than many that it seems like in the world of quantitative finance, there's two sort of camps. One, in the former French camp of efficient markets and one in the behavioral finance camp of Schiller. And what Wes has done is sort of bridge these two gaps in recognizing that yeah, humans are crazy.
We make decisions with our emotions more than our logical brains in times of fear and times of stress. And when we're dealing with our money, um, that often comes to the forefront. And so without further ado, I'd just like to introduce West gray and welcome
Wes: Hey gents. Thanks for having me on here. And I look forward to the conversation.
Art: One of the things Rod was mentioning is that, and a lot of people still don't know this is that there has been a tremendous amount of academic research and science and insight into investing. And that's probably not common knowledge still with the average person that's out there. So these are tough words, like efficient market and Eugene Fama and all these people that are just common to us.
And maybe dive into a little bit on that and what the science is all about.
Wes: Yeah. So, so a lot of people, uh, to include myself back in a day, or just unfamiliar with just how much research is conducted in academic ivory tower institutions. Probably ever since I'd say, you know, 1960s right around Eugene Fama was there at the University of Chicago and they started getting access to a lot more data.
Ever since then, which is almost 80 years now, you have had armies of really high IQ, PhD students, you know, around the globe, looking at the data, trying to understand how and why financial markets work.
Rod: I have to interject there. I was born in the mid sixties and there's no way I'm 80 right now. I'm only 50.
Wes: Well, well, you know, yeah. To 2000 minus 60. That's four. Yeah. So 60, sorry, I can't do math even though I'm a quant, um, last 60 years.
Art: Well, I wasn't even going to question that Rod's the engineer in the room.
Wes: Yeah, no, exactly 60 years plus, but, but, and even before that, obviously people have been doing.
Research, you know, early or forever, but like even in early 19 hundreds, there's academics talking about, you know, different investment strategies and systematically studying them. And so what's great about that is academics and professors, really your only goal in life is to prove to your friends in the business of academia you're smarter than they are.
And the incentives are to always tell each other that you're wrong. Right? So peer review systems, the whole academic edifice, it's not really about trying to make money or build trading strategies that, you know, do this or that it's really about just exploring ideas in such a deep way. And the currency of that business is really just coming up with really cool stuff that your peers and your profession think is also really cool.
But at the same time, they don't want to tell, tell you that it's always about knowing your ideas are dumb. But, but through that whole process, a lot of ideas that, that come out, which are freely available and all the public journals that are out there, it's obviously got some bias 'cause all research has bias. But relative to like a research report from an asset manager, like a big bank where clearly there's an ax to grind because they want to sell you something, academics really genuinely just want to sell you an idea.
And so when ideas move through that, uh, complex there because that's their only real incentive, but, but they have been heavily really vetted by so many people that want to tell people that this idea is bad. That in the end it's just as amazing resource of knowledge. That we can lean on for free.
Art: Yeah. I always found it a real weird paradox that probably the best insights in the world are on this website called SSRN, that he can go on and load down academic papers.
That, I mean, the amount of time and research and energy. And, and also you, you mentioned two things. I think that are really super important, if anyone's thinking about investing or interested in the world of finance that bias and incentives play a huge role in the financial service industry as they do in any other industry.
But they really motivate people in this industry because the incentives around bias actually make people a ton of money in this business. And what is kind of fascinating, always been fascinating to me. And what's fascinating to talk to you today. It's a free world in a sense, it's really the best battles on these ideas and not be folklore or bias or that.
And what insights did you gain from that? Because you were an investor previously. I mean, you were like all of us, I think prior to my exposure to the academic, thinking around how to invest. I was pretty much someone who I would say lived with investment folklore. It was my own insights into things, my inner observations, what the weird dude in the corner, who believed in gold, talked about in
the brokerage firm that I worked at, and it wasn't really, uh, kinda till I came into, you know, leaving the folklore and giving academia that I changed my thinking. So how did, how did you kind of, how did that shape you and I guess, why is that important for people? Like, why the hell we're going to take one thing away about the academic thing.
What's what's the big deal there.
Wes: Yeah. I'm with y'all I'll tell you my story. Cause it's like the biggest, like, love, hate relationship ever. You know, systematic evidence based kind of academic research strategy. So I originally started with no knowledge of that. I've always been like, you know, hardcore value investor, like.
Grew up on Warren Buffett and Ben Graham, who, who they're old school types of just say, Hey, it's all about fundamentals. Do the deep dive research on individual companies, try to get the best assessment inside scoop and buy things that seem cheap relative to what you think they're valued at. Old school investing.
And I obviously thought I was going to be Warren Buffet. You know, put my hand in that. And actually I did pretty well cause I got dumb luck. To start being a value investor in basically the early two thousands, right after the tech bubble in value, went on, just generically, went on this epic run. And a lot of times when you get caught in a good trend, you, you sometimes attribute your success to how smart you are.
And not the fact that you just got good luck because you happen to be in the trend. But then what happened is I started, I entered the PhD program there and I started learning about like these quantitative tools, this whole wealth of incredible knowledge, uh, in academic research, on financial markets. This guy, Nick Barbaris, who's now a very famous behavioral economist.
He was at Chicago at the time. He's now at Yale. He's good buds with, uh, Dick Thaler. Um, he, he taught the behavioral finance course there. And like everything he was talking about, I was like, Oh my God, this is, this is my life. He's doing a course on, on me. The idiot stock picker.
Art: It is humbling though. Like when I started that transition too it is just, I don't know if you happenstance into being an advisor in the investment game, you know, you've got to put certain bits of armor on that define you in various things.
And then you walk into the science world and it's just basically, you're like, I'm like a bad shaman and all his stuff gets kicked out of you.
Wes: They make you feel bad for being a human.
Art: I'm a witch doctor.
Wes: Yeah. So, so, so I, so I got kinda inoculated there. I was like, wow, this is maybe a better idea than doing this old stock picking stuff.
Uh, even though I've been doing pretty well at it, I'm going to put, I'm gonna do it. Right. So, so long story short, I ended up starting a hedge fund in 2008. And I launched it in September 2008, which as you guys know was like near the worst time you could launch an investment product. God just, you can't even time it worse than that.
And the system was a systematic value system. Purely automated. And I was like, this is awesome. Like did all the research, like I don't have my behavioral baggage that Barbaris and Thaler tell me about all the time, blah, blah, blah. Launch that thing all in on quant. Now, literally three months later, as you know, the market basically fell out.
And all of a sudden I'm like, wow, this reminds me of 2000. There's all these really cheap stocks selling for net, less than networking capital, this quant stuff. Like, it just doesn't realize what I know. Cause I did this for 10 years prior, almost like, like I need to go back to stock-picking.
And I literally did that.
I went back and I talked to the clients. Like we had one big client who's most of the capital's like three or four mil just getting started there. And I was like, dude, I know this quant stuff is great, but this is a once in a lifetime opportunity. I've been here. We've got to do deep values, stock picking again.
And he's like, Roger that, like, let's do that. Spin ahead two years through like tons of stress, tons of drama. Like we do well initially then we get destroyed. In the end the performance on that thing is like Russell 2000. But with like five times of volatility and of course, you know, I react to it. It's like, well, what if I had just stuck with the damn quant model?
And obviously it outperformed the Russell and you know, me, the stock picker reformed. And so after that experience, I was just like, all right, like I, I, I need to just lock this thing down where I just cannot do discretion because it's just too seductive. And ever since then, I've just, I do not do any discretionary stuff whatsoever, even though I find a lot more enjoyable obviously than quant you kind of in the weeds, having fun.
Rod: More like a hobby than a, an investment strategy.
Art: Was that the message from Barbaris? You've got to take the insights ... and this is something we're going to try to articulate on this podcast, that there are all these insights, but these insights, you know, they can be either really valuable but are also really cheap.
And what I mean by that is that if I don't know the fact to lose weight, I've got to eat less and exercise. Well, that's a really valuable and expensive insight. But everybody knows that insight right now. So it's kind of very cheap as well. And I, and some of this stuff, behavioural finances is like that, you know, you get all these insights on I'm a witch doctor, but you know, what you did was actually turn these things into principles that people live by.
And I think that's really cool, kind of a, something that we want to kind of emphasize in this podcast on that. How have different investors taken, not just insights alone, but actually turn those into principles that they could own and live with. And it's kind of fascinating to hear that story, because that sounds exactly what you did.
Rod: Was there a specific moment Wes? When did it come out that you wanted to compare your stock picking performance to Russell, and then you did the back test on your old models. Was it like a specific event that changed your mind or was it a bit of a gradual?
Wes: No, I just, I just was trying to be disciplined and be honest with myself.
Like I had, I basically ate like a ton of humble pie. And a lot of times when you're in a position of like getting destroyed, you, you, you get a lot more retro or introspective and thinking like, okay, obviously something happened here and I gotta just be honest. It wasn't bad luck. It's probably me. And, and so that made me go back and reassess like, Hey, what if I had just done basically what I had learned you were supposed to do. And with all the resources suggests you do, and all the behavioral stuff suggests you do. And that was just like the stake in the heart. I got to stop being overconfident and stop believing my own BS and just focus on, and leaning on, like all this huge knowledge base that, that people, their whole lives, all they do is try to study decision-making and, and how to follow processes in particular, in the investment space that can at least get you in the right direction and believes it's assessable and understandable .Where, like, you know how I feel tomorrow when I'm picking stocks, you know, I might pick Tesla if I drank a lot of coffee, but I may pick like, you know, some firm in the Calgary oil patch, you know, if I didn't have coffee. I don't know, like, but that's the fact that I had coffee and my monkey brain can be changed and manipulated just by caffeine and the fact that that can actually affect my decision making, even though I may not know that this is just kind of a scary thing.
Where like rules, they're codifiable, they're testable, they're ex ante. Understandable. And then ex post, we can review them. It just seems like a much better way of approaching the problem. Uh, then you know, kind of ad hoc, winging it.
Rod: During that time of the humility and the formulation of a discipline belief set.
Were you in it alone or was Jack there with you? Did you have a partner? Did you have mentors? What were you going through emotionally in the time?
Wes: This was prior to that. For Alpha Architect, um, I had well three ventures, but really two big ones where it's just me alone and afraid and had different business partners and just screw them up.
So this is kinda my third rodeo and this one obviously has been around for 10 years. So this one worked. I had a couple that didn't work. This one, of course, because it's systematic. Rules-based transparent. Uh, you know, much more focused on, you know, not screwing things up this one worked. Jack and, and that whole, the whole concept of Alpha Architect that really didn't come online until 2010.
And so that was when I had personally, you know, kind of had this revelation and restudied all this stuff again, to convince myself that this is not the future hedge fund stock-picking gun slinging, you know, relying on your gut and your experience and how awesome you are. It's just that ain't going to cut it.
Art: You raise it an interesting point Wes, though. And it's one that we always struggle with too. These teachable moments come from unfortunately, uh, us being put into, uh, humbling moments, you know, and the humility is not humiliation. It's it's, I think it's a different beast altogether, but, um, maybe they only have to put their hand on the stove five times.
Uh, like, you know, I, I know I'm pretty persistent too. And, uh, you know, I have to put my hand on the stove like three times before I kind of get things. I think the science of an academic research actually kinda guide you to a format and principles that you, you know, hopefully you don't have to do do that.
Right. Cause, um, but on the other hand, the paradox is until people kind of get beat up a little bit. Maybe I, you know, we always struggle with that. Do we have to get people who are beat up or can we actually guide them without getting their hand burned?
Wes: Well what helped me is I end up running into this huge psychology literature that's broadly called like the model versus expert literature.
And what's amazing on that again, it's kind of like in finance where you're like, Oh wow. People have been doing quant for not eighty years, but sixty years. Cause I can do math. Thanks to Rod now. But the same thing, like psychologists, it turns out, you know, they have been studying how humans do with judgment and like all their qualitative skills internally versus models.
Since like the fifties and there's this insane amount of literature out there where they basically prove and show via evidence over and over again, this is not something unique to finance. This is the human condition. And so there's a great meta analysis study out of like 150 studies on every prediction thing you could think of. Like predicting, you know, college academic performance, advertising sells, like success in the military, how likely you are to do suicide, whatever, like all these areas where you require experts to try to predict and forecast some outcome, none of which have anything to do with finance or investing, but it's the same kind of function.
In, out of all those studies, like five percent of them they can actually identify where expert judgment can beat some brain dead model. Right? The other 95% the model either equals the expert or beats the expert. It's very rare actually, that you can find systematic evidence that an expert's intuition and knowledge and expertise is actually preferable to literally some simple evidence-based model that we can study in tests and research.
Rod: Thank God I'm not expert in anything.
Wes: This is just a human problem, you know, it's not, not just investing. It's in every single thing that involves forecasting. We're just not that good at it. And after reading that paper and which is like basically a meta analysis and learning about this huge wealth of knowledge that the psychologists have been figuring out forever, that was, that was what helped me.
Rod: You said, I think just the key thing, you said a twice forecasting, but it's really about, we can't do a good job of predicting the future. So let's let's science and the past inform the decisions we're going to make today.
Art: The question I had mentioned earlier, humility and humiliation is seeding expertise to a model almost seems like humiliation.
And, uh, you know, it goes against the kind of core Canadian or American ethos that if you work hard, you win and various things like that.
Rod: We're masters of our own destiny.
Art: And yet the evidence is absolutely against that. And chaotic systems like finance or chaotic systems that you can't predict and, uh, yeah.
Rod: Is it chaotic systems or is it systems that rely on probabilistic outcomes?
Art: I think, well, yeah, you're absolutely right. But probabilistic outcomes are things that, you know, get defined by certain things like COVID and all these things that hit us. Right? Like our innate desire as a human being, uh, you know, for safety and various things like that want us to find some type of meaning in these things. And the reality is we can't control that stuff. And it isn't a certain amount of humbleness that you need to seed yourself as a real barrier to people using these things as well.
Wes: And one of the things I did is, because I was really trying to understand like, okay, what, why is it that experts, you know, who know all this stuff, they spend their whole lives thinking about this.
They got all this great experience. How, why are they not beating these stupid models? Like it doesn't make any sense. And so the way it is, I try to break it down into basically like this three core assumptions of that hypothesis. That experts should be the models. And the first one is that, you know, well, obviously experts have access to qualitative information, soft information.
That's one hypothesis. They also have maybe have more data, right? Like, so the model can only feed in like, whatever you feed it. But an expert can be like, well, I got this research report from RBC. I'm gonna use that too. So it's qual it's, it's actually quantitative data, but they may have access to more. And then the other one is that experts have the intuition and experience and maybe that has some benefit, but really the empirical question is, okay, so you have access to more soft information.
You maybe have more access to more quantitative information and you have experience. Here's the real question though. Does, is there any systematic evidence that soft information increases forecast accuracy? What does the data say? No. So when, when humans assume that their soft skills and that soft information set, they get on average is helping them actually improve their forecast.
Empirically, that's just not true. The other one is okay, more information. So if I, if I have five data points, cause that's what the computer uses, but I'm gonna go out and find 10,000 data points. Does that increase my forecast accuracy? There's all these great studies about humans and, and how, how they perceive additional data as being valuable.
Well, turns out that more information also doesn't increase forecast accuracy. What it does is it, is it increases confidence. i.e. You think forecast is better, but actually hasn't improved. And then the final element of the hypothesis that, well, okay, fine. Soft information doesn't work, more information doesn't really work, but I have my, experience and intuition. Well, when they go out and study well, does that actually increase forecast accuracy? Unfortunately, on average and in general, the answer's no. So all of the three core elements of the hypothesis of line expert should be a model empirically.
They're not true. Because none of those components actually enhance forecast accuracy, empirically. It just people think they do, but that's because they haven't systematically studied all their decisions that they've made. They only focus on the one that worked and be like, well voila! I used to be like that too.
Like I said, I started being a value investor in 2000, right after the tech bubble blew up. And any idiot who threw a dart at a cheap stock made 30% a year for six, seven years. Like, I, I didn't codify it like that at the time. I just said, Oh, I'm a genius. Which made me think that my, you know, all these qualitative skills and expertise or whatever we're adding value.
But the reality is now they've had time to kinda, you know, study and understand a little bit more about how I'm an idiot. You know, I came to this conclusion like, wow, it's just not the case.
Rod: So with so much of this information in the public domain, it’s clear that everybody should have access to it. It's very logic, my background in engineering and big data.
This is why I'm attracted to quantitative finance. Why have so few retail investors adopted these strategies. What is the, what is the barrier to giving it up to models for lack of a better word?
Wes: So the key barrier, and it's not just retail. It's like me. I dealt with this. Like everyone. The key issue is ego. Every human being wants to feel valuable.
You want to feel and think that if you work really hard at something you're actually adding value, it's not going to help your ego or your confidence. If someone tells you actually, you know, all that stuff you're doing, it's kind of a waste of time. And so that's the problem. And so, so really what we've talked about kind of earlier is the challenge is not understanding the open secrets about how the human mind is so screwed up and why falling systematic processes that are data-driven is a better solution.
The problem is, to your point, how the heck do we get people to acknowledge, which a lot of people are willing to acknowledge the evidence in the data, how do we get them to actually implement these things? And that goes to like, well, how do we get people's ego out of the way?
Rod: Wow. It was loving. I was loving our conversation the other day, when you were talking about what is starting to unfold at alpha architect and, and vicariously then through SmartBe is we're out in the market trying to grow our businesses is the psychological endowment effects and other effects to help people own these strategies for themselves. Seem to be the easiest path to help, you know, change that behavioral shift or change that belief system shift.
Wes: Yeah. So actually before this, I was, as I was actually curious, you know, the endowment effect, like who actually invented that? And just so your listeners know, the basic idea is endowment effect means that you value, value things that you own more than their market price is basically the bottom line. Like if you own it and you kind of have endowment on it, you perceive it as being more valuable.
Even though the marketplace may tell you differently, or if you didn't own it, you would think it would be worthless. It's this weird thing. Um,
Art: Yeah, just so people understand how powerful this is that are listening in. They've done experiments where they've taken the coffee cups from the university and literally sold it to the kid for a dollar.
And they won't buy it back from him for a dollar. He like gave them a free cup, like, you know, and he'll want $2 because he now owns it to sell it back to you, even though he was going to get a free dollar out of the exchange. Like it's just like, so crazily, hardwired in us as people.
Rod: Sorry, just one point of clarification before you go on. Is it the same with knowledge though, Wes?
Wes: Yes, I think, yeah. So, so, so the issue with a lot of this stuff that we're talking about, It is people don't own or feel like this knowledge or this data is their own. So it's some other person's data. So, so therefore we can't leverage ego and endowment effects in a positive way because people have ego related to their own skills and insights that have to do with like, you know, their gut instinct.
So the trick is how do we get human behavioral problems specifically, like in the endowment effect? And specifically, how do we get people's ego to actually work in our favor? So our solution is to make people understand and invest a lot of time in actually understanding this knowledge. So now they have an endowment effect related to the ownership of all this academic research and all this data.
And now their ego says, Oh, Because I own this knowledge. It's now mine. It represents what I'm all about. And so now I'm going to stick with this because my ego thinks it's a good idea.
Art: Yeah. I think it's a fascinating thing, Wes. I think we're in the phase two of this whole ... in, in the investment business, there's been kind of this whole explosion of academic research, which gave everyone tremendous insights.
And what I love about what you guys are doing, and what we're trying to do is like, it's this. Okay. If you look at successful systems, whether it's Weight Watchers or things, what they've done is they've taken these insights and back to this concept, they've turned them into principles or, you know, and, and, and that has allowed the people to actually build their own ownership, you know, like, cause you know, and, uh, it was funny.
I was talking to Patty who works with us and I was putting this idea around and I said, and she works out all the time. And I said, okay. So, you know, exercise, lose weight don't eat as much. And I said, Can you do us a favor and we were doing an exercise. Can you turn not eating much into a principal?
And she's like, okay, well it'd be like 80% I would eat good. And dah, dah, dah. And once she did that, man, she was absolutely tied to it. It was just fascinating. So it's a, yeah. Can you talk more about how you guys are taking these ideas and making the rubber meet the road?
Wes: Yeah, our, our mission is to give people endowment on this knowledge.
Not, not because we're trying to be nice guys. But because we want them to be better at investing. You gotta be successful there because if they're successful, we're successful. And so we do whatever we can to allow people to actually access all this knowledge. Because right now, as you guys know, it's buried in primary storage journals and it's written for other academics and it's full of jargon and it's like very difficult to understand.
And so the idea, and that's what makes people never want to have endowment or ownership on it. Cause they can't access it. It's like a bunch of ivory tower geeks think they're better than me. Um, and there may be an element of that. But what we want to do is say, no, this is totally relevant to you. We're going to make it accessible to you.
And then we don't really care how you interpret it. And we actually encourage, you know, advisors and people we work with like, Hey, this is how we understand it. This is how we frame it. This how we think about it. But I encourage you to actually build your own way of how you want to communicate this knowledge and insights to your, to your customers or your clients, because then they get an endowment where they take ownership of that education process.
The whole point is how do we get people more disciplined and more able to stick to the models as opposed to like reverting back to like what I used to do? Oh my God, this is a great opportunity. And I'm really smart. I'm going to go back to stock picking again.
Rod: You know, in, in Canada, we think that, uh, you guys in the States are five, eight years ahead of us.
The universe of advisors that you're dealing with, um, that have quantitative skill sets and knowledge in this area are, is fairly large. Can you help us understand the journey that an advisor goes through from a completely. Uninitiated stock-picking world through to, I've got a belief system in quant.
I'm going to stick to the rules. I'm going to be disciplined and I'm actually taking discretion out of my life.
Wes: The problem is investment education is fraught with tons of noise. Due to the conflict of interest problem. Right.
Art: So can you just, it, yeah. Can you explain to us what your concept of noise is? I mean, that's used in academic literature a lot. What is that? What is that term?
Wes: So like us as an asset manager, we have a clear conflict of interest. Like our willingness to educate the consumer is always going to be shaped in some sense, because we have an incentive to sell them something. Right. And for most asset managers that is obviously like a monster conflict of interest. For us, that is also a massive conflict of interest.
We try to negate that through like having a core mission. Of an education and a core belief of transparency. So at least you can fact check us very easily if you think we're being too biased, but we're obviously you still got this conflict. So the issue is, if let's say I'm a consumer and I'm like, man, I really actually want to learn what the hell is going on.
But when you go to the marketplace, you're going to hear a million things about a million different ideas in the incentives, of sales people in experts is they don't want to educate you. They want to charge you a lot of money for their expertise. So their incentive is to actually over-complicate add way too many bells and whistles and lean on what they know about human psychology. Like, Oh, this looks really hard and complicated. Like, and look at all these PhDs that figured this out. Like, God, I just need to hire this person. i.e They never get endowment effect or ownership of the core idea they got sold. So the issue is how do we get advisors and consumers to understand that there's just some core principles and simple model ideas that are very robust, like on average, most of the research tends to agree in these directions.
Let's get people started there. And then build up their knowledge of just the baseline fundamental building blocks. And then also build up their defenses against salespeople who always want to make things more complicated than they need be because that's their incentive is to make sure you don’t think you can do it yourself.
Art: Yeah. We have a fascinating industry, Rod. We turned kind of very simple ideas into very complex ideas, like a disciplined investment process. That's like kind of saying to afford saying that your new sedan has four wheels. Like, it's a very basic concept, but you know, our whole industry creates a lot of noise around these ideas.
Wes: Well, and think about why now, now, now that we've learned about like what we're trying to do. Well, I want people to get endowment effect on the knowledge. I want them to know. Yes, they could DIY this. Why is to me that a psychology trigger that's good? Because I now know they have ownership of this idea and confidence in what the hell's going on, which means the in the end are they really going to DIY? No. They got other better things to do, but now they have endowment effect on idea and they're going to discipline, able to stick with it.
Whereas most asset managers, financial service firms, they don't want the consumer to have endowment on anything. They want to have endowment on the idea because they wanted to sell them the next greatest wizbang mouse trap thing. And then just, if that doesn't work fine, we'll come up with a new one selling that .They have no interest in giving the consumer endowment effects, because they're worried that if they had endowment effect, they'd be like, well, why do I need to hire you?
I'll just DIY it. But we're, we're, we've worked with the psychology of like, no, Like we, we want people to think and understand enough where they can DIY cause the reality is investing is DIY viable. But then on the flip side, do you really want to like do this? There's a reason there's financial services, because if I'm, you know, working on an oil rig, I don't got time to like manage your portfolio and deal with it all.
So I'm going to hire someone. But the key is we want that person, if we're going to do like a simple model or simple strategy or some process that's based in research, the key element is can we get them to stick with it? Well, the key psychology thing we need is endowment and ownership of this idea.
Otherwise they won't stick with it. And so that's why, you know, simple, straightforward, transparent education about just the facts, in our opinion, is very important.
Art: So how has that translated in the U.S. And of the advice that's down there? Because you're not alone.
Wes: Yes. So advisors down here take ownership.
They kind of say like, you know what? I know there's a better idea. I've been reading the stuff while I actually get it. You're right. Like, there is all this research, like these are open secrets. I now finally understand kind of like what is going on here and why this is a better path. Uh, and now I am going to embrace this as my investment philosophy, my investment culture.
Um, I, now I have endowment effects and then, then their role as an intermediary, which is a highly valuable one, is to kind of convey that to their clients as well. Because in the end, what we're really trying to do is get the clients to stick with like a reasonable investment process. So even if like the advisor knows it, but he doesn't help educate his clients and build it down there, you know, it all falls apart.
But the whole point is like, we want the whole chain, the asset manager, the intermediary, and the end client to gain ownership and endowment on these ideas. So we're all in the same boat rowing, and we're going to stick to the program.
Rod: There's a challenge that I see though Wes in that the word quantitative finance and quantitative investing, quant, means different things to other people.
How do you as an asset management firm or ourselves, help both the advisor community and the retail investor understand that not all quant is the same, that there actually are some people that position themselves as quantitative investors.
Wes: What I like to think about investing is first principles.
So there's some investment idea, investment concept we have. One might be the most simple one would be like value investing, right? Buying cheap stuff relative to fundamentals. Now we could go do this with the discretionary hand. We could also just have a basic set of rules that everyone understands that captures the genesis of this first principle, accurately, repeatably, and with clear transparency. That's the kind of quant that we're trying to execute on.
How do we just systematize first principle evidence-based concepts in a way that everyone kind of knows what we're going after? There's another form of quant, which is just backroom, all the PhDs ,200 IQ, you know, doing 5,000 layers of complexity where no one really knows what's going on in the black box.
The pitch is that the black box is producing like monthly returns of 1% every month with no risk. The reality. And a lot of people buy that pitch over and over again, which is why, you know, there's quant shops that sell that. And that's totally fine. The reality is there's maybe one in a billion. i.e. Like maybe Jim Simon.
Or something at Rentech that actually have done that? And so we're just trying to codify and systematize good ideas in a simple, transparent way. So people can gain an endowment effect and own those ideas and help their clients on those ideas. We're not trying to make people PhDs in physics, which no one will actually, you know, understanding and no one will get endowment effect on which means we're back to the same problem.
Art: One of the reasons we want you on and to talk about is we're in Canada. What we're seeing across the border is there's been a transformation in all of this, in the whole financial community, in the U S. There's this transformation where advisors are moving away from, you know, I'm the expert.
You stay out of my kitchen. I'm the black box .To these new advisors that are following people like you and Vanguard, and a whole bunch of other things are happening. Actually going down this transparency role. And it looks like the engagement in the States and this type of a business model is growing at an insane rate.
In Canada, we do have some barriers here to that type of a business model, mainly just because a, you know, the banks are a syndicate here, but that business model will be coming to, to it as someone who's maybe looking for an advisor. Can you talk about what is happening in the U.S. Like, why are people grabbing this transparency. Why is that transforming the business in the U S..?
Wes: I think people are down here more and more just recognizing that if you're, if you're a financial advisor and you want to maintain a business where you have a longterm sustainable relationship with your client, it's much more important that you're not the role of a sales person.
That's just like, you know, selling darts, selling ideas every day. You really want to be in the position of being like a fiduciary slash educator slash coach. Because if you end up kind of owning that role of basically the professor. And, and your clients in some sense, are your students where you're trying to help them understand and make better decisions and grow, you know, you got a friend for life.
Um, whereas, whereas if you're out pumping like, well, I'm the best pot stock picker out there. Pot stocks may not work forever. And they're like, I'm going to go hire the next guide down the road, who knows the better, you know, electric car, stock picker guy. So I think what people realize down here is that's an unsustainable longterm business model.
If I want to invest the time and effort to build my annuity business via like a fiduciary focused advisor business. I want to build and sustain longterm, scalable relationship with my clients. i.e. I need to be the teacher slash coach. And, and focus on a set of core ideas for where everything's the same message, the same principles, you know, forever.
Uh, and then the clients get taught on that. And then once they're in that, that kind of culture, I mean, they're going to be there as long as you're doing the right thing and charge a reasonable cost and adding value. They're never leaving. And so I think it's just a better business model and we're finally seeing that.
And so obviously if there's a better business model, a lot of times it attracts people to that, you know, that methodology. And that's why I think people are going gangbuster on, on this, down here in the States,
Rod: This whole conversation about the endowment effect and getting advisors and people to own the knowledge themselves.
You often talk about this concept of no pain, no gain that oftentimes these quant strategies make you suffer that you underperform for long periods of time, general market indices or whatnot. Is there any evidence or research? Because the other thing that's fascinating to me about human behavior is really this whole concept of performance chasing, you know, everybody's best investment is the one that's doing the best right now.
And we just have that in our DNA that we want great performance because it's important to us. Money is super important to our futures, to our kids, to our legacy. Is there any evidence that the endowment effect is, or can be more powerful than the other innate desire to chase performance?
Wes: Well, I mean, obviously there's so many human nature issues that, you know, deal with like performance chasing and one of the things that we help educate people on when you actually start reading research and studying what works, what doesn't, is there's a ton of stuff that works.
But when you actually dial it down and think, well, this thing's pretty simple. Why does this work? But then you mechanically go through, Oh, this thing can drag on the S&P for years on end. And you look like a total idiot. You can lose your job in the short run because so many people are focused on short term relative performance.
You know, that's just a fact. And so one of the ways you can build, again, going back to endowment effect and building people's defenses. It is how do we get around the performance chasing problems? Well, the short answer is you never will get around that completely, but we're not trying to partner with every single person on the planet.
In fact, we kind of rely on people being idiots in mass, and that's actually a great thing. Like I don't want to eliminate the fact that people performance chaise, cause that's a lot of times what leads to these effects like valuable men or what have you. So what are I want to do is I want to communicate to folks upfront and anti-sell. This is reality. Like you need to own this relative risk and be almost like an innovator or a pioneer and you have to be different to, to be good. And if you just tell people that and they don't own that idea, or they don't appreciate that idea, or that's not part of their pitch, they don't have an endowment effect on it.
It's like, eh, whatever. But, but to the extent you can say, listen, this is what works, but it's not a free lunch. You're going to have to deal with like the relative performance and all these hard conversations. But if you own that and you communicate that to your constituents, that, Hey, our edge is we are not like all the sheep out there that make stupid decisions and try to follow the hottest thing since sliced bread, then it works.
Rod: [So Art you've been not on the asset management side, but on the advisory side, running quant portfolios with the academic rigor for 15 years, give or take. What's your experience in coaching and educating your client base to understand periods of significant under-performance. And how have you manifested this endowment effect, um, in your life?
Art: I think in the original days, we got really jazzed that we had insights and thought they were super value, because to be honest, like when you start in the finance industry, Uh, no one actually takes you through what Wes went through at the University of Chicago. Which is how do markets actually work? The original business of the brokerage business was set up, uh, almost like a utility to sell stocks.
You know, just like an energy factory, the energy would come in and my job is to go sell the energy. I didn't really, you know, I remember when I was a kid, one of the big stock sales was the AGT, the Alberta Government Telephone.
Rod: It's not America's Got Talent?
Art: Exactly! And really that model still kind of influences things today.
And this is where it's so intriguing me. What's going on in the States is that that model was at my job I was paid a commission to sell a unit of the Alberta Government telephone to you. I did not care what that unit did or performed or anything afterwards. The whole incentive model was based on how many units of X could I sell and what happened in 2000, uh, in Canada is we started to introduce fee-based accounts and people started to go to this model.
So, you know, long story long to answer your question, we're in this revolution too. Where at first we got excited about the insights from academia, because quite honestly, it was a pretty frustrating job. To not know how markets worked. And, and yet you've been tasked with running portfolios, when the job changed from I'm a stock seller to a portfolio manager, you kind of got to know how things work.
And then, um, so academia gave me kind of the confidence in the bridge to understand well, okay. Yeah. I know how to lose weight now. And like, these are the principles and I absolutely believe with Wes, this has to be something that you have to become a teacher almost. You have to become a friend and a guide and I, and we're, we're going.
And I think the route that most will have success on this route is to take these insights and turn them into principles and then tell people that it's principles, not perfection. You're not going to be perfect to these things. So you are going to chase performance. I can't, we can't take the human out of the deal here, but what we can say is eah, get with an advisor, get with a coach who's, you know, uh, most, you know, kind of like a sponsor to you. Who's gonna, when you're up against these things then do these things. And then the other thing, we're very transparent in what we can and can't do. And that takes a lot of just nerve to do. It's really hard to be that transparent. The clients are looking to you as if you're shaman in some ways.
So. But what works is bringing it back to these endowed core principles. Do you still believe in these principles? And I remember, um, you know, I originally worked with dimensional fund advisors and David Booth was, he would always say, do you want me to make money? Or do you want me to follow the index?
And that's what Wes is saying. Like, eventually this stuff makes money, but I can't follow the index. And so, you know, you got to have some principles you live with.
Wes: Well, one thing just to kind of tie up that conversation and you know, how other people might use these different tools to like transform their business and make it more tangible.
The reality is every single advisor shop, every single intermediary will be different, right. They can use these tools, but depending on who you are and who your client base is. Like maybe some advisers there's are some clients they can't go all in on this, or maybe it's needs, needs to be adjusted in a particular way for like the culture or psychology or practice.
Um, so one of the things that that's the role of the asset manager like or DFA or us or SmartBe, is it's really on us. If a client, like an advisor client comes to us and says, Hey, I want to do this. Well, the problem is it's not a one size fits all. We're going to have to sit down and, and be consultative, not judgmental and help that advisor incorporate these ideas into their practice.
And what I always tell people is, listen, do you believe in the following, do you believe in education? Do you believe in transparency? Do you believe in, in no kidding doing right by your clients and making this a lasting relationship? As long as you believe in those things we should have a conversation and we can help you.
That doesn't mean you're going to get the same solution that I gave the Joe Blow or Susie Q down the street. You're gonna get your own flavor. But as long as you have those core beliefs of education, transparency, and, and doing, you know, creating a genuine win-win with that client that you're trying to help out.
This stuff, I think adds value
Rod: In addition to the philosophy there, the value system that you just described around transparency and education, and win-win. The win for the advisor is being on the innovative side of things, having economies of scale with building models, having a more efficient practice, being able to rely on the evidence to, you know, scale more. So I think the win for the advisement community also is probably a more profitable business model than the traditional one.
Art: Well, the old model sucked Rod. It really is hard to pick stocks and pick managers. I came from the trading floor and I became a, uh, an investment advisor.
And, you know, one of my seminal experiences kind of like Wes, I got a research report. I liked technology and I got it on a company called CorelDRAW, which was a kind of Canadian tech story. Our analysts has got it at 13 bucks. I'm buying it at 12 thinking I'm brilliant. And it goes straight to eight and I'm like, this is what I do for a living?
I phone up these people who I told they could trust me. And, you know, I got to stand behind this research report and it just that's when I started to say, I got to get a better system and to your point, yeah, there are all these win-wins, but there's also this side where it just kind of destroys your soul.
When you give money to a money manager and he tells you you're going to beat the market and you know, you go talk to your clients and you hype this guy up and then he underperforms and then you go to the next one and the next one and the next one, you just go, my God, like. No, there's a reason why a lot of people used to drink a lot in the financial service industry.
Um, because you know, it's just soul destroying. So, uh, there's a, there's tremendous empowerment, I think for not only the industry, but actually the clients and the customers. And, you know, Wes is always a fantasy and win-win, and it really is like, this is an industry that historically. It's been win, lose
Rod: Well that empowerment and humility feel like sort of the opposite, two sides of the same coin.
Wes: I just want to emphasize there is, cause we see a lot down here is, is we get folks that, that honestly, especially on the advisor side. Like they want to do this, but they're like, Oh man, this is like a wholesale redo on everything. Like, you know, but then we have to communicate. We're like, listen, man.
This is not something that you do overnight. Like, like we can still incorporate a lot of the benefits of this and it's not, and I require a lot of brain damage on, on your behalf. Like, it's not like we're going to wake up tomorrow and, and, you know, change color or something. So it's just one of those things where, where this is not something you just like do all in.
You can have it adapted and customized to your unique circumstance where you may have different constraints or limitations. And so people shouldn't be afraid of of the quant stuff, the factor stuff like the systems, because it's totally adaptable to their situation.
Art: I think people can tell stories and good salesman can sell anything.
But what I loved about quant is that it wasn't a castle made on sand is that these were bedrock principles. That had rigor and, you know, as much, uh, academic truth around them. So if I was going to build a belief system in a castle, you know, my previous castles were kind of built on, on folklore and, and cause selling's tough being an advisor's tough, uh, dealing with, you know, tough markets is tough.
If you have these kinds of bedrock things that, you know, have a lot of actually rigor and truth to them, it's a lot easier to go out and fight the fight.
Wes: And the key thing to emphasize on that is, is it's not like what the academic research says is like the truth of the world, because no one will ever know the truth of the world.
We just always want to seek to find intellectual truth. And I just trust the process through which that research goes, just because when people in, in academics are arguing, they're trying to smash the other guy's face in and not let them get their new idea out. And everyone retests, everyone else's ideas and their whole role in life is to poke a hole in it.
So ideas that kind of emerge out of a culture like that of, of no. It's not Mr. Yes, it's Mr. N. I just feel to Art's point, it's a foundation that that is not perfect, but it's a lot more stable arguably than foundations based on narratives or one person's high IQ potential.
Rod: I always think of it as stacking the odds in your favor.
And you're right. The battleground of academia is a tough one and they've really, it's an uncertain outcome, the future. And anything that we can do to have a little edge of putting the odds in our favor is a good thing to do. So if I'm thinking about today's conversation and thank you Wes has been real terrific having you on the show. And thank you Art for all of your insights, but it feels like both of you went through a similar sort of investment journey that, um, you both started out having a, a high belief system in your own skills and, and endowment associated with, um, being able to pick winners and losers and different events in each of your lives brought you to this vast area of academics. And the fact that the best and brightest minds of the world are looking at markets all the time, trying to disprove each other's best thoughts. And through your journeys have sort of taken the best, not even just from the finance side of things, but also from behavioral economics and psychology and other things, and have really shaped your philosophies and investment thesis and your value systems around some core tenants that have been in the public domain, but not necessarily widely understood. And I've heard a lot today and really appreciate all of your guys' time. Wes, thanks. Thanks again, any, uh, final parting words to the SmartBe group?
Wes: Just go out there and educate and find win-wins. Can't go wrong with that.
Rod: Awesome. Okay, well, this has been a great episode of the Modern Investment Journey. My name's Rod Heard, cofounder with my partner here, Art Johnson. And if you've liked what you've heard today we're going to try and keep it light and on the human side, we've got a really great lineup of guests over the next couple of weeks, and I will look forward to you tuning in again. Thanks so much.
Art: Awesome. Thanks guys.
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