Affordable, Active, Alpha: Inside the U.S. Quantitative Value ETF (QVAL)

by on November 26, 2014 | ETFs Mentioned:

The proliferation of ETFs has brought countless strategies to the fingertips of average investors in recent years; through the use of a single ticker, virtually anyone with an online brokerage account can access a variety of asset classes from all around the globe or tap into a professionally managed portfolio that was once simply unreachable by self-directed investors [see also 101 ETF Lessons Every Financial Advisor Should Learn]. 

We recently had an opportunity to talk with Wesley Gray, Ph.D, the leader behind Alpha Architect and the recently launched U.S. Quantitative Value ETF (QVAL); he shares insights about his firm, core investment beliefs, and the “secret sauce” that sets QVAL apart from competitors.

ETF Database (ETFdb): What exactly is Alpha Architect? 

wesleyWesley Gray (WG): We are an asset management firm that delivers high-conviction tax-efficient strategies at affordable costs. I would describe us in a few simple words: Affordable, Active, Alpha. We offer our strategies via active Exchange-Traded Funds (ETFs) and Separately Managed Accounts (SMAs).

Perhaps a more relevant question is the following: What do we believe? There is certainly no shortage of asset managers who want you to simply have faith in their proprietary methodology and “special sauce.” Our experience with academia and ultra-high-net-worth individuals has culminated in three core beliefs that permeate everything we do:

  • We believe in Systematic Decision-Making, not ad-hoc decision-making. Disciplined 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.

So we are the antithesis of the stockpicker who relies on his intuition and his compelling story, and who won’t tell you how he makes his decisions, and therefore feels justified in charging you high fees. We don’t buy this. By contrast, our firm is driven by research and a desire to challenge this traditional way of doing business in financial services. I have an MBA and a PhD in finance from the University of Chicago and spent four years as a finance professor. I have developed a deep respect for the value of research, empiricism and discipline as it relates to applied investing and behavioral finance.

My research team consists of my top PhD and Masters students. We have worked together for nearly five years now on academic and practitioner research questions and our faith in the research process, on investing systematically, and on being up-front and honest about what we are doing is continually reinforced the more we work together. We find that the beliefs outlined above offer the best framework for financial management and innovation [see also Why Passive Investing Is More Active Than You Think]. 

ETFdb: What is your overarching philosophy with regard to portfolio management? Please elaborate beyond the passive versus active debate.

WG: We recognize the passive versus active debate can cause people to fall into different camps. We’re not dogmatic about that. Our philosophy does not involve strong views that one camp is right and the other is wrong, since we think each has merits and can play a role in an investment portfolio. Given this, we take a simple approach to portfolio management and ask a simple question: What are the FACTS? The FACTS are Fees, Access, Complexity, Taxes and Search/Due Diligence. Once we have clarity on the FACTS, it then becomes a simple comparison of costs versus benefits.


Our experience suggests that the majority of taxable investors should focus on strategies with lower costs, higher accessibility and liquidity, easily understood investment processes, higher tax-efficiency, and limited due diligence requirements. So on its face, this view would seem to make a strong case for passive investing, but it also applies to questions related to active management.

For instance, we often meet high net worth individuals (and even RIAs) who are unaware of the tax deferral features within the ETF vehicle or why an equal weight portfolio might make more sense than some whiz-bang mean variance approach. Before we start debating whether a strategy can yield an incremental 200 bps of so-called “Alpha,” let’s make sure we address the big picture and minimize fees, taxes, and due diligence headaches [see list of Actively-Managed ETFs]. 

Generally speaking, the FACTS suggest that investors should make use of more managed accounts and ’40 Act products, and rely less on expensive, private funds. The academic evidence is overwhelmingly in favor of simple, transparent, tax-efficient strategies versus expense “black box” approaches. 

ETFdb: What was the inspiration behind creating the U.S. Quantitative Value ETF (QVAL)?

WG: We were inspired by two distinct sources: the limited and expensive options provided by the market today for a high-conviction high expected performance value strategy, and the demand we observed from investors for a cheaper, more tax efficient alternative to mutual funds and/or hedge funds.

Let’s start with the market itself. There are very few high-conviction (<50 stocks) active ETFs in the market today, and any non-ETF products out there are expensive. So if I want to be a value investor and express my true conviction as such, I either have to 1) save fees by doing the work myself and then get killed on taxes OR 2) pay hedge fund / mutual fund fees to get that effective high conviction exposure, and still get killed on taxes. I cannot overstate this point on taxes: the taxes incurred during any rebalancing make virtually every traditional vehicle unattractive on an after-tax basis. That’s just the brutal reality of options available to investors.

On the investor side, we had a deluge of interest from investors with <$1M in investable assets. They were saying, “We want to do this. How can we do this?” This demand reinforced our belief that the market wanted an active ETF solution. You don’t have to be an investing genius to see why this could make sense. So we reached out to our multi-billion dollar family office partners and they loved the idea. It was a perfect fit: a tax efficient, high conviction strategy that suited both HNW investors and Main Street investors [see also The Cheapest ETF for Every Investment Objective]. 

With an active ETF, we can manage any account of almost any size, and at an affordable price. You get a first class product, and you don’t need to be a family office to negotiate a low fee. Compared to other active options, such as mutual funds, quant hedge funds, and the like, our management fee is a bargain. Second, we capture the tax advantages of ETFs and apply them to an intelligent active strategy. This is an issue that plagues “traditional” active managers, since they can be forced to make buying and selling decisions based on tax considerations, rather than based on valuation and fundamentals.

ETFdb: What is QVAL’s objective and how does it actually work? How does it differentiate itself from existing value-focused funds?

WG: The QVAL objective is straightforward: Buy the cheapest, highest quality value stocks. We deploy a five-step process to accomplish our objective (see graphic below):

  1. Identify Investable Universe: Our universe generally consists of mid- to large-capitalization U.S. exchange-traded stocks.
  2. Forensic Accounting Screens: We conduct financial statement analysis with statistical models to avoid firms at risk for financial distress or financial statement manipulation.
  3. Valuation Screens: We screen for stocks with low enterprise values relative to operating earnings.
  4. Quality Screens: We rank the cheapest stocks on their long-term business fundamentals and current financial strength.
  5. Invest with Conviction: We seek to invest in a concentrated portfolio of the cheapest, highest quality value stocks, which maximizes our expected returns over the long run. This form of investing is by definition contrarian, and requires disciplined commitment, as well as a thorough understanding of its theoretical and intellectual underpinnings in order to stick with it, since it may underperform in the short run.


As for the second part of your question, as to how we are differentiated from our competitors, there are a few factors. First, we offer a rigorous, statistics-based defense against permanent capital impairment. Second, we offer a very smart way to screen for price, and have a lot of evidence to back up why we think so. Third, we use a lot of the quality signals from the philosophy of value investing that you often see used in fundamental research shops, but we do so systematically across the entire equity universe to identify the very highest quality companies.

In the end, we systematically form our portfolio, rather than picking a stock story we like and then back into some of the value-related characteristics the stock happens to have [see also When the Fine Print Matters for ETF Investors]. 

For example, you won’t hear us say, as you might hear a fundamental shop say, “Hey, this stock looks pretty cheap based on its P/E, and it has nice returns on capital and boy do we have a good feeling about management.” Instead we are going to say, “This stock is liquid enough not to cause problems, it is not showing statistical signs something very bad is likely to happen, it is objectively cheap using the best valuation tools we can find, and it is doing these 10, 12 or 15 financial things right that Ben Graham and very bright academics have shown us we should pay attention to, therefore it sure looks like a decent statistical bet on its own but we want to include it as part of a basket of other similar securities, and equal weight them to give you the best chance to succeed over time.”

That is a very different investment proposition than relying on the hot manager du jour, who relies on what their gut is saying, is subject to behavioral biases, and who claims to be a value investor. We just don’t believe there are many value investors out there of this latter ilk who are worth paying what they are charging for their services.

One of our clients was describing us to another investor and said, “These guys are not quants, they are value investors.” And that’s right. We really are value investors just like any of these fundamental managers are, or claim to be, since we are looking at exactly the same accounting-based measures and metrics, BUT — and here’s the difference — we are doing so in a rigorous and systematic way, using academic research, and quantitative tools, and eliminating the chance we will be influenced by our faulty human biases. Finally, we do so cheaply and in a tax-efficient wrapper via the ETF. These are what differentiate us from the competition.

The Bottom Line

Utilizing a value-focused investment approach is as desirable as it is difficult. For those looking to tap into an actively-managed portfolio that offers concentrated exposure to high-quality, undervalued equities, QVAL most certainly warrants a closer look; this product separates itself from the pack by adhering to a strict process that takes emotion and bias out of the equation all the while relying on hard data to steer allocation decisions rather than compelling stories. 

Follow me on Twitter @SBojinov

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Disclosure: No positions at time of writing.