ETF Expert Corner

Alpha Architect’s Jack Vogel on New Book “DIY Financial Advisor”

November 24th, 2015 by ETF Store Staff

Alpha Architect’s Jack Vogel, one of the authors of “DIY Financial Advisor“, discusses key investor takeaways from his new book including why you should be wary of “investment experts”.



Transcript

You can listen to our interview with Jack Vogel by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: Let's now welcome in Jack Vogel, CFO and Co-Chief Investment Officer at Alpha Architect. Jack is joining us via phone from just outside Philadelphia. Jack, great to have you back on the program.

Jack Vogel: Yeah, thanks for having me back.

Nate Geraci: Jack, the name of the new book is DIY Financial Advisor: A Simple Solution to Build and Protect Your Wealth. This was penned by yourself along with Wes Gray and David Foulke. I thought the foundation for the book was laid right at the beginning with a pretty thorough take down of so-called investment experts. You explain in great detail why the everyday investor, so everyone listening to this show, can actually beat these "Experts". There are several reasons you cite in the book. I think the most interesting is that you explain how these experts suffer from the same behavioral biases we all suffer from. To start here today, explain this for our listeners. What are some of these biases? How do they impact investment experts?

Jack Vogel: I think a simple one would be, maybe I'll just give you an example. One behavioral bias that's been shown is the bias of anchoring. In some academics, these people have said, "Listen, first I'm just going to ask you for our Social Security number and then I'm going to ask you for the price of a toaster." What they found is by simply anchoring the question by first focusing on a Social Security number, you can actually affect the price that someone would pay. If your Social Security number is below 50, you pay less. If your Social Security number is above 50, you pay more for the same toaster.

How does this affect investments? One way that this can affect investments is it's also talked about in a disposition effect whereby investors are prone to hold their losing stocks for too long because they don't want to realize the loss because it's psychologically painful. On the converse, they tend to sell their winning stocks too early because they like to realize the gain. This anchoring effect, where the purchase price has some actual impact on decision-making on whether or not they should buy or sell the stock that they hold in their portfolio.

Nate Geraci: Jack, why do you think some investors assume, these so-called market experts, don't have these biases? There's a great quote in the book that, "Everyone makes mistakes and because we recognize our frequent irrational urges, we often seek the judgement of experts to avoid becoming our own worst enemy." Why is that? Why do we assume experts don't make the same mistakes we do, or have the same behavioral biases we do?

Jack Vogel: I think it's twofold. I think one is that everyone does make mistakes. One thing is if you defer to an expert and they make a mistake, it's, I think, less painful to an individual investor. You can always turn around and go to your friends and say, "Yeah, my advisor, who I trusted made a mistake. That guy's an idiot." Whereas, if you're the person making the mistake, that's a little bit more painful. What we think of when we're trying to build any strategy is we'd like to build a model and just simply follow the model because we don't want to be, in the heat of the moment in trading days, making rash decisions on buy and sell.

Jason Lank: Jack, I want to relate a short discussion I had yesterday with a friend. I was mentioning we'd have you on and discuss an interesting book and we were going to talk about the fallacy of experts. He raised an interesting question. It was, "You mean two smart guys are going to interview another smart guy and they're going to tell me that other smart guys, but not them are wrong?" There's some circular logic there going on. Certainly all of us are in that category. We're giving advice. We're trying to help people, yet how do we protect ourselves from ourselves?

Jack Vogel: Yes, that's a great question. One way we as experts can protect ourselves from ourselves is to, as we like to say, use models. Let's go to a security selection model where let's say you want to go and buy value stocks. Value stocks, as it was shown in academic studies, have outperformed. One of the issues is there's always a great story for why the value stocks in the portfolio are probably going to go bankrupt. If you're a value investor, that's probably a good long term bet. However, there's the natural inclination, as an expert, to override the model. Your insight is so gray that you just know this company's going to go bankrupt. On average, you're probably better off just following the model and just buying the cheap stocks.

Nate Geraci: Jack, another interesting point you make about market experts is, let's just say there are some really good investment experts out there and as an investor, we can find them. They're not free. The fees they charge can eat into any edge they have. Can you talk about that, the importance of understanding the fees and incentives in place for your investment managers and your investment advisor?

Jack Vogel: Sure. On average, all the studies have shown the lower the fee the better the performance. Especially this is the case when it comes to passive investing. If you're going to buy S&P 500, you should just pay the lowest price. I think there's two other areas I'd recommend investors assess when it comes to fees. The first is just too truly understand the motives when anyone gives you advice on an investment strategy. If you're talking to your advisor and all of a sudden they're recommending an alternative mutual fund that charges 2.5%, you may want to ask them if there's any fee sharing arrangements. What we've seen in the marketplace is a lot of times there's these arrangements where if an advisor places you into a mutual fund, they may get paid on that. One thing is to just fully understand that when you're working with an advisor, are they getting paid for putting you in funds, and if so, you might want to question that advice.

The second area, I'd say, is if you do decide to go down the active management route, one thing is you have to weigh the pro of trying to beat the market through active management against the con, which is the fee. I'll just give you a quick example. Fund A, which is a smart beta 500 stock mutual fund or ETF charges 35 basis points for 50 basis points of expected out performance. That may be worse off than fund B, which charges 75 basis points for a 300 basis points expected out performance. If you go down the active management route, I think you do have to weigh the fee versus the portfolio construction and try to really weigh the pros and cons there.

Nate Geraci: Again, we're visiting with Jack Vogel, CFO and Co-Chief Investment Officer at Alpha Architect. Jack is one of the authors of the new book, DIY Financial Advisor. Jack, one of my favorite chapters in the book lays out a very simple framework that every investor can use to evaluate their investments and even their financial advisors. The beauty of this is in its simplicity. The approach is called, FACTS, F-A-C-T-S. This stands for fees, access, complexity, taxes, and search. I would love for you to explain this for our listeners. This is really a very handy way to think about your investments and your investment approach.

Jack Vogel: Sure. As you point out, the acronym is FACTS. I'll just go through one by one. On fees, all else equal, you want to keep fees as low as possible. However, you do want to understand as I previously pointed out if you go into active management, you have to weigh the fee versus any expected out performance. For access, for some high net worth individuals, people may be intrigued by a hedge fund idea, we like to say all else equal for access. You want to always have access to your money; be able to liquidate at any point. Hedge funds with a lockup, that could be potentially painful. An annuity with a redemption penalty in the first 5 years, we probably wouldn't recommend that.

Complexity, which is C in the FACTS, we like to keep this at a minimum. The whole point of our book really is we outline an endowment type portfolio that you can be accomplished with 7 ETFs. That's pretty simple. On taxes, you want to defer taxes for as long as possible. We are huge proponents of using ETFs in a portfolio. This whole book basically says you should use 7 ETFs. There are some huge tax advantages of ETFs versus a mutual fund wrapper. The last one, which is search, this applies really if you're investing in hedge fund managers, or you're a manager of someone else's money where there's a cost for going out and finding the best manager.

Nate Geraci: Jack, you mentioned ETFs. As I think about the FACTS framework, it's difficult for me not to jump right to ETFs. Obviously, we're also big proponents of ETFs. Don't ETFs check the box in a positive manner on each area of the FACTS framework?

Jack Vogel: They really do because if we go through fees in general, fees on the ETFs are less, lower than mutual funds, probably half or less than that. On access, you can trade them not only any day. You can trade them any second. Yes, you have 100% access. Complexity, in general most ETFs are pretty simple. That's good. On taxes, as I pointed out, the ETF wrapper is a great mechanism for deferring taxes. On search, ETFs are transparent. When you go out and try to find a manager, you generally have to know everything that's in their portfolio.

Jason Lank: Jack, I want to perhaps take the other side of this as to whether ETFs check the box so to speak. That's with the C, the complexity. 10 years ago, I think many, many of the ETFs were very plain vanilla and easy to understand and really not complex. As the industry evolves, we're seeing actively managed ETFs, some really interesting strategies, some of them very complicated. As the industry evolves, certainly not all ETFs are homogeneous. Is there a concern in the industry that as we get more and more, in terms of complexity to ETFs, we might start un-checking a box or two?

Jack Vogel: I think that's always a concern. One counter argument to that, though, is on the complexity issue, let's just take an active value manager. They could either do it in an ETF wrapper, or a mutual fund wrapper. Your active value manager in an ETF wrapper, they can't really hide behind this complexity argument where they say they have some proprietary algorithm and they just have the best analysts in the world. The reason is because every single night you can go on their website and see what holdings they have.

Whereas, in a mutual fund wrapper that discloses their holdings only quarterly, they can still kind of hide behind that argument where intra-quarter we're doing some trades back and forth based on our proprietary research. I do think on the complexity, especially if you have to disclose your holdings every day, which you do in an ETF, that argument still is better in an ETF wrapper relative to a mutual fund. On fees, you would have to do a comparison from ETFs to mutual funds, which most people don't do. They just compare apples to apples, ETFs to ETFs. That may take a little more work on an investor standpoint, but I think they would find nine times out of ten that the fees on the ETF are lower than the fees on a mutual fund.

Nate Geraci: We're visiting with Jack Vogel, CFO and Co-Chief Investment Officer at Alpha Architect. We're discussing their new book, DIY Financial Advisor. Jack, on the subject of investment advisors, the book lays out 10 things people don't like about investment advisors. I thought this was a great list. If you don't mind, I'd like to walk through this for our listeners.

The 10 things were 1, they charge too much. 2, you can't understand what they actually charge. 3, they're always trying to sell a company product. 4, they are overly aggressive in recommendations. 5, they constantly change investments. 6, their investment strategy is too complicated. 7, they don't listen to any other opinions. 8, calls to the advisor are secondary to the richer guys. 9, nobody will take ownership of mistakes. 10, investments have poor returns. I think that's a great list. These are all things investors should probably consider when hiring an advisor, or evaluating their current advisor. Should investors just bring this list to their next meeting and make sure their advisor is doing the opposite of everything listed here?

Jack Vogel: Yeah, that's probably a good idea. I would agree with you on that. One thing, if you're going out to find an advisor, obviously the lower the fee the better. You can just do the math. The second one is we would recommend that most investors at least try to really understand what the advisor is doing, which I know for some people can be a painful mental experience. We really recommend for the long term understanding of where your wealth is going, you might what to do that. A lot of people work really hard all day, but when it comes to their investment advice, they just want to defer and just say, "Hey, you can figure it out." We don't really recommend that. We think it's a good idea for everyone to try to understand exactly what's going on.

Nate Geraci: I think that's an excellent point. On this subject of poor investment advice, you mention in the book the mainstay S&P 500 Index Fund A shares. This is a mutual fund. It charges 60 basis points and a 3% front end load. This is just a standard S&P 500 index fund, which you can get much cheaper elsewhere, but this fund currently manages around $2 billion. The point being that somebody is recommending this fund to investors. This is an easier area of investing so to speak. This is large cap U.S. stocks. What does this say about what some advisors may be recommending for more difficult areas of the market?

Jack Vogel: Yeah, I'm sure if they can get away with having $2 billion in a fund that is going to lose by about 55 basis points to Vanguard every single year, when it comes to more complex investment strategies, I'm sure you can make even more money on fees. That's one thing we would just recommend anyone who invests with anyone, including ourselves, or any other advisor, to just truly understand how the advisor gets paid on giving you advice. Make sure if they're giving you advice to go into some high fee fund, you can just ask them. Say, "Are you getting paid to put me in this?" That may help.

Nate Geraci: In terms of the solution your book offers, the Do It Yourself Financial Advisor, in my mind, I sort of boiled this down to 3 key things for investors to focus on. 1, diversification. 2, factor investing, specifically taking advantage of value and momentum. 3, and perhaps most important, using a systematic investment process to protect us from ourselves. I think most investors understand the importance of diversification, just not putting all your eggs in one basket. Let's talk about the last two. First, value and momentum. Can you explain these in layman terms for our listeners? Why are these both important?

Jack Vogel: At a high level, value investing is you buy cheap stock. Academics have studied it. Ben Grahams talked about it. Warren Buffett is a value investing disciple. The whole idea is just systematically you always buy cheap stocks. Academics have found that this out performs, before costs over the long term. With momentum investing, it's kind of a different approach where you basically sort securities on their past 12 month return and you buy the ones that have done well in the past. On one hand you're buying the cheap securities for value investing. On the other hand with momentum, you're buying the stocks that have done really well over the past. One of the reasons we like to combine the two strategies in a separate portfolio, so you run your value portfolio or your momentum portfolio, is academics. We found in our research, has shown that these two factors tend to work well at different times, which is nice.

A quick example is the Internet Bubble, momentum investing worked very well in the Internet Bubble. When the Internet Bubble crashed, momentum was similar to the market. In the Internet Bubble going up to it, value under-performed, but when the Internet Bubble crashed, value investing performed better than the market. We like to just, at a high level, say, "Hey, do 50% value, 50% momentum”, and if you're going to be an active investor, we think they're two of the best bets you can take.

Jason Lank: Jack, I've read value and momentum are the granddaddy of the factors out there. They've worked for decades if not centuries. How can that be if it's so successful, why doesn't everybody jump on the bandwagon and the returns sort of melt away? How can they be effective over decades and decades?

Jack Vogel: That's a great question. I'll just stick to value. There's a similar argument for momentum. I think it's easier to focus just on value. One of the reasons is if you want to be a true high conviction value investor, which is what we recommend you do, as opposed to diversifying your portfolio, you're going to have a large tracking error to the portfolio. A quick example of value and why everyone doesn't do it is if you look in the front page of Baron's in 1999, the quote says, "Warren Buffett is losing his magic touch." Why did it say that?

From 1994 to 1999, for six straight years, value investing under-performed the market. Clearly Barons was looking at Buffett who's a value investor and saying, "Well, this guy's lost his magic touch." You miss the great value investing run from 2000 to 2004. We don't think this will go away in the super long term because there's this thing called a "tracking error." If you're managing someone else's money, imagine going to them and say, "Hey, listen. I know I've under-performed for 6 straight years, but trust me. I'll win next year." You're probably going to lose your job if you do that.

Nate Geraci: Jack, I think the other key point for investors, in your book, and we've touched on this a little bit earlier, is just having a systematic investment process in place. We're not going to get into all the details of exactly what you recommend in the book, but again, can you just explain this for us in layman's terms? What does this mean?

Jack Vogel: With any investment process, as I told you about before, you want to, at the outset, come up with a model. When you're in the battle, the battle being your money's actually live, invested in assets, you want to just simply follow the model. Our model's, we think are pretty simple. Basically, you invest in stocks, real estate, bonds, and commodities. You assess the signals monthly and just follow the model.

Nate Geraci: Jack, with that we'll have to leave it there. Congratulations on the book. We wish you continued success. We certainly appreciate you joining us today.

Jack Vogel: Yeah, thank you very much for having me on.

Nate Geraci: That was Jack Vogel, CFO and Co-Chief Investment Officer at Alpha Architect. You can purchase their new book. Again, the title is DIY Financial Advisor, by visiting alphaarchitect.com.