Moneyball for Mutual Funds

Back in college, I received an open-ended final assignment in my statistics class: find some interesting data, clean it up, analyze it, and look for meaningful connections.

Knowing that my professor, like me, was a baseball fan, I did a little experiment. I took a random sample of baseball players, and then evaluated whether their salaries were correlated with their future production. There was one major outlier: the weak-hitting shortstop Rey Ordóñez, who was paid almost entirely for his glove. I eliminated Rey because his combination of high salary and feeble bat would have skewed the entire analysis significantly. Yet even after making this adjustment, the results were clear. Salaries and production were completely uncorrelated. Baseball owners and general managers were misusing their resources and failing to get meaningful returns on their investments.

Of course, while I was doing my rudimentary analysis, the groundwork was being laid for a revolution in how value was measured in baseball. Today, so-called sabermetrics have overtaken the game, and every team now employs them when evaluating talent and making contract decisions. Billy Beane, whose strategies gained notoriety in the book Moneyball and the subsequent film of the same title, was one of the first to implement such strategies, which has allowed his shoestring-budget Oakland A’s to compete with the New York Yankees and other titans of Major League Baseball for over a decade.

At Palisades Hudson, the bulk of our client portfolios are invested in mutual funds. You can find just about any data point imaginable with mutual funds, just as you can in baseball. And, like baseball statistics, there are mutual fund data points that are either overvalued or undervalued by investors. The mistakes investors make when evaluating mutual funds have a lot in common with the mistakes that Beane continues to exploit.

Overrated: mutual fund past performance and high school baseball players. With mutual funds, make sure to look at a fund’s dollar-weighted returns, which reflect the returns its investors actually achieved. For example, a tiny fund can have a great year, be showered with cash from its investors, and then have a string of bad years. You should be wary of these “one-year wonders,” even if the one year was a blowout. Similarly, Beane popularized the idea of drafting college athletes, rather than high school athletes, because of their longer, more meaningful track records.

Underrated: mutual fund diversification and drawing walks. In investing and in baseball, there is a benefit to being able to zig when others zag. The more diversified a mutual fund is (whether by industry, region, size, etc.), the lower its likely risk, which can lead to higher long-term returns. Similarly, while many baseball players seem to hack at every pitch, the walk can be a powerful weapon. A team of patient batters is more likely to succeed against a dominant pitcher. They will get more runners on base than a team of sluggers, which will in turn improve the odds for more runs and, ultimately, more wins.

Overrated: Morningstar star ratings and baseball players’ appearance. There are no shortcuts when analyzing data. Some investors may see that a mutual fund has a four-star Morningstar rating, and that is where their analysis ends. Similarly, baseball general managers have a history of preferring handsome, athletic-looking players and avoiding the not-so-handsome or unathletic players. Beane chose batters others thought were too fat to compete and pitchers with bizarre throwing motions, shunned by other teams. By digging past the surface, he found value where others didn’t.

Underrated: mutual fund 2008 performance and pitcher strikeouts. Sometimes it all comes down to how you performed during crunch time. Where mutual funds are concerned, 2008 saw too many blowups that could have been avoided. It was one thing for funds to decline alongside the broad markets, but some funds didn’t keep an eye on risk controls and did irreparable damage to their investors. Beginning next year, the 5-year performance of mutual funds will no longer include 2008, but that measure will continue to be valuable to those who take the time to review it. Similarly, for a pitcher to avoid a blowup, sometimes he needs a strikeout. Since the difference between a shallow pop-out and a gargantuan home run can be as little as a fraction of an inch, the ability to throw pitches that avoid the bat altogether is extremely valuable.

Overrated: mutual fund manager tenure and stolen bases. To be clear, both of these metrics have value and should not be ignored. But they can be overvalued and, as a result, overpriced. Many mutual funds are managed by a team or by a manager that is assisted by a team of analysts. A fund may have had the same manager for decades, but is he really the brains of the operation? Sometimes these managers focus more on selling their fund to investors than on picking the actual investments. Similarly, a stolen base has value, but speed is a commodity that can be found in many, many players. Attempted stolen bases can also lead to outs. Considering you only get 27 outs in one game, losing them to unnecessary stolen base attempts hurts a team’s chance of winning.

Underrated: mutual fund expense ratios and OPS (on base plus slugging percentage). Ignore these measures at your own risk. A mutual fund’s expense ratio is the best predictor of its future returns. The lower the expenses, the more likely a fund is to outperform. So why would anyone invest in a fund with a 5 percent load or a 2 percent expense ratio, when there are low-cost, quality funds available in virtually every asset class? Expense ratio should be the first thing an investor considers when evaluating a mutual fund.

Similarly, while few baseball fans are familiar with OPS, it is a much more useful measure than batting average, home runs, RBIs or the other statistics that we fans grew up with. By adding on-base percentage and slugging percentage, one can measure a player’s ability to both get on base and hit for power, weighting both equally. Simply put, a player with an OPS of .900 or 1.000 is an MVP-level player. And unless a player is playing gold glove-level defense, if he has an OPS below .600, he probably belongs in the minor leagues (or should look for a new profession). Hardcore sabermetricians constantly work at coming up with even better measures of player value. But OPS is a great place to start.

As the amount of data accessible to us continues to grow, our challenge becomes less about finding the relevant data and more about what we do with it. Our biases can play into how we make decisions and analyze data, from investing to sports. Even if you’re not the general manager of a baseball team, you still make thousands of decisions every day, based on data you may over- or undervalue. Think carefully, and use your knowledge to allocate your resources wisely. Let others overpay for the Rey Ordóñezes of the world.