What ‘Moneyball’ can teach advisers about better portfolio construction

By focusing on market diversification, you can more easily build winning portfolios based on objective data.

“We’ve got to use every piece of data and piece of information, and hopefully that will help us be accurate with our player evaluation. For us, that’s our life blood.” — Billy Bean, subject of “Moneyball: The Art of Winning an Unfair Game”

This quote provides an invaluable lesson to financial advisers as we seek better portfolio construction. As in baseball, accurately evaluating investment strategies — the players — is an adviser’s life blood. Yet, our industry is plagued by sub-optimal evaluation strategies that challenge our ability to connect the best “players” to each portfolio.

It’s time to take a page from Moneyball to identify the true determinants of portfolio performance.

In 2002, Oakland A’s GM Billy Beane and assistant Paul DePodesta shed light on a warped player evaluation system, reinventing the method for building a winning team, or as I like to think of it, a portfolio.

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The mainstream methods for projecting offensive production — batting average, runs batted in (RBIs) and stolen bases — were incorrect.

Taking an objective look at the data, Mr. Beane and Mr. DePodesta found that the less regarded on-base percentage and slugging percentage more accurately determined offensive success (portfolio performance). They even identified trading inefficiencies, where managers tend to overpay for overperforming players. As performance reverts to the mean, returns are diminished by the inflated price tag.

HOW IT APPLIES TO YOUR ADVISORY FIRM

Our industry is faced with similar challenges, but they are harder to spot because we have a stake in the game. Too often outdated and subjective methods are used to evaluate portfolios. Both advisers and clients tend to overpay for overperforming assets, only to be left with frustrating returns.

Like player evaluation, asset allocation is regarded as the best determinant of portfolio performance. Yet, a closer look at the data clearly states otherwise.

In 2010, Roger Ibbotson (our Billy Beane/Paul DePodesta) took an objective look at the determinants of portfolio performance. He found that despite its popularity, asset allocation had a minimal effect on overall performance.

Rather, 80% of performance is driven by market movement, regardless of asset allocation mix. Like on-base percentage and slugging percentage, market movement is a more accurate determinant of performance.

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HOW TO BUILD A WINNING TEAM

By revising your investment strategy to focus on market diversification, you can more easily build winning portfolios based on objective data.

Encourage clients to think about the true determinant of performance — movement of the market — to better select players for their portfolio. Broaden their focus beyond recent trends, understand their projected behaviors in each cycle and select strategies that align with those behaviors.

There are three types of players that can work together to create a winning team, all of which excel in different areas of the game.

Strategic: This player has the highest offensive potential, with full market participation and volatility, but is also subject to a slump.

Tactical: This player can grind, finding select opportunity when the game is rocky (sideways or fully valued markets).

Liquid Alternative: This player performs well off the bench, with little to no correlation to the other players, performing when the rest of the team is working through a slump.

Preparing your clients for market cycles with the right blend of these distinct strategies can help optimize portfolio performance.

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GAME PLAN

• Guide investors through the risk assessment process. Explain the importance of finding the right player-mix for their team.

• Show the stats, or performance, for each player. Past performance may not project future results, but helping clients understand the role each investment played validates your strategy.

• The game is cyclical. Every player experiences ups and downs. Help clients understand that paying a premium for a trending asset is risky.

• Maximizing each pick is critical to winning the game. Our league is competitive. It is key to rely on objective market analysis. Don’t let emotions influence your roster.

Beyond improving your investment strategy, playing Moneyball in your advisory practice helps you tell a more compelling story. You can easily validate each investment decision, assuring clients that your guidance is rooted in objective, data-driven reasoning they can understand.

Your clients will love the clarity, reliability and simplicity of your strategy.

Gary Manguso is vice president, product strategy at FTJ FundChoice, a turnkey asset management program headquartered in Hebron, Ky.