Are Individual Investors Misbehaving?

This week on The Long View, author, chief investment officer, and Alpha Architect founder Wesley Gray talks individual investor behavior, market efficiency, exchange-traded funds, and value investing.

Here a few excerpts from Gray’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Benz: You’ve also spent a lot of time examining the research on the way individual investors behave, drawing on the research that people like Terry Odean and Brad Barber have conducted on the topic. We had Odean on the podcast earlier this year. So, it’s not a pretty picture when we look at investor behavior. But do you think net-net investors are less prone to misbehave now than before? And if so, what are the implications for professional investors?

Gray: I have a counterintuitive thing for you. A lot of people say, “Wow, there’s all this data access. There’s all this new transparency.” Anyone with a computer now can almost effectively equate to have the same data as a Bloomberg at this point. So, all this data, all this transparency, free trading, and there’s basically zero frictional costs. How can it possibly be the case that markets aren’t really, really efficient, and how that makes sense? Well, I would suggest to you—and this is not a new idea—this is something Jack Bogle talked about. What you’ve done is you’ve unleashed the opportunity for the worst behavior in mankind’s history. I can now allow people to have a ton of information, so they can get way overconfident in their own ideas. They can trade with basically what looks like zero cost, even though it’s not actually zero cost, because your order flow gets sold to Citadel or what have you. And all this ability to take action for everyday investors, in my opinion, is making the opportunity for behavioral errors probably the largest it’s ever been in the history of the marketplace.

Ironically, I don’t actually think the market is skewed to become more efficient over time. I actually think that behavior is actually making it worse. And then, well, you might say, well, the institutions aren’t dumb. And, actually, the institutional imperative or this need to be how do you perform relative to the benchmark every day, every quarter, every year—I think those incentives have actually only gotten worse. This idea that you can go allocate to someone and say, I actually have a 10-year horizon. I don’t really care what—nothing against Morningstar—but I don’t care what my Morningstar stars say right now. I think that incentive is actually even worse. I think, actually markets, at least from a behavioral lens and an institutional imperative incentive lens, might arguably be set up to be less efficient on a go-forward basis. Again, that’s what I think. I actually see it all going the opposite of what efficient market says, because all the behavior and all the incentives of the marketplace are actually warped to allow people to make terrible decisions at zero cost these days. And I just don’t see human nature changing. That’s the number-one thing that’s always going to lock is human stupidity. I’m very bullish on that on a go-forward basis.

Retail Investors and Market Makers

Ptak: To follow up on that, if we suppose, as you are, that frictions have gone away or been lessened, and that’s led to misbehavior among retail or individual investors, but also, we’ve seen incentives squeeze institutions in ways that are unhealthy for them. So, you’ve got both of those important cohorts misbehaving and perhaps not performing optimally. If we assume the markets as zero sum, who is the offset to that? Is it the market maker?

Gray: Market makers, and the sharp critique in that math I think is a little bit off, because the issue is, everyone eventually has to access the market for liquidity and buy and sell at some price. And the people that do that, you can call him a market maker, but it’s also active market participants. Because passive owners, it’s just flows-based. You click the button, you buy; you click the button, you sell. You’re not looking at fundamentals. You’re not saying, I’m going to sell at this price or buy at this price. So, anytime anyone has to interact with the marketplace, they’re going to be offset with someone who’s an active participant to provide liquidity on that trade. That’s just the reality of it.

All of the excess will go to whoever has got that long-term capital who can buy at the right prices and sell at the right prices, which is effectively active management or liquidity providers. And I guess, through the sharp critique lens you could call him a market maker, but there’s market makers at the micro level and there’s also market makers at the macro level. And a good example of this, which I think is obvious, would be private equity. So, private equity is like a slow-motion train wreck. And if you look at private equity, you say, why did that perform so well? Well, in the old days, you could buy companies in private equity at a 50% discount on enterprise multiple basis to public markets. And, to the extent that everyone is like, whoa, this private equity thing is amazing and I don’t have to mark to market, so I can get rid of my institutional imperative problem and I could mark to fake, and I could tell my clients I’m making all this money, unlike this DCF that doesn’t exist. Why is that awesome? Well, it’s awesome because as I’m going through that cycle, the valuations were 50% of public, and now they’ve moved to parity with public. And so, all of a sudden, I have this massive world of private equity providers who everyone and their mother wants to allocate to, because on the backtest it looks like they have amazing realized returns, which is actually true, but they’re failing to account for the fact that they also have like a 50% valuation boost along the way, which is arguably one time. It’s not like when you bought at total enterprise value of 5 times, now you do 10. It’s not like it’s going to go to 20 where you’re going to get that excess return boost.

So, this is a situation where, who’s providing that? Well, all the capital providers, the CalPERS and anyone who is allocating to this. Even if they do it passively, they’re over here now paying off the croupiers in the form of private equity firms. And who’s the seller there? Well, it’s the private business owners who are probably selling their companies at way higher valuations than they should be. And who’s the loser? Well, it’s the “passive” gobs of capital that just keep clicking the private equity buy button. So, you can see there’s a natural winner and loser in that market. The natural winners are obviously the sellers of private equity, the institutions in the middle; also the private business owners who are probably selling to the public at way too high a price. But then, you also have another dynamic. These capital owners, these massive capital owners, a lot of times they’re passive in nature, they’re also having to do something with their public assets. What are they doing? Well, they’re like, let’s click the button sell VWAP across the board on this capital. Someone is got to be right on liquidity there. I don’t know if it’s Vanguard, I don’t know who it is, but arguably some active investor that’s got to be taking that on. And then, when they sell that, that capital then gets dished over to private equity.

So, you can see at the micro level and then all the way rolling up to the macro level, this idea of passive investment is ludicrous to me. What it is, is there’s this huge fund flows that shift around all the different marketplaces out there, and they’re getting clipped on the croupiers, what Munger calls the middle people, they’re always going to win, like the casino. And then, also, just whoever is on the other side of these trades that has a discipline and capacity to either buy at the dear prices and sell at the high prices, they’re going to be the winners. And passive is obviously going to earn whatever return they’re going to earn. But I’d argue, step back two years ago, if you just thought an S&P 500 investor was passive and you showed me the valuation, well, I’m going to tell you what the expected return is. It’s going to be terrible. Right now, it might be better. But right now, if you look at the “passive” private equity investor, you look at the fees, the taxes, and the current valuations, I can predict—I’m not going to say 100%—but if you were to say, “Wes, 10 years from now, what is the expected return on private equity given valuations and given fees and taxes?” I can tell you with very high certainty it sucks. I can also tell you with very high certainty that if you buy a portfolio of stocks that are selling at 5 times P/E right now, 10 years from now, they’re going to crush the stock market in the form of the S&P 500. That’s just, I feel, is math. It’s the math of valuations paid in the marketplace. That has nothing to do with passive and the Sharpe critique. It just has to do with the fact that everyone is active in the marketplace and even an S&P 500 is basically a mega-cap beta fund that’s slightly overpriced. Well, what is the expected return on that factor versus other things? It sucks. So, I’m not a buyer of the whole Sharpe equilibrium thing, because the reality is you don’t not have to interact with the active marketplace ever. You always have to interact with them.

How to Incorporate Value, Momentum, and Trend Strategies

Ptak: I wanted to ask you, maybe to stick to this theme of behavior. I think you’ve got a pretty interesting take on how to incorporate strategies like value, momentum, trend, all of which we’ve discussed to this point in the conversation. You feel like they ought to be split out, if I understand you, because if they’re combined, maybe it’s harder for investors to look through and understand why the combined strategy is performing as it is. I guess that I’ve tended to think of it in a slightly different way, which is that people, when these things are split out and they see the way they behave in isolation, they might behave even more rationally. But you’ve come to a different conclusion. So, based on your experience and research, how have you come to conclude that they’re better off left split out so people can look through them?

Gray: I wouldn’t say it’s better off. It’s just we have our core beliefs and our mission and how we go about business, and then other people have their ways about going about business, and I could be convinced either way. And I know all the arguments for either side of this. Let me just explain why we do what we do, and I could argue for the other side, too.

So, in general, empirically, in my opinion—let’s just take the very simple thing. We could do pure value. We could do pure momentum. And we could do 50/50. We could also say, no, I’m not going to do that. Let’s go look at value and momentum simultaneously and get the best combo of those. And so, these are two ways you could go about it. And you can argue about, well, one is more efficient, one is less efficient and what have you. Empirically, at least in the context of what we do, which is, concentrated investing. We’re going to hold 50-, 100-stock portfolios. They’re all the same. It’s six of one, half dozen of the other. I feel like it’s not even worth arguing about the 50 basis points plus or minus, because as you guys know, that’s nothing in the grand scheme of a backtest. It’s all noise. I think they’re the same, whether you do 50/50, pure value, pure momentum, or you do a mix, you’re going to get the same spot. If you’re running closet index portfolios, where you’re benchmark-hugging, have low tracking error, I think the arguments for actually mixing is better, where you focus on value and movement at the same time.

But for what we do, empirically, I don’t care. They’re the same. Why do I like the pure play? Well, the reason I like the pureplay is I like education and I like our core belief of transparency. And in my experience, it’s much easier ex ante or before the thing happens, to explain to someone, this is a value program, here’s my exact details of our process. We have no black box; 100% transparency. This is what it does. This is how it works. After the fact, we say, this is what we do, this is how it works, this is what it did. The client can look at that and be like, “Makes sense.” This thing got destroyed. I don’t care, because this is the process. This is what it is, this is what it does, this is the outcome. Same thing on momentum.

The problem when you start mixing things is it’s extraordinarily difficult after the fact to explain to people what happened. Because now we got to have this mix of what percentage of momentum was it, what percentage of value was it? And trying to disentangle the attribution of a totally integrated factor portfolio is very challenging. And I think Cliff Asness, I think he was talking at Morningstar probably five, six years ago in the depths of the hell of factor investing that we’ve all lived through. And so, for me, in our setup, it was much easier where I can say, our value strategy, it sucks. And everyone was like, well, yeah it sucks because it’s a value strategy. All good. Momentum strategy—holy cow, our systematic momentum strategy is like an ARK fund. This is awesome. Well, should I get excited? No. It’s because it does price momentum during a price momentum market. Great. Everyone gets it. But meanwhile, Asness and AQR, they do the hodgepodge factor approach. Their stuff just looked generally bad, and they’re trying to explain that’s because it’s partial momentum, partial value, partial quality, partial low beta. And everyone is just like, “Cliff, dude, whatever man, I’m moving on.” So, because that’s a lived experience now and we’ve just seen it firsthand, I’m just a huge believer that the only thing that stops people from good investing is being highly informed and educated and have a lot of transparency into what they do ahead of time and after the fact. Otherwise, they’re never going to stick with it. And so, that’s a long-winded way of saying that empirically I don’t think there’s any difference in these methodologies, personally. But behaviorally, I think there’s a lot of differences in the sense that you can attribute the process directly to the outcome—much cleaner when it’s siloed effectively.