Passive ETFs have been a boon for individual investors, giving them an easy way to own the market without accumulating fees, but the impact has gone far beyond the retail market. Your typical hedge fund has to do a lot more work to justify their fees, and the demand for low-cost active management is mostly being met with so-called smart beta, which means paying expense ratios three or four times higher than a passive ETF for what amounts to indexing with a slight tilt.

Last month, Alpha Architect decided to try a different approach with the launch of ValueShares US Quantitative Value ETF (QVAL),

“We’re doing true, high tracking-error active management. We have a forty stock portfolio,” explains Alpha Architect team leader and QVAL fund manager Wes Gray in an interview with ValueWalk. “The only way you can buy this currently is to hire a 2/20 hedge fund or a mutual fund like Legg Mason Inc (NYSE:LM). We’re trying to deliver that exposure at half the cost, and we’re delivering it via ETF so we can minimize your tax drag while they’re gonna send you a 1099 every year.”

Alpha Architect’s five-step process

Gray originally started Alpha Architect as a research firm, but after a few years clients asked him to start managing separate accounts so that he could apply his quantitative value approach directly. The switch to ETFs is primarily for the tax benefits, but it also means that individual investors who don’t have enough to open a separately managed account can also get involved.

“Everyone knows Google Inc (NASDAQ:GOOGL) (NASDAQ:GOOG) is a good company, everyone knows The Coca-Cola Co (NYSE:KO) is a great business, so it’s not like you’re getting any sort of edge there. The stress in cheap is that everyone knows it’s cheap but when they look at the stock they wanna puke. That’s a behavioral reaction that we want to exploit systematically,” says Gray.

To do that, he’s set up a five-step process for identifying value stocks. First, he sets a minimum market cap of $2 billion which, along with some daily liquidity requirements, cuts his starting universe to about 1000 domestic stocks. Next, he applies forensic accounting models that have been shown to predict fraud or future bankruptcy with some accuracy, and cuts any stock that shows up in the bottom five percent of any of those models, which leaves about 900 stocks to choose from.

The third step is both the biggest cut and the point where value considerations come into play. Taking his cue from Ben Graham, Gray rates the stocks by enterprise multiple and keeps the cheapest 10%, throwing out everything else.

Once you’ve whittled the list down from 1000 to 90, all of the stocks you’re looking at are pretty cheap, but they’re also pretty unloved, usually for a reason. At this point, Gray does a two-pronged quality check so that he has confidence that the companies he invests in will still be a going concern for the next couple of years. He starts with what he calls the ‘pre-flight checklist’ including things like quick ratio, free cash flow, and an improving balance sheet. If all ten items are cleared, he looks at profit margin stability, return on capital over the last eight years, and other measures for some indication of economic moat.

Ultimately he ends up with an equal weight portfolio invested in about 40 different securities.

QVAL’s value proposition

QVAL is barely a month old, and Alpha Architect has only been managing accounts with $200 million AUM for two and a half years, and Gray acknowledges that not having a significant track record means taking a chance on QVAL.

“Yes, you do have to take a leap of faith that you believe in the people, the pedigree of the people doing it, and their process,” says Gray.

The Alpha Architect team is made up of industry professionals and a fair number of military veterans (Gray is a former Marine), with a high-powered pedigree: Gray got his MBA and finance PhD from the University of Chicago and his colleagues include a number of Harvard and Wharton MBAs. He argues that ultimately it’s the people, pedigree, and process that drive performance (the four P’s), and that it’s hard to match the QVAL ETF value proposition.

With an expense ratio of 0.79, QVAL is more expensive than your typical ETF, but Gray says that’s not the right comparison to make. With active, high tracking error management he’s really competing with a handful of other high conviction value funds like Tweedy, Browne LLC or Legg Mason, which have fees 100 or 150 bps higher. He also points out that you could invest 90% of your funds in a low-cost passive ETF like the Vanguard S&P 500 and the other 10% in QVAL for an overall cost of about 8bps, in a sort of do-it-yourself smart beta strategy, well under the 40+ bps you would typically have to pay.

He’s also not worried about people cloning his portfolio since their just going to get killed by taxes at the end of the year, paying at least four time as much as they would if they had simply invested in QVAL to begin with. He recommends that investors put their bonds in their IRA accounts and invest in equities via ETFs to stay tax deferred basically indefinitely.

Interview With Wes Gray: The Five Step Process Behind The QVAL ETF