Momentum-based Stock Selection With Wes Gray, Ph.D. (EP123)

thanks for tuning in to this broadcast of the resilient advisor my name is Jay Coulter and joining me today is Wes gray we're gonna have a conversation about my new favorite topic quantum finance and portfolio construction I want to start with Wes his background because it's very impressive Wes served in the Marine Corps earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize winner Eugene fama he served as a professor at Drexel University is the founder of Alpha architect which is an asset management firm dedicated to making an impact dedicated to an impact mission of empowering investors through education which is gonna be a reoccurring theme of this broadcast he's contributed to countless industry publications had papers published and is the author of four books including one of my new favorite books on this topic quantitative momentum Wes thanks for coming on hey J thanks for having me all right so my journey down this path of researching and learning how to understand quantum finance started about hundred days ago my friend Clint Sorensen over at well shield suggested that I reach out to your friend Cory hoffstein and I had him on the podcast earlier last week yeah had Clint Sorensen on yesterday and Cory referred me to you and reading through quantitative momentum something really stuck with me and it's a quote from your book that that I'd like to read to set the context here for this conversation sure alright so from your book remarkably while modern-day academics refocused on the concepts of stock selection momentum many practitioners continued to be stuck in a time warp the reasons for this regressive behavior are likely related to the practitioner training pipeline the academics who trained all the MBAs they go on to manage portfolios we're still being taught portfolio mathematics so they could solve asset allocation decisions stock picking training was a waste of time because it was a sucker's game on strict interpretation of em8 wes that describes me my career all the training I've had from my MBA to my designations and financial planning and portfolio construction you earned your PhD from the University of Chicago the cradle of EMH and you studied under Eugene fama how do you become a quant coming out of that well yeah I'd like to say that I'm actually reluctant quant and I actually think it's not a waste when people are trained in the dark arts of you know fundamental stock selection and kind of understand how markets work at like the boot you know boots level the thing that I learned is as a stock picker in my early days like I started in the internet bubble at the tail end of it I actually got lucky in the sense that I kind of start as a value guy and you know at the end of the internet bubble there I didn't you know I was obviously doing terribly in a relative sense for about a year and then you looked like a genius because you didn't own a bunch of like dot-com companies right right oh I had the unfortunate experience of having a ton of success early on as a stock picker and then I had the fortunate experience of basically getting my ass handed to me you know a little bit later and then I I quickly realized like wait a second as I was learning about these quant tools and all these behavioral problems you know I did a hard kind of look in the mirror and said wait you know fundamental insights and ideas about how markets work are always going to be important but I just need to use systematic tools to express them because I'm an idiot and I screw these ideas I have up all the time so that's how I became a quant and I'm never gonna claim I'm a pure quant because I actually think pure quants who just it's just pure numbers and you know they don't even care about how you know the fact that you're buying an actual company when you buy a stock that that's not really my flavor of quant for me it's just a way to systematize what I think are reasonable ideas is my philosophy on it well I I love the humility in that answer and that really speaks to if anybody reads any of your work you can see not only the humility but the really the breadth of research and the depth of experience that you apply to this so listeners don't be fooled here he's not an idiot so so what one of and I'm gonna jump around here a little bit here yeah it would be sequential what stood out to me from your work was something that I struggled with on this journey in the beginning and that is distinguishing between growth and momentum I'd put the two together and so to educate listeners on how you distinguish between the two and why they aren't the same yeah so really it kind of boils down to a lot of things in finance it's really important to just define what the heck you're talking about and also give you a little bit of backstory on momentum and why this one in particular so confusing so and it's all started frankly from academics so before the word momentum showed up in academic research this was it was always referred to as relative strength for example right and you're literally just buying winners that like things that are doing well relative to other things and then and that's how it's always been called right and then in 97 this guy actually Chicago PhD mark Carhartt wrote this paper where he looked at the the famous jiggy's and Timman paper which is kind of like the momentum paper in academic literature but will a people realizes the word momentum is never mentioned in jagadisa tippmann it comes about from car hearts paper where he creates this thing called the momentum factor right and in the and adding up causing a ton of confusion because a lot of people that were like trend followers and did other things there's there's a lot of confusion when people mention the word momentum and what the heck this thing actually means because academics mix it up with relative strength and so so long story short momentum which most people consider relative so let's just call it relative strength because that's probably more familiar with your audience is the basic idea are sorry what was the I just lost my train of thought there we're trying to distinguish between momentum oh yes yes so momentum which is really relative strength to your audience is this idea it's just a purely price base look at the characteristic of a stock so has this thing been doing relatively well over the last 12 months compared to everything else in the universe right whereas growth is often associated with you know expensive you know ratios of like like p/e ratios maybe there is elements of like fundamentals like strong revenue growth or strong earnings growth and to the extent that that someone's doing growth investing and it's exclusively focused on actual growth and fundamentals a lot of times that does and can overlap with with pure price momentum relative strength but what is kind of remarkable is that there is a difference between momentum which is a straight up price base component and growth which can mean a lot of things to a lot of different people so in and with what makes it more confusing is that an academic research just like how academics screwed up the definition of relative strength and started calling it momentum growth which to a lot of practitioners means like well let's buy things that have like you know 20% earnings a year growth is associated not with that in academic research but it's associated with expensive like price to earnings ratios or something right and so to the extent that growth is defined by some expense ratio or so not an expense ratio but some valuation ratio then then you definitely have a divergence right there's a huge difference between expensive stocks and stocks that have strong relative strength and so again all these things it's just really important to just make sure that you understand what people mean when they say the word momentum or they say their word growth in how that's defined because depending how you define it they can be vastly different concepts yeah definitions matter yeah increasing things and talking about the economy or markets yeah less I'm gonna throw a slide up sure Momentum's performance this is from your book from 1927 to 2014 yeah I'd cast listeners I'm just gonna read off the top lines these are the compounded annual growth rates for the S&P over this time period in 1927 to 2014 of 9.95 for the espy growth 8.7 value twelve point four Momentum's sixteen point eight five here's the question yes from a financial advisors perspective if there's tremendous yet it's not accepted in the adviser community wholesale what why is that you know I've been thinking about that question for a long time because a lot of people know value right it in values a similar sort of strategy where we know what kind of works over the long haul but we also know that it's hard to stick with it bounces all over the place you can get fired in your job if you do too much of it but for some reason people have no problem own and you know crappy value funds that underperform for ten years and their if you look out so marketplace there's hundreds of them but then you look at momentum momentum has the same sort of kind of academic backing and evidence behind it but even arguably more so than value it's it's a lot in some sense it's easier to understand like value buy cheap stuff momentum you just buy winners like houses strategy can you get and and the data is pretty damn clear that it works you know better than value it is pretty simple to understand so one would expect that you know a lot more people would want to get involved or at least add that as a complement to the portfolio um that said when you talk to a lot of people especially folks that have kind of a value meant to them isn't it the problem with momentum is is it always feels like your bag holder right because you're always buying high relative strength you're always buying the stocks that you're literally at the 52-week high most of the time and I think people have a real problem for whatever reason with buying stocks that have strong positive momentum and I don't know that's just this just again speculation but that's that's one of the things I think is that people just can't handle feeling like there's a bag holder like buying at the top where it's very easy to buy a value stock that's off you know 70% because you feel like you're getting a good deal so but that's just one idea I honestly don't know why more advisors and investors don't put momentum you know directly in their portfolio it's kind of puzzling so Wes here's another quote from your book as a follow-up to that question mm-hm so this is the quote from your book momentum does not work all the time and can fail spectacularly yes ARC's reality prevents many large pools of capital from dipping their toe too far into the momentum pool momentum is simply too dangerous yeah help advisors reconcile and I'm talking about for advisors that have a process for building portfolios yeah how do they add momentum knowing that fact yeah well it's the same logic of how they add value because because you could replace the word momentum in that that quote there and place value and it holds true like doing value investing is a totally insane way to earn extra return with the heck of a lot more volatility in chaos that just by and sp500 so why do people buy value well a lot of times it's a way to diversify some of your equity risk from just doing straight passive and so the same argument kind of holds for momentum like obviously you need to size it right because momentum like the statistically just shown here like in many respects it has higher vol and more dramatic movements even then concentrated value portfolios but what's super cool about momentum is it's totally different than value portfolios it's totally different than you know S&P 500 so to the extent that one believes in the concept of diversification and you want to try to like pool as many you know different risk as you possibly can you know I think momentum it make since just from that straight standpoint and again the key thing knows you've got a you know you got to use like anything you got to take it in the appropriate moderation in such a way that it achieves your clients goals for example if you know grandma shows up and she's like oh yeah I want to you know I want to invest you know and you do some planning with her and you identify like wow she needs all our money in the next two years well you probably not gonna allocate anything to stocks and you're sure as hell not gonna have like anything to momentum stocks right whereas you know another person comes in there may be like hey I got twenty year horizon you know I got huge risk tolerance I totally get it I'm just trying to compound my face off here and you know what happens in the short run is you know up to the market gods well there you be like yeah you know you should probably do some S&P probably some values probably also do some momentum you know so it's just like anything in finance room marketplace there's trade-offs for everything and you know the role of advisors just intelligently allocate those risk rewards into kind of portfolios so you know everyone's better off hopefully in the long haul compound your face off I love that term I've seen it through your work before yeah alright next I want to go back to the book I want to read another quote and this is about a poker analogy that you use for describing this construct so here's the quote the building blocks to identifying sustainable performance where as follows and this is in the analogy from the book number one identify bad poker players number two understand the limitations of the best poker players to exploit the bad poker players and number three exploit the opportunity that then presents itself I cannot do that analogy any justice kichul could you walk us through what you're talking about yeah so so the example is is in poker is kind of a good way to explain it right so so warren buffett's very famous for for saying that having this quote attributed to him where it's like hey if you show up at the poker table and you don't know who the fish is you know you got problems right but but that's actually not enough because if you show up to the poker player table you know you're not the fish but you also know you're not the best poker player at the table you're also gonna lose your ass right and so the key is you never want to sit down at a game where you you do what Buffett says you don't know you're an idiot that's obviously a bad thing but you also never want to sit down to a table where you think you're better than the idiots but you don't realize that there's Warren Buffett at the table right and so the key as an investor and in any kind of game of life like in game theory is you want to find a situation where you sit down at the poker table and you say okay there's the idiot I'm definitely no more than that guy there's Warren Buffett but he doesn't want to play at my table all right Roger that I've got it I got a chance it went in here right and so so that's kind of like the the high-level concept that we're going at here it's just a framework for thinking about what games you choose and so how would we deploy that and say financial markets well let's say that there is a strategy that mints money right it's so easy and or it's it's you know it's not so easy it's actually hard to find but it can just mint money and you're like Bernie Madoff right so one can only guess that the people that want to play that game are probably going to be the 200 IQ guys because everyone's got any one's gonna want to play that game right but the question is do you really have the skills and are you really the smartest poker player at that table probably not if there's a way to mint and print money someone's probably better than you at that game because there's huge incentives to win on that game right and this is the game of like what rentec does and like market makers and prop traders we're you know they've got armies of like Caltech physics PhDs like doing you know Lightspeed algorithms the front run all of our traits like good luck we're not gonna win that game fine so so what other games can we play well we can go look at a game like momentum or value I call them open secrets right so a lot of these open secrets are often caused and created by some idiots at the table right like momentum value like all these anomalies have different reasons you know buried in behavioral finance for why they exist but then the question is well why isn't rentec doing this or why aren't all these prop traders with 200 IQ is exploiting this and so the and so the question is that's an interesting question and the answers is following they can't and it doesn't make sense for them because what they're doing is games where they can mint mint money how do you mint money you find a game that you can leverage up ten times with other people's money you can hedge the risk and just lock in your profit right those are like prop trading kind of long short market neutral hedge fund type games but if I go to my Caltech PhD and I say hey mister PhD go run the numbers and they're gonna be like wow yeah there's there's this momentum thing you're talking about there's this value thing you're talking about and then there's this other esoteric thing that I'm you know that I'm never going to understand but they look at this momentum thing they'll be like wow this is pretty incredible you know to your point on the data like this earns a lot of excess returns you know even after controlling for the risk over long time periods so how am I going to exploit this arbitrage well I'm gonna have to I'm gonna have to get some leverage to make sure it's capital efficient and then I'm gonna have to hedge so I'm gonna go buy some momentum stocks on lever and then short market or short something to kind of hedge out the market risk and then they're gonna be like okay what's that look like and what they're gonna find is that it looks like an abortion because you will die many times over on levered capital trying to exploit a lot of these open secret anomalies because they're not amiable to being levered up and it's very costly to try to hedge law of the risk because they kind of beat to their own drum which means that strategies like that like value everyone know knows value works it works for a reason people don't want to buy junk and things that are like like ugly nasty and other people get paid higher returns to take that paint on that's a gnome thing and yeah it's kind of an arbitrage but why don't the 200 IQ Caltech people go after that because it's not easy to arbitrage you got to actually hold and deal with this pain of this you know strategy so so and that's kind of like a game where like value or momentum we're where we know that there's reasons they exist a lot of times it's behavioral and there's other idiots at the poker play playing table but we also know that it's not like there's vast huge swathes of 200 IQ capital that looks at it as like free money because it's not free money it's painful it's difficult it's challenging to actually stick with these damn things and so that that's why a lot of that's why that's a reasonable game for pretty sophisticated people to play to the extent they have the horizon and they have the discipline and they can get past their own behavioral issues you know that that's a game we could potentially win I think yeah I love the construct finding a game you can actually win makes a lot of sense I cannot tell you how many advisors that I've run across over the years that are trying to play games that they just cannot win and I'm heavily for it and their clients capital pays heavily yeah and it's usually eight I mean what I always ask people like cuz I used to work for a huge fan office where all I did was get pitched like you know the the smart guy ideas on the street and they always charge like huge amounts of money they always got the best salespeople in Indiana I'm thinking why why if this is so good and you can mint money why the hell are you selling it to me if you can this is so good and it has a - Sharpe ratio you should not let me participate at all you should go to goldman sachs prime brokerage say i've got this money printing machine we're gonna you're gonna give me 10x lever on my own capital I'm gonna compound my face off and I'm become a billionaire on my amazing strategy right and that's what smart 200 IQ people would do it's called prop trading right but and so why will unless you really believe someone is selling you that which they're not if they were they would be the idiot at the poker table because they should be using it on their own money in the first place like the logical consistency of what a lot of people buy into just makes no damn sense to me because they had they never thought through this basic poker idea like who's uh who's at this table or can I even actually win this game ninety-nine ten percent of the times it's probably not right right what wess let's pivot so a part of my journey understanding quantitative finance building portfolio is one of the most simple constructs is the look-back period sure and the different types of look-back periods in results I'm gonna throw up your data on the screen but first yeah this is the 12-month price trend we're sitting in here today is the last day of April we've been this crazy time period yeah markets down today but as opposed yesterday you were almost gonna be punched back into the market if you were using a 12-month look-back period here your experience do you find people when they are building portfolios using look-back periods changing their minds midstream deviating from their process and more importantly how can I visors keep from doing that well that's a hard question because it's like how can you prevent humans from being humans I don't know the answer at the highest levels I can just tell you that the techniques that I use to avoid the problem and that's called these systematic rules where in the end you come up with some process they that you believe is you know economically grounded something you can actually stick with through thick and thin or as this likes to call you'd stick through you know like grim death that's the only way I know of how you can get systems to work in your favor because if you go about thinking you just end up screwed enough in the current marketplace actually a perfect example I guarantee if you would asked 99% of anybody's you know whatever two weeks ago or even asked them today do you think this market is are we looking good like two weeks ago three weeks ago you know people said well it's looking really good but the markets also blown up so it's kind of interesting right now you talk to any single person you say well what do you think they're like god it's looking terrible but why is this market keep going up right because you're just overthinking it and this is a theme that is throughout all markets if you start using your head and thinking too hard you screw things up whereas basic like brain-dead trend falling rules are pretty effective at making you be a buy-and-hold investor most of the time and then to the extent that you know we enter a phase where there's potential left tail problem ie negative 50% drawdowns they do a pretty effective job of sidestep in those on average right and it's very simple very straightforward and the bottom line though is you have to stick with the program and what's interesting is there's a lot of stories and evidence of people not sticking sticking to those programs so for example there's a study actually I think it was in one of the Scandinavian countries because they don't care about privacy and you get access to every trade every stat you'd ever want to know on every citizen in the society and so what they'll do is they actually go into the trading activity of individual accounts and they can identify beforehand who's a trend follower right because you can kind of see like what's their training activity when when the trends breaking like at the 200-day or the 252 day or whatever you know they can say hey who's a trend father because they'll see people get out of it and so what they do is they then identify this this group of all these thousands and thousands of investors who are trend followers and then they ask the question well how good are they a trend font and what happens is you notice is that investors are really really disciplined about taking the rules on the way out so if the rule says hey get out they got no problem with that rule however when the researchers then look and say okay when the 200-day is now you know the price is above the 200-day are they good at getting back in IE do they follow their own damn model guess what the answer is oh no one follows the model and so that's why it's so important to have a model like right now like it was easy to get out when the market was looking shaky in February and you know the history of trend like this prevents you from death so you got out most people don't have an issue with that but right now you know now that were flirting with trend might be back on like do you want to get in most people like God know like God please don't but that's how you screw up these systems and it's shown over and over again in the individual trading behavior well I can relate to that analogy so well because I just started building trend following models at the began here I used the two hundred and fifty day moving average oh boy it got me out I was a genius i what a great time shift my methodology and as of last night we're 70 points away on the SP from back in and I'm sitting there saying maybe I need a different I know I'm telling you right now either you're either in on these systems or you're not because it's better to just like with systems you either follow them like almost like a religion or you just don't or you don't do the system you do buy-and-hold which is also a system actually but but the bottom line is whatever you're gonna do whatever process if it's gonna work it doesn't really matter so much about the process it matters do you stick with the process because most processes work if you don't booger them up so and that's very true with Trent and I mean I can I can even tell you some stuff we haven't published this research but like I'm kind of a data junkie and just for you know shits and giggles I was like hey I'm gonna try to get some more data and so I actually got access to daily data on S&P all the way back to 1885 and then I got some additional data its monthly unlike its from GFT and a bunch of spice resources you can get going all the way back to like 1864 for a bunch of different markets and I and I was like hey let's just do some basic trend rules on all these markets from 1860 to 19 seven which is kind of like the pre crisp period before like most people have data they dill his back testing yeah and I was just curious like hey you know there's like the the pandemic in in 1918 there's all these depressions across the globe and sure enough like brain-dead long-term trend falling achieves its goal across every country and over the long haul if your goal is to be buy and hold and capture equity risk premiums most the time but avoid death when it comes ye the you know the monster draw downs the 50 percent things and I'm talking like trying to dodge 10 20 percenters because now you're just a day trader it works so there's something baked in that cake in in in seeing another you know 70 80 years of out-of-sample data across different assets across different countries and literally seeing a blueprint of the Zetas the same exact effect you see from the past hundred years that just gives me a lot of confidence again that there's something baked in that cake it were if you just have the discipline to stick to something it's probably gonna work and achieve your objectives if you cannot mess with it too much well let's go to your data this is from your book and this is back to look back periods and portfolio size and yeah I found this interesting you know when Corey came on last week we we went deep on the different look-back periods and very this research here you have it on the number of stocks that should be in a portfolio and and just to speak to it for podcast listeners a 50 stock portfolio significantly outperforms the market over every single time period and when I say the market it's your universe of 500 securities so so with that Wes what does this tell you about portfolio construction as a financial advisor as we want your portfolio size other than the obvious data yeah so so first to just highlight the dense between this and kind of what Cory would talk about and again this goes back to the problem of why academics called this momentum so Cory's talking about trend falling look backs right where it's like hey we use the 12-month moving average to get us out the three month moving average or whatever right and there's great discussions you can have there this right here these look packs are relative or for port for stock selection portfolios where the look-back period is related to the relative strength periods ie are we going to compare the last twelve month or turn on every single stock and buy the winners or the last three month and by the winners or what have you and that's a little bit different than trend falling which is kind of telling you when to get in and out of a market this is more about like saying hey you're always going to be invested in stocks it's just what stocks do you want the ones that have the best 12-month return the best six month return of the best 12-month return I either look back period in this context and then the other aspect you mentioned there is how concentrated do you want it right you could do the you could do the 500 you know winners you could do the top 200 winners or the top 50 winners or you could just buy the the number one winner right and so what's interesting this is actually you know something that we focus a lot on and we try to inform the public about is there's it's pretty dang clear from academic research that expected returns are related to characteristics or factors what I mean by that what I mean by that is you tell me the p/e ratio on this portfolio and I will tell you the expected return and if you tell me that the p/e ratio is 15 versus 10 versus 5 I'll tell you that the 5 will outperform the tan which outperform the 15 on average right that's baking the cake well how do you get portfolios that have a p/e of 15 versus 10 versus 5 it comes down to how concentrated it is because if you buy a portfolio at the top 500 cheapest let's say the market has a PE of 20 well if you buy the 50 if you buy the top 500 cheapest probably that portfolio is gonna be cheaper but it may be 15 P right if I buy the top hunter cheapest well we're getting in the real cheap stuff but maybe that has a p/e of 10 if I'm going down to the top 50 cheapest this is total dirt ball cheap stocks now I've got a portfolio that has a p/e of 5 well guess what the more you have of a characteristic because we already know this relates expect two returns the more returns you're gonna get that applies in any of these things that quote-unquote work so it applies in value as well as momentum so in momentum if you own the 500 best winners you know the obviously the the 499th winner is gonna be a lot less of a winner than like the number one winner right so as you is you basically amp that portfolio up and concentrate it more and more in these high momentum names that portfolio is going to have a higher and higher momentum characteristic well to the extent you believe that momentum drives expected returns if you have more of it you're gonna get more expected returns in that and that's just a fact like it's logically makes sense and empirically true of course the downside is you know because nothing's free in life is as you concentrate more and more to buy a specific characteristic like momentum obviously like the volatility goes up and and how that portfolio differs from an index goes up so so basically concentration is a key component of portfolio construction that will drive you know what goes on in the future for whatever investment you're buying so you'd always want to look at that angle that's the most important and it's broadly applicable to frankly any kind of quant funds you're gonna buy is look how concentrated it is right and in very specific to momentum basically with momentum on the that thing there I think on that chart there was probably related to look backs you generally want to be on like relative strength momentum we were doing stock picking twelve like the longer Interlake home intermediate terms like the twelve month type things is kind of that sweet spot where you know 12-month winners keep on winning whereas if you're just looking at the one-month winners they actually tend the mean revert right like in Lao that's what they call that like oversold overbought type stocks that like like what traders say like the old wives tale is actually true like if it's oversold or overbought it tends to revert but if it's been winning over the last twelve months you know it actually tends to keep on winning so so kind of that that longer-term look back is is which one focus on if you want to capture the so-called momentum effect so I had Gary Antonucci on a couple weeks ago to talk about his dual momentum strategy and we're loved about that is that that was a great starting point for me because he's able to articulate in the way that I could understand not having a lot of experience in the space and then I got model fascinating and I started building my models of course with the 12-month look-back periods sure and then you start tinkering back and forth so that's actually a great tale into this question like what is the optimal look-back period for an advisor who's new to quant yeah it's to start building portfolios for clients well so again we want to make sure we differentiate between like trend following type systems which is what Corey and Gary would be talking about and those are systems that try to tell you like when to take market risk or not so let's talk about that first and then we'll talk about stock picking momentum which is a little bit different so if you're talking about trend falling and these systems like you know dual momentum or what Corey talks about and we do it as well is the first question always ask is what is your goal right as as advisor what and in general most people that are doing trend falling in like an advisor context is how do I capture the market benefit and I understand I got to take some of the risk but I just don't want to die right like my clients understand that when they buy stocks it's gonna get crazy but I can't have them losing 50 percent right and so so that's kind of a goal and so we we now want to try to get a trend model that's gonna try to basically you know capture that the problem with trend models is there's no free lunch like everything in the marketplace so the more you dick with the thing the more you fine-tune it the more you data-mine it the more likely it is to be the case that you didn't find something that was real you just found something you wanted to see and and if you implement the strategy in practice you're going to get whipsawed to death destroyed and transactions cost etc so my recommendation is much more akin to what Gary would say versus Cori and this is just a philosophical difference I think on the concept the Occam's razor is just if there's a simple model that gets it done go with that despite the fact that 200 IQ people say something different right sometimes simple is beautiful and it also prevents you from trading too much which is why it's even more beautiful so I'm a big fan of just like Gary's rule twelve-month absolute momentum you know 12-month moving average combo the two that's what we do but I like simple you know long-term rules that are forced you to be buy-and-hold most of the time and they have very few transactions and I think that's the best way to keep people again buy and hold most the time only pull the trigger when they need whereas if you go shorter term look backs you combine hundreds of systems you just start doing too much activity and I think activity in many respects is is kind of the death of investors a lot of times so I'm just not a fan of like the hyperactive you know trend-following systems to achieve the goals that most advisors want that's for Trend phone now with stock selection where you want to use momentum or really it's not trend you want to use relative strength to try to pick the stocks that you think you're gonna win in the future there it's really important ironically that you pick some rule it's got to be a long term nature like let's say twelve months or whatever but then in order for that system to work it has to actually train a lot right like if you read that fund every year there's gonna be no benefit like like momentum is something word literally you have to own a portfolio where it always has these high octane high momentum names because to the extent and like you hold you get a momentum portfolio today but you hold it for a year because momentum is so dynamic by the end of that year or even three months into that that portfolio I bet you 90% of those names don't even have high momentum anymore right so the key with momentum is a stock selection system is to you know do your 12-month look-back or whatever you think's great and then the key is just to have high turnover on it in high rebalance frequency because you actually always got to be owning these securities that have the highest momentum and unfortunately that requires a lot of trading which is is again a trade off but that if you want it to work that's what you got to do well with the transaction cost coming down that just really leaves you with the bid-ask spread that you're dealing with if you're trading and you know the tax implications for advisers yeah and that's why if you're gonna do momentum as a stock picking strategy it's almost you have to do it through an ETF wrapper to kind of you know defer the taxes and and presumably let like a professional deal with execution it's it's just it's not not realistic for an advisor to sit there and have a two hundred and fifty percent a year turnover strategy and SMA because that one they're gonna probably get bad execution and then more importantly they're gonna destroy their client and tax drag where you can just go buy an ETF that's doing the same thing but so both those problems obviously being cognizant of like the fees you're paying everything but it it doesn't make any sense for advisers to DIY stock selection momentum in my opinion trend fallings different that's something I think that advisors can do but without when you know you without killing the client basically so well I know that you and your team at alpha architect have several ETFs in the marketplace and what I have found through this experience is there's some really smart people and really smart firms like yours putting out creative products that to use your language are simple and still get volts overtime it's just it's fascinating to do the research on those and even more applicable I assume that there'd be high expense ratios cheaper than SM A's in some cases so really an applicable tool for financial advisors that want to add momentum to a portfolio Wes I I had to cut my question set down significantly for you I had so many yeah sure we're already at 40 minutes let me let me get through two more questions if you don't all right you know something interesting in your book I found is the seasonality of momentum yeah and the research that you went through to demonstrate this for pike s listeners the chart is the average returns by month from 1927 to 2014 and there's some clear standout data in here west walk us through it what do you see and what are the implications sure yeah so so again this is referring back to the stock picking momentum which it which is a little bit different than trend falling for example but with super interesting in stock picking momentum is again this is a strategy that you know in a long only context you're just literally buying the winners and in a long short short context you're obviously buying winners and shorting the losers pretty straightforward but the question is is that is the momentum effect gonna be the same all the time or is it the case that maybe it's not just random but there's a reason why momentum would would presumably work better in one month versus the other and in the real simple example and the one that we talked about in the book just keep it straightforward is like tax loss harvesting right so so there's a huge known seasonality effect like in value where value usually bombs out you know early on or at the end of the year and then in January it has like this epic rally right and a lot of people say well that obviously because you know everyone's book they're just bombing out their losers ie the value stocks and then they turn around 30 days and buy them in January well you can take that same logic and apply that to momentum why would how would tax loss harvesting for example affect momentum portfolios well think about it in November December especially if you're using a 12-month momentum look-back well every stock that's in a momentum portfolio in november/december is going to be the last stock on earth that any advisors gonna sell because why did you sell you're winners so these securities are gonna have this this weird situation where nobody wants to sell them and and so you don't have any selling pressure for any fundamental reason because there's this huge like tax drag effect that's be the hypothesis and similarly losers are gonna keep losing because well everyone wants to sell they're losers regardless of fundamentals because I'd rather have the tax you know tax benefit you know and so so and sure enough when you look at momentum portfolios um you see this effect where if you systematically rebalance and it almost kind of front run like a tax loss harvesting effect for example instead of rebalancing your you know your momentum portfolio in the end of January why don't you do it in like November because you're gonna basically get ahead where you're going to own all these super high momentum names at a time when no one ever is gonna sell them so there's no selling pressure on them and you might get these like momentum drift affects what you would much rather do that then buy them in January when you know no there is none of this pressure anymore right like at the end of January like the winners well people just sell them or buy them if they like them so so there's all these opportunities and marketplaces where a lot of times they're structural reasons why why why returns have seasonality and so instead of just you know randomly you know buying and selling and trading your portfolio on X date you know we think it makes sense to try to at the margin you know rebalance and in set up portfolios to do whatever they're going to do in a way where you kind of get a front run you know the overall markets actions and that just happens to be one thing that's relevant to momentum like like tax loss harvesting seems to have a huge effect we're like you know returns in momentum November December are totally insane whereas in January they kind of suck you know that makes sense because they're like this tack cloth kind of effect there's some other effects we talked about like window dressing and in quarter ends but you know it gets you know it's a little bit more complicated but it's the same idea it's you basically have an opportunity to kind of systematically front-run but it not an evil way just is what it is you know a lot of market participants because they have incentives for tax or other things yeah I don't think of that as front-running that's strategically rebalancing yeah exactly man's front run is another man's you know strategic rebalancing exactly it's just everyone in the marketplace has different incentives and and I I'll be glad to get front run like like if I'm if I'm selling a stock at a loss and banking a huge tax benefit like yeah sure if you want to take a bit or two off of me great like that's awesome you're providing liquidity and I'm getting this tax benefit like it's a win-win so a lot of times front-running is just a form of liquidity for people that got different needs in the marketplace so it's an evil word obviously from a you know regulatory standpoint because it is nefarious in some cases but the concept is not unfair in my opinion it's just it's a way to provide liquidity for for people gotcha all right last question so what I have found interesting about this whole quantity versus folks like yourself and Clint and Corey in even Gary did that matter are very very involved in educating investors these aren't secret black boxes necessarily and the more education it seems that somebody provides the bigger the perform becomes what yeah that's who clearly chosen to go down that path I encourage listeners to go to alpha architect calm and look at the vast amount of resources that they provide what sent you guys down the path of becoming educators you know I it's it's hard to say I think it's like personal preference like I have always just hated lack of transparency and people bullshitting to me you know maybe it's because I came out of the service where it's just much more direct like I just want to know what the hell's going on like if you're gonna charge me that's totally cool because I know you got to make money just tell me what I'm gonna pay and telling what you're doing like it's all good here and so I've always just had this kind of firm belief in you know unlike having people in business just kind of convey in a transparent authentic way like okay what are you doing why are you doing it and what am I paying you and cool we'll move from there and so it just always made sense to me that if you led with education process first so you explained exactly what you're doing and why and then you charge like a reasonable fee that's affordable and transparent for given service that it would naturally attract people like me like consumers that like if I have someone like banging on my door or call me 50 times a day I'm not inspired to buy I'm inspired to send a pipe bomb to the dudes house you know and so that's why when we built our business and kind of our culture and philosophy I know and maybe that's what other I know I can't speak for the others but that's just kind of I always believed in man so that's why I fir mission is what it is and and our one of our core firm beliefs is is transparency just this because that's what I it's kind of like what my grandmother you say you know like the gold golden rule the whole Bible stuff like treat others as you want to be treated like I feel like your business like same thing like like if I'm selling a product you know I want to know you know I want to tell people what it is you know are you invested in it with your own money is probably the first question you know what's this thing doing what are you charging me for it just like if I'm buying a product I say whoa do you use it they I hope they say yes and I say okay cool what are you doing and what I got to pay for it I mean that just seems like common sense to me but so that's why we do it and I don't know why other people don't do that but you know other people got their own thing so that's cool let's market for everything Wes let's wrap with this dirt Cory told me that you have a big birthday coming up and it ends in an oh yeah 20 any midlife right issues going on this week no man like like it's coronavirus times which is great I'm not it makes you kind of a private person like I don't really like being the you know the grand standard and all these parties and I was actually kind of freaking out like my wife was gonna do some you know surprise deal and it turns out they were and but been out of this coronavirus like you know it's actually a good thing because you know no one could do that so I'm like yes no surprise birthday parties that I've got to deal with you know people go crazy at my house so yeah I just yeah and my original plan was I was gonna go to Disney World with my my wife and kids but that was the downside of Crona they cancelled that obviously but yeah turn 40 man it's it's yeah so yeah listeners pick up a copy of quantitative momentum you will not be disappointed it is data rich and written at a level that you can understand if you're curious about the markets follow Wes on Twitter it is at alpha architect and then the website is alpha architect calm Wes thanks so much for coming on yep thank you Sara appreciate it Jay

Channel: Resilient Advisor

Views: 1,716

Rating: 5 out of 5

Keywords: jay coulter, resilient advisor, the resilient advisior, momentum investing, portfolio construction, wes gray, alpha architect, quant, quants

Id: cfTybbZ1Ods

Length: 52min 18sec (3138 seconds)

Published: Fri May 01 2020