the sustainable active investing framework: simple, but not easy by wesley gray at quantcon 2016

Wesley R. Gray, PhD

T: +1.215.882.9983F: +1.216.245.3686

[email protected] Foxcroft Road

Broomall, PA 19008

Affordable Active Management | Built to Beat Behavioral Bias | We Empower Investors Through Education

Prepared: 05/03/2023

ACTIVE INVESTING IS SIMPLE; BUT NOT EASY

2016 © Alpha Architect. All Rights Reserved.

2

Markets are not perfectly efficient

“Your conclusion has to be false.”–Eugene Fama’s comment on dissertation

“…value investors have stock picking skills.” --Wes’ Dissertation

Active stock selection can beat passive benchmarks…


3

No ammo?No Kevlar?No water?

Combat Ready?

Rational People Irrational People

Newsflash: Humans aren’t robotsSource: Author Photograph

Humans are influenced by bias stress increases bias


4

Markets are not Perfectly Efficient

Human Beings Can Be Irrational!

We are All Going to Be Rich!

???


5

Behavioral Bias

Limited Arbitrage

Who is the Worst Poker Player at the Table?

Who is the Best Poker Player at the Table?

Opportunity

So why are finance professors not billionaires?

Active is simple, but can’t be easy


6

Behavioral Bias

Limited Arbitrage



Opportunity


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*The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Please see disclosures for additional information. Additional information regarding the construction of these results is available upon request. Source: Gray and Vogel, 2012, Analyzing Valuation Measures: A Performance Horse Race over the Past 40 Years, The Journal of Portfolio Management 39, p. 112-121.

Rule 1: Buy Cheap StuffRule 2: Refer to Rule #1

Glamour (1)234

Value (5)Spread

Valuation Metric CAGR Performance (1971-2010)


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Systematic Overreaction?

*The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Please see disclosures for additional information. Additional information regarding the construction of these results is available upon request. Source: Alpha Architect, LLC (top), Data are from Dechow and Sloan, 1997, Returns to Contrarian Investment Strategies: Tests of the Naïve Expectations Hypothesis, Journal of Financial Economics 43.

Expensive <----- Valuation -----> Cheap

Past

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Behavioral Bias

Limited Arbitrage



Opportunity


10Source: Shleifer A., R. Vishny, 1997, The Limits of Arbitrage, Journal of Finance 52, pg. 35-55.

Stock Price

“Rational” Value

Current Value

“Irrational” Value

T=0 T=1 T=2

Delegated Managers Face Career Risk Concerns

T=0 T=1 T=2#1 $100 $150 $200#2 $100 $50 $200

Career Risk


11Source: http://online.barrons.com/news/articles/SB945992010127068546; Calculation details available upon request

Warren Buffett has “Lost his Magic Touch”

Sustainable active investing has to be painful!

Value Index vs. S&P 500 Index from 1994 to 1999

http://online.barrons.com/news/articles/SB945992010127068546

http://online.barrons.com/news/articles/SB945992010127068546


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Behavioral Bias

Limited Arbitrage

Source: N. Barberis and R. Thaler, 2003, A Survey of Behavioral Finance, Handbook of the Economics of Finance.

Overreaction

Career Risk

Active is simple, but can’t be easy



Opportunity


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Long-Term Performance

Source: Alpha Architect, LLC

Key to Long-Term Performance Success

Sustainable Alpha

Sustainable Clients

Long-Term Performance

i ii iii

Active Investing Bad Investing

Need Sustainable Process + Sustainable Client

Manage Fees and Taxes

1

2

3

Long Horizon and Discipline IS Alpha


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For those who believe they are the best poker players

APPENDIX


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Disclosures

Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only.

Past performance is not indicative of future results, which may vary.

There is a risk of substantial loss associated with trading commodities, futures, options and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities and/or granting/writing options one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading futures and/or granting/writing options. All funds committed to such a trading strategy should be purely risk capital.

Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all, are described herein. No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual trading results. The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, all of which can adversely affect actual trading results. Hypothetical performance results are presented for illustrative purposes only.

Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected.


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Statistics Descriptions

CAGR: Compound annual growth rate Standard Deviation: Sample standard deviation Downside Deviation: Sample standard deviation, but only monthly observations below 41.67bps (5%/12) are

included in the calculation Sharpe Ratio (annualized): Average monthly return minus treasury bills divided by standard deviation Sortino Ratio (annualized): Average monthly return minus treasury bills divided by downside deviation Worst Drawdown: Worst peak to trough performance (measured based on monthly returns) Rolling X-Year Win %: Percentage of rolling X periods that a strategy outperforms Sum (5-Year Rolling MaxDD): Sum of all 5-Year rolling drawdowns Down %: The Down Number Ratio is a measure of the number of periods that the investment was down when the

benchmark was down, divided by the number of periods that the benchmark was down. The smaller the ratio, the better

Up %: The Up Number Ratio is a measure of the number of periods that the investment was up when the benchmark was up, divided by the number of periods that the benchmark was up. The larger the ratio, the better

Tracking Error: Tracking Error is measured by taking the square root of the average of the squared deviations between the investment’s returns and the benchmark’s returns

Negative Correlation: Correlation of returns relative to benchmark returns when the benchmark is negative Positive Correlation: Correlation of returns relative to benchmark returns when the benchmark is positive


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Strategy Background for Value vs. Market Slide

Simulated Historical Performance: 1/1/1994 to 12/31/1999

All returns are total returns and include the reinvestment of distributions (e.g., dividends) Gross of all fees and transaction costs From Ken French Website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

LegendValue Stocks = Top Quintile B/MSP500 = S&P 500 Total Return IndexRF = Treasury Bill Total Return Index

Hypothetical performance results have many inherent limitations, some of which, but not all, are described in the disclosures at the end of this document. No representation is being made that any fund or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently realized by any particular trading program.

Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

Please see the disclosures at the end of this document for additional information.

Source: Alpha Architect, LLC

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

Wesley R. Gray, PhD

T: +1.215.882.9983F: +1.216.245.3686

[email protected] Foxcroft Road

Broomall, PA 19008

Affordable Active Management | Built to Beat Behavioral Bias | We Empower Investors Through Education

Prepared: 05/03/2023

QUESTIONS?

the sustainable active investing framework: simple, but not easy by wesley gray at quantcon 2016

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