Even God Would Be Fired | Wes Gray on Bubbles, AI Valuations and Why Size Was Never the Edge

Episode Summary

Executive Summary: Wes Gray argues that factor investing still works when framed correctly: valuation and profitability matter more than size, bubbles and concentration are hard to time, and investors should expect and tolerate underperformance. He also explains how ETF Architect scaled by solving tax, operational, and structural frictions—especially through 351 exchanges—bringing low-cost, tax-efficient ETF wrappers to complex assets and conversions.

Main Topics: Factor investing in bubble/concentrated markets (Priority: 5/5): Gray says markets may be expensive and concentrated, but timing bubbles via valuation is empirically unreliable. Investors should instead diversify, keep fees low, and accept lower expected long-run returns. Value investing, intangibles, and profitability (Priority: 5/5): He criticizes book-to-market as a weak value measure because it captures many unprofitable firms. He prefers earnings and operating income, arguing intangibles are a secondary issue compared with the larger flaw of using book-based value. Small-cap premium and the role of quality (Priority: 5/5): Gray argues the size premium is largely a misunderstanding: small-cap outperformance usually reflects cheapness and quality differences, not size itself. He says many small-cap value studies are distorted by unprofitable junk names. AI, growth, and market efficiency (Priority: 4/5): He sees AI as transformative for productivity and business processes, but believes much of the market’s enthusiasm is already reflected in prices. AI may create short-horizon edge in trading and operations more than in long-term alpha. Behavior, passive investing, and investor underperformance (Priority: 4/5): Gray emphasizes that human behavior remains broadly unchanged, but market access has become more polarized—either disciplined long-term investing or speculative excess. Passive flows likely affect prices, though the precise impact is hard to prove. 351 exchanges and ETF conversions (Priority: 5/5): He explains 351 exchanges as a tax code mechanism allowing property to be contributed into a new ETF/C-corp without immediate tax, enabling tax-efficient conversions of concentrated, low-basis, or operationally messy portfolios into ETF wrappers. ETF Architect’s business model and industry opportunity (Priority: 4/5): ETF Architect scaled by identifying white space in ETF infrastructure: conversions, launches, and tax-efficient structures. Gray sees future opportunity wherever ETFs can reduce costs and improve transparency, especially in areas where Vanguard is not competing.

Key Arguments: Valuation timing is extremely difficult; even if a bubble is obvious, there is little reliable evidence that valuation-based market timing works. Expected returns for expensive, concentrated large-cap growth/quality exposures are likely lower over the long run, so investors should moderate unintended factor bets. Book-to-market is a flawed value metric because many low book-to-market names are unprofitable; earnings-based measures better capture true cheapness plus quality. Small-cap outperformance is not caused by size itself, but by the tendency for small-cap universes to contain more genuinely cheap stocks. The apparent deterioration in small-cap value may largely reflect a quality problem, not the death of the value premium. AI is already materially useful in coding, systems, and productivity, but long-term market alpha may still be hard to extract because prices adjust quickly. Passive investing likely changes supply/demand dynamics, but its exact market effect is difficult to isolate empirically. Underperformance is an expected and even desirable part of earning long-run excess returns because the payoff to a factor or strategy often comes with painful drawdowns. 351 exchanges are valuable because they let investors move appreciated property into ETF structures without immediate tax, improving efficiency and liquidity. The biggest ETF opportunities exist where products can be made cheaper, more transparent, and more tax-efficient than incumbents—especially in complex or hard-to-wrap exposures.

Data Points: ETF Architect platform size: 100+ funds - Gray says the platform has surpassed one hundred funds. ETF Architect assets: $37B+ - The hosts cite the platform as having over $37 billion in assets. 2010: Company origin period - Gray says the business was not originally built around ETF infrastructure in 2010; that line of business emerged later. 2019: Operational inflection point for 351 exchanges - Gray says 2019 was when it became operationally feasible to use 351 exchanges due to regulatory clarification. 25% rule: No single security over 25% - He explains the diversification constraint for tax-free RIC treatment in 351 ETF contributions. 50% rule: Top five contributed securities under 50% - He describes the IRS diversification limit for contributions into a RIC/ETF structure. 20% annual return: Approximate long-run result in the Ben Graham-style backtest - Gray references a historical cheapest earnings-to-price strategy that returned about 20% with high volatility. 20% volatility: Approximate volatility in the referenced value strategy - The same Ben Graham-style strategy is described as having high volatility. 10x liquidity: Equal-weight mid/large-cap vs small-cap comparison - He says equal-weight mid- and large-cap portfolios had roughly ten times the liquidity of small-cap portfolios. 50% profitability rate: Approximate share of small-cap book-to-market names making money - Gray claims only about half of small-cap high book-to-market companies are profitable in some datasets. 80-90% profitability rate: Approximate share of larger book-to-market names making money - He contrasts small-cap value with the broader universe, where far more firms are profitable. 1% mutual fund fee: Referenced legacy fee level - He contrasts traditional mutual fund fees with ETF pricing. 3 bps: Vanguard-like low-cost index fund example - Gray uses this as an example of how cheap a competing passive fund can be. 50 bps: Illustrative ETF fee level - He cites this as a typical ETF cost versus higher-fee structures. 60-70 bps: Current buffered ETF pricing example - Gray suggests there may be room to compress costs in buffered ETF strategies. 30 bps: Potential lower-cost buffered ETF level - He implies some buffered ETF products could be brought down to around this level.

Pivotal Quotes: "You should embrace and enjoy underperformance." — Wes Gray: Closing question on what he believes that most peers would disagree with; he argues drawdowns are part of long-run excess returns. "Valuation timing is insanely difficult." — Wes Gray: His answer on whether investors can do anything in a bubble; he says the information is useful, but not for successful market timing. "Value is what matters, not size." — Wes Gray: His explanation of the small-cap premium and why factor returns are often misattributed to size.

Implications: Listeners should focus on robust factor definitions, profitability, and tax efficiency rather than trying to predict bubbles or chase size effects. For ETFs, the biggest growth comes from converting messy, taxed, or expensive assets into cheaper, transparent wrappers.