Executive Summary


This article provides an overview of Preston and Stig’s interview with Wesley Gray, an Executive Managing Member from the asset management company Alpha Architect that specializes in Quantitative Value ETFs.
This article and podcast answers the following questions:

  • Who is Wesley Gray and why did he start an ETF?
  • What is the difference between an ETF and a mutual fund for the investor?
  • Why is an ETF typically cheaper than a mutual fund?

Who is Wesley Gray?

Wesley Gray earned an MBA and a PhD in finance from The University of Chicago Booth School Of Business. Today he is an assistant professor of finance at Drexel University’s LeBow College of Business, where his research focus is on empirical asset pricing and behavioral finance. He is also an Executive Managing Member of the asset management company Alpha Architect that is built around his research on Quantitative Value in stock investing.

Based on Wes Gray’s research on quantitative value, he decided to create an ETF. He wanted to capture the extra return he could get from buying cheap value stock, and at the same time omit the human bias in selecting stocks.

What is the main difference between an ETF and a Mutual fund for the investor?

Mutual funds have a lot of work ahead of them whenever they receive the “buy” order form investors. First off, the order must be processed internally. Consequently, it records the amount of money deposited and identifies the person who placed the order. Thereafter, the portfolio manager from the mutual fund invests that money in the stock market and also buys and sells securities while incurring transaction costs. Note that the process is different and works in the reverse manner whenever investors sell. This simply means that the more complex a transaction gets, the cost climbs higher for investors.

Compare that to an ETF. If you have an ETF, your end customer is the individual investor; however, technically there is an intermediary. The ETF will sell what is called “a creation unit”. A creation unit is a block of shares; for instance, 50,000 shares that are sold to the bank. In return, the bank delivers the underlying assets to the ETF. The stocks are not out on the market where it’s traded with the investor. The reason why the bank wants to do this is because they can participate in many small lucrative deals that benefit all three parties: The bank, the investor, and the ETF. If you ever look up an ETF, you can see that it’s sold at a discount or a premium to the net asset value; for instance, a premium of 0.1%. This means that the bank can essentially sell the ETF and buy the underlying assets and sell the ETF and make a small arbitrage profit. The process works similarly if the ETF is trading at a discount. The bank will then buy the ETF and sell the equivalent stocks in the open market.

By repeating this process over and over again, it secures a consistent small profit for the bank. The investor has a low cost certainty that he is always buying and selling at the fair market price and the ETF can sell its product very efficiently.

Why is an ETF typically cheaper than a mutual fund?

One of the most common answers you hear about the benefits of ETFs is low cost. According to Wes, there are 3 benefits from investing in an ETF that makes it possible.

1) Lower Taxes When a mutual fund is selling on behalf of an investor, the fund eventually needs to sell one or more of the securities in the fund. The capital gain that is incurred is taxed, and the investors in the mutual fund pay for that with a smaller return. For an ETF, the rules are a bit different. An ETF is allowed to effectively defer taxes because ETFs are trading with a bank that is under another tax regime. The end results are lower taxes and better returns for the investor.

2) No cost for holding cash A mutual fund manager knows that it’s not efficient for him to constantly sell securities and incur taxes whenever a single investor wants to sell. Therefore, he has a cash reserve to omit this. The implication for the remaining shareholder in the fund is that they are effectively paying the mutual fund manager a high fee to hold cash, which is making no return.

3) No sales force on the pay roll All companies want to sell their products, and mutual funds are no different. They spend huge amounts of money on their sales team. Marketing dollars might go to banks that are compensated a hefty commission for each dollar they can generate into their funds, or mutulal funds might be paying agent set out to locate and sell to high net worth individual investors and organizations. For an ETF, the story is a bit different. They don’t know who actually created the sale to the investor buying their shares, and therefore, it really has no incentive to compensate anyone for a higher volume.

Books and resources mentioned in this episode

Wesley Gray’s book, Quantitative Value – At his price

Toby Carlisle’s book, Deep Value – Read reviews of this book.

Daniel Kahneman’s book, Thinking, Fast, and Slow – Read reviews of this book.

Wesley Gray’s site, Alpha Architect

Wesley Gray’s white paper for his, US Quantitative Value ETF: QVAL

Historical return for growth, Growth Investing Vs. Value Investing

Videos that Support this Podcast

Wes presenting at the 2013 Nantucket Project Finance Forum

Wesley Gray – Quantitative Value

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