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The Inner Workings of a Quant Contrarian Strategy

Finance professor Wesley Gray discusses his upcoming actively managed value ETF.

Samuel Lee, 06/10/2014

A version of this article was published in the April 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Wesley Gray is the finance professor turned quant behind the upcoming ValueShares U.S. Large Cap exchange-traded fund. He cowrote with Tobias Carlisle Quantitative Value, a lucid, entertaining, yet meaty guide to the construction of an automated stock-picking strategy. Gray's upcoming exchange-traded fund will implement a version of the strategy laid out in the book.

Aside from his qualifications, including a Ph.D. in finance from the University of Chicago and a professorship at Drexel University, Gray's credibility stems from the good work he's done on quantitative investing, tackling interesting topics like valuation-based market-timing (it's hard) and the efficacy of various dividend stock strategies (total shareholder payout is a better signal than dividends alone). I've followed Gray's career for a few years, watching his firm evolve from a shoestring operation to a serious, albeit scrappy, money manager. His blog is one of my must-reads.

Because Gray is both voluble and transparent about his thinking, anyone is able to conduct due diligence on his processes and capabilities in-depth. Most funds--ETFs, closed-end funds, open-end funds--provide nearly content-free marketing materials on their processes to the public, making real due diligence hard, if not impossible, with the materials on hand. I've studied a lot of the content from Gray's firm, Empiritrage (now Alpha Architect), and am impressed with its candor and comprehensiveness.

What follows is a lightly edited interview conducted via email.

Samuel Lee: Let's start with a softball--Why launch an exchange-traded fund? The ETF business is brutally competitive. A viable fund is said to require $100 million or so in assets.

Wesley Gray: Mutual funds and hedge funds belong in the dustbin of business history. The ETF structure is transparent, lower-cost, and much more tax-efficient. From an investor's standpoint, the decision is a slam dunk. From a fund manager's standpoint, the decision is much tougher, since there is less opaqueness, less stickiness, less ability to use the traditional distribution channels, and so on. In other words, less profitable for the "croupiers." But we don't have a problem with that. One of our firm's core values is to be consumer-friendly, so we are going "all-in" on ETFs, and we think we have a unique product that is highly differentiated from the competition. We think there really isn't a true active manager in the ETF space today--you either find passive or closet-passive, such as so-called smart beta. We are explicitly avoiding indexing and quasi-indexing approaches. We want to be a genuine high-tracking error, index-irreverent, high expected value-add active asset manager, exploiting mispricing caused by a combination of behavioral bias and limited arbitrage. The key differentiation between us and traditional active managers is we want to deliver affordable active management, as opposed to overly expensive active management, which is the status quo among mutual funds and hedge funds. I want to make my Ph.D. dissertation advisor--Eugene Fama--proud to support active management by making it affordable. Although convincing him we can provide "alpha" will be a challenge.

We see two challenges in the ETF business: garnering the initial capital and distribution. For initial capital, we have largely solved this problem: We currently work with several large family offices and various wealthy individuals who have committed an initial $50 million to our first ETF, so we think we can be break-even right out of the gate. For the distribution problem, we have decided to be "disruptive" and avoid the traditional Wall Street man channel, which adds expense for the investor. Instead, we are developing a direct-to-consumer marketing channel. This approach will liberate the investor from the costs imposed by the middleman and also decrease overall costs.

Samuel Lee is an ETF Analyst with Morningstar.

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