Until Bill James's Sabermetrics won wider acceptance, immortalised by Michael Lewis in Moneyball in 2003, Major League Baseball players were rated by subjective talent scouts and a few basic statistics. James first defined Sabermetrics as "the search for objective knowledge about baseball" in 1980, but it took over 20 years for it to be accepted as a powerful tool for rating players and understanding their impact on the financial side of the game.
What does this have to do with understanding investing? As with baseball and Sabermetrics, technology has enabled a new breed of asset manager to connect in a more meaningful way with the end investor.
Explaining asset management is like explaining baseball
Although I've lived outside the US for 18 years, I can't let go of baseball. Friends in London and Ireland laugh and say "it's a kids' game", remembering days spent playing rounders in short pants. That is, until I tell them how hard it is to use a round bat to connect with a round ball coming at you at 100mph. Ted Williams, arguably the greatest hitter who ever lived, took nearly five years off from baseball to be a fighter pilot in two wars, because his eyes and reflexes were that good. If your eyes are good enough to hit a baseball 40% of the time, it makes sense that you can pick off a few enemy fighters.
I discovered Sabermetrics in the 1980s, and it was complicated back then. Sabermetrics looks at the minutiae of every event on a baseball field and turns them into meaningful metrics. As its use in the front offices of MLB franchises grew, so did its commercialisation, with the likes of Moneyball.
Keeping things simple
On Episode 173 of the Fintech Insider podcast, Shaun Port from Nutmeg said: "those who sell complicated things tend to keep them complicated. We like to simplify things and make them accessible." That has worked for Nutmeg, and it worked for Michael Lewis. With Moneyball, Lewis took something very complicated and wove it into a story (and a movie) about the Oakland Athletics. It made him millions.
"It never occurred to anyone in the market for baseball players to assign values to the minute components of a baseball player's performance, until baseball players became breathtakingly expensive." Michael Lewis, Moneyball
Active asset management is still complicated and expensive, as is running a baseball franchise. Among other things, you need to be a master of data and fundamentals to succeed at either. Explaining asset management is like explaining baseball to one of my Irish or English friends: it's going to take a long time, and it's not going to be very exciting. When you get to play the game, or even just watch one, it all makes sense. But like my friends on this side of the pond who don't watch baseball, not everyone gets to watch asset managers in action.
Educating investors
People new to investing generally understand percentage returns and fees, but once you start talking about alpha, beta, Sharpe ratios and tracking error, they get lost. It's like when I start explaining batting average, slugging percentage and runs batted in to my Irish and English friends. When their eyes glaze over, you change the subject, or show them a YouTube video. But without knowing how to separate the All Stars from the benchwarmers, you're not going to pick the winning team.
The asset management industry is changing faster than people realise. The demographic that generates 90% of asset manager revenues is driven largely by professional investors such as pension funds, other institutions and wealth managers. These professional investors pool the wealth of individuals into bulk investments with multiple asset managers, and charge fees on top of the asset manager's fee for their services.
New options for asset management
Since the global financial crisis, new options have emerged. Robo-advisors let individuals bypass institutions and their fees and invest directly in asset managers' funds. Robo-advisors such as Wealthfront, Nutmeg and Scalable Capital pair your appetite for risk with their own algorithms to propose a portfolio of low-cost funds. Many take great care to provide educational resources to bring you up the curve, as it's in their interest as well as yours. Some take a hybrid human and robo approach; others are all robo.
Outside of robo-advisors that make the decisions for you, you can do your homework and build your own portfolio through platforms like Fidelity, Hargreaves Lansdown or DeGiro. How do you pick the right asset managers and funds, though? All those YouTube videos and metrics will leave your head spinning. How do you find useful, meaningful, easy-to-understand metrics that let you invest on your own?
What metrics do asset managers use?
The key people in an asset management shop are the portfolio managers who make the day-to-day investment decisions. The best ones outperform the markets regularly by having a good strategy and executing it with intelligence, instinct and intuition. Jason Voss from the CFA Institute explains these "3 i's" well here.
Portfolio managers are more like the manager of a baseball team than a player, though. The best score high on the 3 i's, but without coaches and a team, they can't execute. Sabermetrics has made some very useful measures commonplace, and my favourite is WAR, or Wins Above Replacement, the Monte Carlo simulation of baseball. WAR measures the number of wins a single player is theoretically responsible for across a 162-game season, compared to an average player. It's the basis for all kinds of metrics, even the financial projections for individual teams. Like the portfolio manager and the 3 i's, a player's rating means nothing without their team.
WAR rating vs. star ratings
Could there be a WAR-type rating for investment funds? Fund-rating houses have their star ratings, but you need a finance degree to understand what goes into them. What's the difference between a cheap 3-star fund and an expensive 5-star fund if I'm only investing to save for a property? The rating house will tell me to ask my financial advisor.
Can I tell you what goes into a WAR rating? Some of it, maybe, but it doesn't matter. Because I'm a baseball fan, I understand the context of a player with a WAR of 10 versus one with a WAR of 2, and it's immediately meaningful to me. Without my finance degree, I can't make sense of the difference between a 3-star and a 5-star fund. I know five stars beat three, but in what context? Should I put all my money into 5-star funds?
Beyond star ratings, the traditional fund metrics are percentage returns and fees: how much money is the fund making me, and how much am I paying for it? Baseball's historical stand-bys are batting average, home runs and runs batted in, and next to WAR they're myopic. The old-school stats are fun to track, but like returns and fees, they can hide a player's true flaws.
"[We're] looking at the places where the stats don't tell the whole truth, or even lie about the situation." Jack Armbruster, derivatives trader, quoted in Moneyball
Beyond the stars
A portfolio manager friend tells me that metrics like hit ratio and win/loss ratio are commonplace inside asset management shops, but individual investors rarely hear about them. Hit ratio measures how often a portfolio manager makes good decisions versus bad ones. Win/loss ratio measures how much money they made on the good decisions versus how much they lost on the bad ones. A portfolio manager might be right more often than wrong (hit ratio), but unless they time the market and take big enough bets, they won't make much money for you (win/loss ratio).
Will asset managers produce a WAR-type rating any time soon, one the average investor can immediately relate to? I'm hopeful, but asset managers rely heavily on institutional investors and wealth managers to inform and onboard the end investor. Those are professional investors, qualified to explain the merits of one asset manager over another, for a fee.
Why is this important?
With the intergenerational transfer of wealth underway from Baby Boomers to Gen X and Millennials, asset managers and wealth managers want to remain the caretakers of whatever is handed down, because billions of dollars in fees are at stake. The transfer itself will trigger a decision about what to do with the money. Forever the optimist, I think we'll see asset managers connect more closely with their end customers' needs, take an interest in hand-holding through the wealth transfer, and reach new demographics in the process.
Will it be hit ratio and win/loss ratio that asset managers turn into a metric that connects with new demographics? There's a considerable distance between asset managers and the end investor, so trying too hard to reach them is like the Boston Red Sox trying to make fans of my Irish and English friends. The Red Sox don't target that demographic, just as asset managers rarely market directly to individual investors.
Asset managers leave it to their distribution partners, the institutional investors and wealth managers, to reach the end investor. (There's a little regulation called MiFID that matters here too, but we won't get into that.) These partners understand the key metrics, but they're too far from the portfolio management process to field questions on one manager's hit ratio versus another's.
Why do people buy what they buy?
We covered this on Episode 173 as well: the average investor doesn't think "I need to buy an investment fund" based on its product features. It's more "I'd like help achieving my financial goals." In a conversation with a friend from India, I mentioned the Windermere Hierarchy of how people make buying decisions. He brushed it aside, telling me that where he comes from, people buy based on the emotion a product or service triggers, or how it makes them feel.
Jason Bates, one of the co-founders of 11:FS, talks about "surprise and delight" in user experience. Those sound like feelings to me. Tom Blomfield from Monzo points to an "I want that too" feeling. I've spent a fair amount of money on the Boston Red Sox over the years, and I'll keep doing it, because of how the experience makes me feel. Wins and losses, WAR ratings, All Stars and benchwarmers are all product features that deliver the outcome: a passionate baseball fan.
Making investing accessible
Moneyball is just a book, and a good movie to watch on a plane. Reading it made me appreciate the business of baseball and how technology can make the financial side of the game accessible to the average fan. How can asset managers use technology to make the fun side of investing accessible to the end investor? And how do you build new digital propositions without burning bridges with your distribution partners?
Borrowing a page from the digital banks, the key is to build new propositions for new customers. Serve the underserved.
Originally published by 11:FS on 30 January 2018, when Pete was Asset Management Lead at 11:FS.
