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A Deep-Value Quantitative Hedge Fund Strategy

A look at finance professor Wesley Gray's new exchange-traded fund.

Samuel Lee, 11/21/2014

This article was published in the November 2014 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

ValueShares US Quantitative Value QVAL has an unusual history. Its creator, Drexel University finance professor Wesley Gray, began his career as a money manager while studying for his Ph.D. at the University of Chicago under Eugene Fama. Friends and family gave Gray around $3 million to run in a systematic value strategy. Gray also wrote the Empirical Finance Research blog. Eventually, he began providing free stock screeners based on academic research. He graduated to publishing his own research on stock-picking rules. It culminated in a brick of a book fittingly called Quantitative Value, coauthored with value investor Tobias Carlisle and published in late 2012. In it, the two survey the literature on stock-picking signals and synthesize their own strategy. Around the time the book was published, Gray's firm began offering tax-managed separate accounts implementing the strategy. Gray soon realized there was an even more tax-efficient vehicle: the exchange-traded fund.

Many ETFs make heavy use of a tax arbitrage enabled by the in-kind creation/redemption mechanism. When an authorized participant redeems a basket of ETF shares for the underlying securities, the ETF sponsor can select shares with the highest tax liabilities (that is, the lowest cost bases). The transaction is done "in-kind" and so is not considered a taxable event by the IRS. A clever ETF sponsor can reduce or even eliminate year-end capital gains distributions to investors. Many high-turnover ETFs have never distributed capital gains.

At least one quantitative hedge fund noticed and briefly contemplated launching high-turnover ETFs itself. However, doing so would have required daily portfolio transparency. Gray's firm made the plunge when it launched QVAL on Oct. 22, 2014.

Few funds come with expository tomes. Fewer still are comprehensive and reveal a penetrating mind. Quantitative Value demonstrates a common-sense understanding of what academics call anomalies. Academics still puzzle over how the historical outperformance of value stocks can be reconciled with asset-pricing models grounded in efficient markets. (Contrary to what some would have you believe, the notion that value stocks outperform solely because they are riskier is not the academic consensus.) Gray believes value strategies exploit behavioral biases. His true mentor is not Fama, but Benjamin Graham.

Gray and Carlisle understand the pitfalls of using historical data. People who don't deal with data every day don't realize that it does not appear in a state of perfection but is often incomplete, inconsistent, and error-ridden. Almost every quantitative investor has to make judgment calls about how to deal with these problems. In general, the two show a good understanding of the problems affecting historical stock market data, an understanding that does not seem to be shared by most analysts running around with back-tests.

Around the time I read Quantitative Value, Gray's firm filed to launch QVAL. I was impressed enough to write at the time that "if the ETF comes out with an expense ratio of less than 0.50% and gains at least $100 million in assets, I will likely reallocate most of the [ETFInvestor's model portfolio's] U.S. equity position to it." ("Swaps," ETFInvestor, December 2013.)

The bad news is the fund is more expensive than I'd have liked (I'm cheap), charging 0.79% on assets per year. The price is, as Warren Buffett puts it, within a big zone of reasonableness, when you consider what you get in return for what you pay. One way to see QVAL is as a hedge-fund-style quant value strategy that just happens to be an ETF. Most quant ETFs use dead-simple rules and do not have managers actively tending their models. Before I get into whether you should buy it, let's discuss its methodology.

Samuel Lee is an ETF Analyst with Morningstar.

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