WHY VALUE INVESTING IS SIMPLE, BUT NOT EASY
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1 WHY VALUE INVESTING IS SIMPLE, BUT NOT EASY Prepared: 3/10/2015 Wesley R. Gray, PhD T: F: Foxcroft Road Broomall, PA Affordable Active Management Built to Beat Behavioral Bias We Empower Investors Through Education
2 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. 2
3 Sustainable Alpha Pyramid Typical Investor Focus Past Results Operations Investment/Risk Management Process Recommended Focus Robust Idea Generation Past Results Don t Drive Future Returns! Source: Alpha Architect 3
4 value investors have stock picking skills. --Wes Dissertation Your conclusion has to be false. Eugene Fama s comment on dissertation Markets are Not Perfectly Efficient Source: Valueinvestorsclub.com 4
5 Rational People Irrational People No ammo? No Kevlar? No water? Combat Ready? Some People are Irrational! Source: Author Photograph 5
6 Markets are not Perfectly Efficient Some People are Irrational! We are All Going to Be Rich!??? 6
7 WHAT IS BEHAVIORAL FINANCE?
8 Prices are Right No Free Lunch No Free Lunch Prices are Right Source: N. Barberis and R. Thaler, 2003, A Survey of Behavioral Finance, Handbook of the Economics of Finance. 8
9 Who is the Worst Poker Player at the Table? Behavioral Bias Opportunity Limited Arbitrage Who is the Best Poker Player at the Table? Source: N. Barberis and R. Thaler, 2003, A Survey of Behavioral Finance, Handbook of the Economics of Finance. 9
10 Where can we find sustainable alpha? 1. Psychology: Provides opportunity 2. Limited Arbitrage: Minimizes competition that can exploit the opportunity Psychology Limited Arbitrage Social Biases Cognitive Biases Emotional Biases Frictional Institutional Herding Behavior Availability Loss Aversion Trading Costs Tracking Error Authority Bias Overconfidence Disposition Effect Shorting Costs Window Dressing Anchoring Leverage Costs False Diversification Framing Fundamental Risk Sell Side Analysts Limited Attention Noise Trader Risk Benchmark Dependency Alpha is Driven by Bias + Limited Competition 10
11 VALUE INVESTING: AN APPLIED EXAMPLE
12 Behavioral Bias Explanation Investors systematically overreact to growth rates and fail to account for mean reversion. Lakonishok, Shleifer, Vishny 1994 (Journal of Finance) Current Prices Reflect Past Performance *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
13 Behavioral Bias Explanation Systematic Mean-Reversion Behavioral Bias *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
14 SO WHY AREN T WE ALL VALUE INVESTORS?
15 Warren Buffett is Losing his Magic Touch Value Stocks SP % 1.35% % 37.64% % 23.23% % 33.60% % 29.32% % 21.35% Value Investing = Poor Job Security Source: Calculation details are in the appendix 15
16 Behavioral Finance and the Value Anomaly Psychology Limited Arbitrage Social Biases Cognitive Biases Emotional Biases Frictional Institutional Herding Behavior Availability Loss Aversion Trading Costs Tracking Error Authority Bias Overconfidence Disposition Effect Shorting Costs Window Dressing Anchoring Leverage Costs False Diversification Framing Fundamental Risk Sell Side Analysts Limited Attention Noise Trader Risk Benchmark Dependency Value Anomaly is Explained via Behavioral Finance 16
17 We Seek to Buy the Cheapest, Highest Quality Value Stocks Minimize Behavioral Bias Value Philosophy Empirical Analysis Quantitative Value 17
18 APPENDIX
19 Our Business The foundation for our approach is grounded in the science of behavioral finance and can be described in 2 steps: 1) We identify mispricing caused by investors persistent behavioral bias. 2) We design systematic algorithms that are Built to Beat Behavioral Bias. Managed Accounts Active ETFs Systematic Equity ValueShares Robust Asset Allocation MomentumShares Custom Alternatives Source: Alpha Architect, LLC 19
20 Our Value Proposition Why We Exist To empower investors through education. What We Believe We believe in Systematic Decision-Making, not ad-hoc decision-making. Disciplined, consistent, and repeatable processes are more reliable than discretionary judgment. We believe in Empirical-based investing, not story based-investing. Rigorous data-driven research drives success; stories drive sales. We believe in Transparency, not black-boxes. We are committed to having investors understand what we are doing. What We Deliver Affordable. Active. Alpha. Our Edge We design robust algorithms that exploit mispricing caused by irrational investors. Source: Alpha Architect, LLC 20
21 Understanding the Asset Management Landscape Understanding the Landscape Index No conviction No tracking error No alpha Low fees Active Closet Index or Smart Beta Little conviction Little tracking error Limited alpha Average fees Investor Costs Active High conviction High tracking error High alpha potential High fees Closet Index Affordable Active Affordable Active High conviction High tracking error High alpha potential Affordable fees Passive Active Share We Deliver Affordable Active Alpha *Cremers, K.J. Martijn, and Antii Petajisto, 2009, How Active Is Your Fund Manager? A New Measure That Predicts Performance, Review of Financial Studies 22, p
22 Strategy Background for Value vs. S&P 500 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: Legend Value Stocks = Top Quintile B/M SP500 = S&P 500 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 22
23 QUESTIONS? As Of Date: 3/10/2015 T: F: Foxcroft Road Broomall, PA Affordable Active Alpha Built to Beat Behavioral Bias We Empower Investors Through Education
24 Interactive Brokers Industry Sponsored Webinar Series Emmet Peppers - sales representative with IB specializing in Advisors and Hedge Funds Dr. Wes Gray is the founder of Alpha Architect, LLC, an SEC-Registered Investment Advisor and has been an Advisor client of Interactive Brokers for several years. I am pleased to introduce Dr. Gray, who will present today s webinar. Please contact epeppers@interactivebrokers.com if you are interested in becoming a client of Interactive Brokers. 24
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