Notes from the Diamond #3: Everything Has Its Price


Trivia question #3 of 108: From how many ballgames was former Baltimore Orioles manager Earl Weaver ejected before the first pitch had been thrown?  Answer in main text.  

“Baseball has everything” – a former Yale baseballer (identified below) who sank into politics

Off the Wagon.  By all accounts, Paul “Big Poison” Waner was one tough sumbitch.  Like his younger brother Lloyd — known as “Little Poison” — Paul was also a fine ballplayer, despite or perhaps because of his heavy drinking.  In fact, Big Poison boozed so habitually that the team for which he played for most of his 20 years in the big leagues, the Pittsburgh Pirates, included an abstinence clause in Waner’s contract one year — a clause the team waived proactively within weeks of its adoption when Waner’s slumping performance suggested he played better off the wagon than on it.  Big Poison’s interests having been realigned with those of his employer, he went on to complete a playing career that landed him in baseball’s Hall of Fame.  Little Poison made the Hall of Fame too, having smacked enough hits that, when combined with his brother’s, put the Waners atop the list of siblings with the most total career hits, the most accomplished trios in major league baseball (MLB) history — the Alous and DiMaggios — not excepted.[1]

Paul and Lloyd Waner in 1932

Extremely Difficult.  Why didn’t Pirates management foresee that inducements aimed at enhancing Big Poison’s play would have the opposite effect?  Perhaps it should have.  But those of us who’ve spent substantial time negotiating performance-based incentives (PBIs) — as principals, agents or both — are perhaps more inclined than others to give Waner’s misguided overlords a break: excepting only rare cases in which principals and those working for them wield both uniform metrics for gauging success and uniform time horizons for assessing its pursuit, devising effective bonus schemes for highly trained professionals is extremely difficult.  Indeed, relative to other purely cerebral challenges in both money management and baseball, structuring incentives for such pros that do more good than harm on balance is the administrative equivalent of what the ballplayer who did it more reliably well than anyone in his own time or since (Ted Williams) called “the single most difficult thing to do in professional sports”: using a bat to hit baseballs thrown by major league pitchers.

To help younger players do at least passably well what he himself had done so expertly, Williams devised the colorful graphic shown here for his classic how-to book The Science of Hitting — essentially a payoff table denoting the probability that a skilled batsman like himself would notch a hit when swinging at a ball pitched into each of the 77 discrete positions comprising the strike zone for a batter of his size (i.e., seven balls wide, eleven balls high).  Beyond simply wanting to introduce this intriguing chart to readers who’ve not seen it before, I’ve included it here because the logic underlying it has aided my own work as an allocator over the years, informing decisions respecting the deployment of both human and financial capital as well as corollary choices respecting incentives for investment pros to whom I’ve entrusted clients’ capital or my own.  

Immutable Conditions. What lessons about incentivizing highly trained pros have I learned along the way?  Among others, I’ve learned that it’s essential to keep personality traits plus other immutable boundary conditions governing a given principal-agent relationship foremost in mind when structuring it, adjusting not merely tactics but strategies to suit such conditions.  Williams did precisely this in determining not merely how to apply his bat to a given pitch but whether to swing at all.[2] Of course, Teddy Ballgame (as Williams was known) didn’t publish the aforementioned bible for batters until after his playing career ended, either because he felt he was learning important new lessons about hitting even as his career wound down, or because Williams wanted to maximize his competitive edge until he hung up his cleats, or perhaps both.  Dunno.  What I do know is that I myself still have lots to learn about the art and science of structuring effective principal-agent relationships in money management; and I hope without knowing for sure that I’ll be engaged in such work for many years to come — if not until the anticipated Hall of Fame induction of the current Bosox player whom Williams likely would have most enjoyed mentoring, then at least through the end of what’ll hopefully be a storied MLB career for the player in question, a 26-year old wunderkind whose parents deliberately and presciently gave him the initials MLB.

How many more years will devotees of MLB (the game if not also the man) have the pleasure of watching Marcus Lynn “Mookie” Betts play before the mandatory five-year waiting period for his election to baseball’s Hall of Fame commences?  Again, dunno, nor does anyone, MLB the man not excepted.  More to the point of this note, to what extent has Mookie’s Williams-esque dominance of statistical measures of big leaguers’ output been the product of specific contractual incentives aimed at eliciting such results? I doknow the answer to that question, and reveal it below, after revealing a few (for now) of the things I’ve learned about the use and abuse of PBIs as a longtime student of both money management and baseball.

Readers looking for additional (or alternate!) sources of wisdom or experience on contractual arrangements in money management will find well-crafted papers on it by academics here, here and here, and by practicing accountants or attorneys here, here and here.

Thing 1 — Don’t Whip A Winning Mount.  Of the countless available photos of Hall of Famer Joe Torre — the only major leaguer to achieve both 2,000 hits and 2,000 wins as a manager — I chose the one included here for two reasons: (1) Torre appears not in the uniform he wore while leading the New York Yankees to the playoffs in 12 consecutive seasons but rather in the uniform he donned after telling the Yankees to take a hike; and (2) conveniently for me, Torre appears alongside another gifted manager on whom my second thingy (below) focuses.  Why did Torre swap Yankee pinstripes for Dodger blue in 2008?  He did so for several reasons, the decisive one arguably being Yankee management’s insistence that he swap a material portion of his base pay for the opportunity to earn certain performance-based bonuses: so many dollars each for winning divisional or league titles, or the World Series, were he to continue piloting the Yanks. Perfectly sensible, no? 

Try senselessTorre having already guided the team to nine divisional titles, six league titles and four World Series crowns as their manager, without any such discrete incentives having comprised part of his compensation.  In short, not only didn’t Torre neither want nor need such PBIs to do his best work, the mere suggestion that they form part of his contract insulted him to the point that he took his talents elsewhere, ultimately guiding the Dodgers to divisional titles in 2008 and 2009 en route to his 2,326th and final career win as a manager in October 2010.

The lesson for capital allocators in the Torre-centric tale just told?  Don’t assume money managers who prefer more stable pay constructs over those entailing potentially sizable but contingent bonuses lack the right stuff, with the latter defined broadly to include both the ability to do stellar work and innate confidence in their capacity to do so.  Believe it or not, some of the most skilled and trustworthy investment pros with whom I’ve worked and continue to partner are quite content to earn relatively stable incomes financed solely via asset-based fees, relatively being highlighted to acknowledge that asset-based fees on portfolios comprising volatile assets can fluctuate materially, especially if the capital being deployed emanates from clients with dispositions as volatile as the late Earl Weaver’s.  In his 2,540 games as manager of the Baltimore Orioles over 17 seasons (1968 – 82 and 1986), Weaver evinced enough angst about the proceedings to get himself ejected 91 times, including ejections from both games of a doubleheader three times and from two games before they’d even started.  I don’t know who had the privilege of managing The Earl of Baltimore’s money, but I don’t regret that I wasn’t part of what was likely a long and ever-changing line of such cats.      

Thing 2 — Don’t Underestimate Primal Needs.  Readers clued into the 2018 MLB playoffs now unfolding will be familiar with the neo-modern strategy known as bullpenning: reducing the edge that batters typically gain when facing a given pitcher multiple times by rotating hurlers more frequently than the typical 20th century manager or indeed 21st century starting pitcher would cotton.  I’ve labeled bullpenning “neo-modern” because no less a baseball sage than Hall of Fame manager Tony LaRussa deduced the merits of strict pitch counts a quarter century ago, putting them into practice as skipper of the Oakland Athletics in 1993.  Alas, as is true of many pioneers in money management as well as baseball, LaRussa was so early with his innovation —and so deficient in anticipating its corrosive effect on the karma of the players whose performance he sought to boost — that he was compelled to abandon bullpenning after a handful or so of games. 

Why did LaRussa’s strategy fail?  Because the 50-pitch limit it entailed made it nigh impossible for starting pitchers to meet MLB’s five-inning threshold for notching wins.  To be sure, as the analytics-laden execs inhabiting most MLB front offices and indeed dugouts these days would readily attest, LaRussa’s strategy indisputably enhanced his team’s odds of achieving its cardinal goal of winning as many games as possible.  But this same strategy conflicted squarely with the cardinal goal of the very people on whom its successful execution most relied: pitchers whose longer-term earnings prospects depended heavily on the number of wins they personally racked up.

Today’s Starting Pitchers Almost Never
Complete What They Begin

Why didn’t LaRussa have the As’ front office rework his pitchers’ contracts to achieve fuller if not perfect alignment of their interests with those of the ballclub for which they labored?  Prior to the sea change in labor relations in pro baseball unleashed by the de facto repeal of MLB’s so-called reserve clause in 1975, the As might have attempted if not actually executed such a paradigm shift, big leaguers being essentially beholden to the teams that employed them unless and until a team chose to trade a player for other talent and/or cash.  Since the advent of free agency for most major leaguers in 1975, however, a preponderance of such players and especially those lacking the 6+ years of MLB service on which unfettered free agency is preconditioned have focused less on dollars actually received under their current contracts than on dollars potentially received from their next contract, and the one after that (if there is one), and the one after that (ditto), ad libitum, until they hang up their cleats a final time.

It doesn’t take someone as bright as the Oakland pitcher who objected perhaps most strenuously to LaRussa’s platooning scheme, former Yale star and current MLB broadcaster Ron Darling, to understand why a preponderance of big leaguers — assumedly those below the MLB average age of 29 years plus older guys who sense their playing abilities are peaking — focus more on putting up stats that’ll impress potential future employers than on doing things that’ll merely help their current ballclubs win: in present value terms, earnings derived from contracts not yet signed typically dwarf those derived from current arrangements, an increasing fraction of which have so-called opt out provisions that enable players who perform especially well over a given interval to shift voluntarily from one team to another willing to pay them bigger bucks.

Thing 3 — Don’t Confuse Skill and Luck.  Why don’t MLB teams mitigate the misalignment of interests just described via baseball-oriented analogues to the two-part fee structures that institutional investors use so commonly to apportion financial risk between managers they employ and themselves?  Two and twenty, anyone?  C’mon now, if you owned the Red Sox (to pick a major league team at random) and could pay ace Bosox pitcher David Price $2 mill (sic) in base pay plus $20k for every strike he throws in regular season games in 2019, wouldn’t you prefer that gamble to paying Price the flat $31 mill his current contract specifies?  Inked in late 2015, that contract is the richest in baseball history for a pitcher, paying Price $217 million for seven seasons’ work, with an opt-out for Price after the 2018 playoffs wrap up.  Given Price’s generally strong but somewhat uneven performance since executing his current contract, it’s unlikely he’ll exercise his opt-out, and unlikely too that he’ll pitch well enough in 2019 to make him wish he’d negotiated the 2 and 20 scheme hypothesized above.  To be precise, if such a scheme were to be implemented for 2019, Price would have to toss 1,450 strikes to earn $31 million.  Possible?  Sure, Price having thrown 1,765 strikes in 2018.  Probable?  I’d take the under on that bet, fully aware that if our hypothetical “2 and 20” scheme were in place and Price were to throw the same number of strikes in 2019 as he did in 2018, he’d earn $37.3 million or 20% more than the $31 million the Bosox are legally obliged to pay him.     

In theory, as with contracts governing investment advisory services, there are countless ways of apportioning risks in MLB player contracts, the dollars to be paid on a guaranteed or contingent basis being infinitely adjustable and the metrics used to compute contingent bonuses being limited only by the imaginations of the parties involved or quant jocks employed by them.  In reality, however, just as parties to money management contracts are constrained by laws and regulations from apportioning risks as they might ideally wish, MLB players and teams are constrained in contract negotiations by an even thicker patchwork of constraints, including especially a Collective Bargaining Agreement (CBA) that prohibits player bonuses based on statistical measures of on-field achievements.

Interestingly and perhaps shockingly to some readers, such prohibited measures include not only traditional and familiar “stats” like a pitcher’s wins or earned run average (ERA), or a batter’s home runs or runs batted in (RBIs), but most elements of the large and growing universe of “advanced” stats that baseball wonks like yours truly enjoy tracking.  (See the table of selected stats for David Price below to get a general sense of how wonky this stuff can get.)  Why does MLB’s current CBA prohibit player bonuses based on statistical measures of on-field achievements?  It does so because bonuses of that sort would be highly susceptible to gaming — by team owners no less than players, teams being subject to salary caps that some owners sought to evade via bonus schemes so artfully drawn that MLB owners as a group adopted strict limits on such hijinks several years ago.  Of course, performance-based bonuses in money management are also highly susceptible to gaming, mostly by money managers as distinct from clients, the latter having few tools at hand to mess up incentive fee schemes outside of too-frequent calls and emails about recent returns that bring managers’ worst behavioral tendencies to the fore.

2008 Rays (A+) 4 0 0 6 6 34.2 9.61 1.82 0.00 0.311 80.0% 49.4% 0.0% 1.82 1.67 2.26  
2008 Rays (AA) 7 0 0 9 9 57.0 8.68 2.53 1.11 0.247 93.9% 57.7% 15.9% 1.89 3.98 3.19  
2008 Rays (AAA) 1 1 0 4 4 18.0 8.50 4.50 0.00 0.393 67.7% 52.7% 0.0% 4.5 2.93 3.76  
2008 Rays 0 0 0 5 1 14.0 7.71 2.57 0.64 0.205 79.4% 50.0% 6.7% 1.93 3.42 3.9 0.2
2009 Rays (AAA) 1 4 0 8 8 34.1 9.17 4.72 1.31 0.261 67.5% 42.0% 18.5% 3.93 4.66 3.57  
2009 Rays 10 7 0 23 23 128.1 7.15 3.79 1.19 0.268 68.5% 41.5% 11.1% 4.42 4.59 4.43 1.3
2010 Rays 19 6 0 32 31 208.2 8.11 3.41 0.65 0.270 78.5% 43.7% 6.5% 2.72 3.42 3.83 4.2
2011 Rays 12 13 0 34 34 224.1 8.75 2.53 0.88 0.281 73.3% 44.3% 9.7% 3.49 3.32 3.32 4.4
2012 Rays 20 5 0 31 31 211.0 8.74 2.52 0.68 0.285 81.1% 53.1% 10.5% 2.56 3.05 3.12 5.0
2013 Rays (A+) 1 0 0 2 2 7.1 14.73 3.68 0.00 0.267 71.4% 57.1% 0.0% 1.23 1.2 1.48  
2013 Rays 10 8 0 27 27 186.2 7.28 1.30 0.77 0.298 70.0% 44.9% 8.6% 3.33 3.03 3.27 4.4
2014 2 Teams 15 12 0 34 34 248.1 9.82 1.38 0.91 0.306 72.7% 41.2% 9.7% 3.26 2.78 2.76 6.0
2015 2 Teams 18 5 0 32 32 220.1 9.19 1.92 0.69 0.290 78.6% 40.4% 7.8% 2.45 2.78 3.24 6.5
2016 Red Sox 17 9 0 35 35 230.0 8.92 1.96 1.17 0.310 73.6% 43.7% 13.5% 3.99 3.6 3.52 4.5
2017 Red Sox (AAA) 0 0 0 2 2 5.2 12.71 3.18 1.59 0.524 39.7% 23.8% 11.1% 9.53 3.87 3.52  
2017 Red Sox 6 3 0 16 11 74.2 9.16 2.89 0.96 0.278 77.0% 39.9% 9.8% 3.38 3.64 4.2 1.6
2018 Red Sox 16 7 0 30 30 176.0 9.05 2.56 1.28 0.274 77.3% 40.1% 13.2% 3.58 4.02 3.95 2.7
Total   143 75 0 299 289 1922.1 8.68 2.32 0.90 0.287 75.2% 43.6% 9.9% 3.25 3.34 3.46 40.7

Selected Advanced Stats for MLB Pitcher David Price (courtesy of FanGraphs)

Wait: with so many well-schooled pros plying their trades in the money management arena, why haven’t the best among them devised bonus schemes not susceptible of gaming to an extent intolerable to any interested parties?  They have, I’d suggest, and will discuss such schemes in later notes.  That said, I’d also suggest that even well-engineered schemes tend to do more harm than good from a principal’s or client’s perspective when the metrics on which bonuses are based are ill-conceived.  The next note in this series will focus on such misconceptions, looking at them through the prism of the ongoing and unwarranted efforts by the world’s largest educational endowment to produce returns rivaling those produced by Ron Darling’s collegiate alma mater.  As we’ll see, if the powers-that-be at Harvard want to hold their own feet as well as those of the endowment’s hired guns to the fire in a manner that’ll truly advance the university’s long-term interests, they’d adopt metrics different if not radically different from those they’ve customarily employed to assess the endowment’s evolving performance. 

Room for Improvement.  Speaking as we just were of unconventional metrics, if one were designing an optimal bonus scheme for a big league pitcher like David Price and weren’t subject to the constraints on player contracts imposed by the aforementioned CBA, one would almost surely not use an imperfect measure like pitches hitting the strike zone as the sole metric on which bonus payments depend.  (Revisit the graphic at page 2 to imagine the pounding a big league pitcher might undergo if he hurled pitches only into the sub-zone framed by dotted red lines.)  Just as there are sounder metrics for assessing the evolving performance of Harvard’s endowment and indeed most institutional funds than the metrics currently favored by such funds’ overseers, so too are there sounder metrics than such familiar stats as wins or ERAs for measuring a pitcher’s skillfulness. 

Note that our focus here is skill or the lack thereof, as distinct from results per se, the latter obviously reflecting — in baseball no less than in money management — factors beyond the control of the performer being judged.  Interestingly and perhaps unsurprisingly given plummeting IT costs and the “big data” revolution they’ve helped spawn, baseball-obsessed statisticians have worked up in recent years a host of “defense independent” measures of pitching prowess, including some shown in the accompanying table dissecting David Price’s exertions (e.g., FIP and xFIP).[3]

Could analogous metrics be devised to help allocators do a better job of distinguishing skill from luck in money management?  Some investment pros would argue that they’re already being judged and indeed compensated via such enlightened metrics, e.g., the manager of a sector-focused hedge fund whose carry or incentive fee is based on the fund’s performance relative to a sector-specific benchmark, or the CIO of an endowment whose bonus depends on her fund’s performance relative to an agreed-upon “peer” group of institutional funds.  I don’t think such arguments are entirely without merit.  But there’s almost as much room for improvement in the methods used to evaluate investment pros circa 2018as there was for improvement in the methods used to evaluate baseball pros when the Sabermetrics revolution began in the 1970s.

Open Question.  We’ll leave open here a crucial question that later notes will address, namely whether and to what extent methods of evaluating investment talent superior to those most widely employed today might usefully focus on qualitative rather than quantitative factors.  Advanced analytics like those depicted above having become table stakes for MLB franchises since the 2004 World Champion Red Sox showed the world how powerful such methods can be, baseball’s best minds including perhaps most conspicuously former Bosox general manager (2002-2011) and future Hall of Famer Theo Epstein are increasingly focused on qualitative attributes when assessing players’ bona fides.  I mention this in closing by way of encouraging readers who find baseball stats unexciting to hang in there with these notes.  As much as I enjoy diving into such stats, I enjoy the game’s unquantifiable aspects even more.  And there are plenty of the latter, just as there are in money management.  In fact, I wouldn’t have pledged to crank out 105 more of these notes if what one lover of my chief avocation said about it didn’t apply equally to my chosen profession: “Baseball,” a former Yale baseball captain named George H.W. Bush once smilingly observed, “has everything.”     

On deck: the use and abuse of peer group comparisons in money management and baseball

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[1] Paul and Lloyd Waner notched 3,152 and 2,459 hits, respectively, for a total of 5,611.  The Alous racked up 5,094 hits in total: 2,101 for Felipe, 1,777 for Matty and 1,216 for Jesus.  The corresponding figures for the DiMaggios were 4,853 hits in total: 2,214 for Joe, 1,660 for Dom and 959 for Vince.

[2] Later notes in this series will explore the divergent ways in which the competitive edges of skilled pros in baseball and money management tend to evolve as their active careers in each arena unfold, with superstars in money management tending to enjoy the “magic of compounding” to a more pronounced and prolonged extent than superstars in the more physically demanding domain of pro baseball.  That Williams benefited from such “compounding” to a considerable and hence logical extent is borne out anecdotally as well as statistically, no more convincingly than with the tale of what unfolded after Williams walked on four straight pitches during a game against Detroit late in his career.  “Bill,” Detroit catcher Joe Ginsberg complained to home plate ump Bill Summers.  “Don’t you think that last ball was a strike?” “Mr. Ginsberg,” Summers replied.  “Mr. Williams will let you know when it’s a strike.”

[3] FIP stands for Fielding Independent Pitching, a stat as intuitively appealing to baseball junkies like me as it is needlessly complex to casual observers of the game.  Ditto for xFIP, which is shorthand for Expected FIP.  Wanna know more about such arcana?  I didn’t think so.  But if insomnia strikes and safer cures for it aren’t available, click into the Glossary section of FanGraphs and master as many equations as you can before your game gets called due to darkness.


Notes from the Diamond #1: Always Something New to Learn

Yazstremski waits for the bounce.

Don’t be afraid to take advice. There’s always something new to learn. — Babe Ruth

Trivia Question 1 of 108 — What baseball Hall of Fame catcher earned valedictorian honors while also posting a 75-3 record as a pitcher in high school? Answer furnished in main text. Ditto for an answer to the question, “Why 108?”

Boston Red Sox pitcher Brandon Workman at bat in the 9th inning of Game 3 of the 2013 World Series

The Wind Up.  Big differences in their physical demands aside, playing pro baseball and managing money for a living have much in common — a happy fact for those of us who find both endeavors engrossing and a godsend for money managers whose quarterly letters would be intolerably brief or dull absent baseball-related arcana.  Truth be told, the literature exploring parallels between baseball and investing is already so vast that Epsilon Theory (ET) faithful might reasonably pose the same question to ET management that Red Sox Faithful shouted at their TVs as the worst managerial miscue in living memory was unfolding before their eyes several years ago: “Why?!”  No, I’m not referring to Bosox manager Grady Little’s catastrophic act of omission in Game 7 of the 2003 American League Championship Series — acceding to star pitcher Pedro Martinez’s pleas that he continue pitching — but rather to the even dopier decision of Bosox manager John Farrell a decade later: letting pitcher Brandon Workman take his first-ever major league at-bat with the Sox and Cardinals tied 4-4 in the ninth inning of Game 3 of the 2013 World Series.  The Sox lost both games, of course, ending their season in 2003 and adding unnecessary angst to a stress-filled but ultimately triumphant season in 2013.  In due course, this series will explore both of the miscues just referenced plus other noteworthy hits, runs and errors in both money management and baseball, all with the aim of elevating readers’ investment games if not also their appreciation of America’s national pastime.[1]

Unwelcome Change.  I know, I know: in many folks’ eyes, football supplanted baseball as the national pastime long ago — a mutation as regrettable and seemingly irreversible as the shift toward extremism in American politics that Ben Hunt discusses so penetratingly in his multi-part note entitled Things Fall Apart.  Unable as I am to trump Ben (pun intended) in political punditry, I’ll generally avoid politics in this series, leaving it to Ben and other ET contributors to draw parallels if and as they see fit between the shifting fortunes of professional sports on the one hand and political factions on the other.  That said, I can’t resist quoting here the late political journalist Mary McGrory’s lament respecting mutually reinforcing trends she espied in the nation’s political and recreational proclivities long before POTUS 45 declined an invitation to throw out the ceremonial first pitch on Opening Day during his first year in office: “Baseball is what we were,” McGrory observed.  “Football is what we’ve become.”

The Pitch.  Shifting from wind up to pitch … ET faithful deserve an answer to this important question among others: why should they allocate a portion of their scarcest resource — time — to this note or indeed any of the 108 planned and presumably weekly missives comprising the series hereby commencing?  At least three reasons for doing so come to mind.  First, Babe Ruth had it right: there’s always something new to learn about any field of human endeavor, including the fun fact that, as the accompanying diagram confirms, baseballs have precisely 108 stitches.  Second, Ben Hunt has it right: sometimes the best way to replace bad habits with good ones in a chosen field is to look outside it for wisdom or inspiration — as Ben has done so effectively and entertainingly for us money management types with his Notes from the Field. Third, ET contributor par excellence Rusty Guinn has it right also: sometimes the best means of elevating one’s game is to take it on the road so to speak — to contemplate the origins and soundness of habits and beliefs outside one’s chosen profession or political persuasion with an eye toward assessing critically what Rusty refers to as an investor’s “priors”.  We all have ‘em, like it or not.

Anatomy of a baseball

No Guarantees.  I’ve put priors in quotes because I myself have never used that term in decades of writing about investing, nor do I expect to use jargon like it often if ever in this series.  But Rusty fancies the term; I like and respect Rusty (and Ben); and I’ve already learned much from Rusty’s series entitled Notes from the Road.  I won’t guarantee that readers will find these Notes from the Diamond comparably insightfulBut I will pledge that they’ll spawn chuckles on occasion, while also avoiding quotes from an overexposed baseball legend who’s understandably but unjustly remembered more for his malapropisms than for his central role in notching ten World Series titles for the Evil Empire (a/k/a New York Yankees).  After all, why subject readers to deja vus from Yogi Berra when the supply of edifying utterances from other baseballers is large and growing?

Superficial Stasis.  As skilled as Berra was behind the plate, the high school valedictorian referenced in the trivia question at page 1 was even more so, as well as a gifted philosopher in his own right.  Responding to a dinner companion’s jibe that the game he played for a living was intolerably slow, Hall of Fame catcher Johnny Bench intoned, “Baseball is a slow game — for slow minds.”  Rightly understood, investing as distinct from trading also entails prolonged periods of superficial stasis — superficial because effective investors must and do ponder more or less continuously whether newly arriving information necessitates portfolio changes, mindful that it seldom does.  Interestingly, the principle just flagged — favor inaction over action unless the latter is truly vital — is arguably the single most impactful insight spawned by the so-called Sabermetrics Revolution that’s transformed pro baseball in recent decades, i.e., the reshaping of what players, managers and — yes — umpires do or don’t do on the field based on advanced statistics not readily available before certain information technologies were developed.  Among many other insights these Notes will explore, Sabermetrics — a term derived from the acronym for Society for American Baseball Research or SABR — has confirmed decisively what baseball cognoscenti have long conjectured: that a base on balls or walk can be as good as a hit.   Indeed, for reasons to be explored in future notes, the “big data” revolution that’s transformed pro baseball no less than it’s transformed financial markets in recent decades has proven that walks can be better than hits for teams notching them under certain circumstances.

For the Love of It.  What other insights from baseball of potential utility to investors will these Notes explore?  At the risk of having Ben Hunt consign me to his necessarily large nursery of raccoons — i.e., finance types who pilfer Other People’s Money by, among other means, overpromising as habitually as Ted Williams reached base safely[2]  — I’ll answer the question just posed while also wrapping up this inaugural note by providing a sneak peek at insights I plan to explore in the 107+ notes to follow.  I’ve added “+” to 107 because, more than five decades after I first laid eyes on Fenway Park’s gorgeously green grass, and more than three decades after I sank into money management, I’m as intrigued as ever by both baseball and investing.  Whether such intrigue gives me an edge in the latter pursuit is unclear, but I like to think it does, just as I like to think that major leaguers who truly enjoy their work have an edge over those who don’t.  As in finance, which comprises a regrettably large sub-population of raccoons, professional baseball comprises numerous actors motivated primarily by money.  As in finance, it’s long been thus in baseball, as perhaps the edgiest player of all time confirmed when rebuking his fellow pros as his long and distinguished playing career (1905 – 1928) was nearing its end.  “The great trouble with baseball today,” Ty Cobb scolded, “is that most of the players are in the game for the money and that’s all. Not for the love of it, the excitement of it, the thrill of it.”

Coming Attractions.  Thrilling or not, the useful insights derivable by applying ongoing advances in baseball strategies and statistics to money management are legion.  I’m excited by the prospect of pinpointing many of them in future notes, including these:

  • Why it’s not merely useful but essential for professionals to “change their stripes” — a stubbornly enduring no-no in money management whose conscious violators include not a few investment pros as successful in their evolving endeavors as Johnny Bench was in his. Why did Bench switch from pitching to catching at a crucial point in his development as a player?  Because he and those advising him deduced correctly that his foremost physical skill — a strong throwing arm — would be optimally applied as a catcher, thus permitting Bench to use his smarts as well as his physical gifts as frequently as baseball rules permit.  We’ll explore Bench’s metamorphosis and its significance for investment pros in greater detail as this series unfolds.
  • How the metrics used to assess on-field performance condition the behavior of not only players but umpires — a phenomenon with great relevance to client-manager relations in institutional funds management. As we’ll see, the fleet-footed fellow whose most celebrated achievement as a baseballer was his breaking of Ty Cobb’s all-time stolen base record understood intuitively what many capital allocators understand dimly if at all . “Show me a guy who’s afraid to look bad,” said six-time All Star and Hall of Famer Lou Brock, “and I’ll show you a guy who can be beaten.”

Not afraid to look bad: Lou Brock (#20) in action in 1964

  • What practitioners pursuing excellence must do to maintain an edge as the information revolution advances. Quite apart from rules changes already implemented that preclude future career stats as stellar as those achieved by past outliers in each domain — e.g., Wes Crawford or Bob Gibson in baseball; Michael Steinhardt or Peter Lynch in money management — the relentless and mutually reinforcing advances of technology and transparency portend continued shrinkage in the pool of dominantly successful practitioners in professional baseball no less than in professional investing.[3]  By transparency, I mean the timely collection, compilation and dissemination of essentially all available objective data germane to the aforementioned professions.  As many readers are aware, and as future notes will discuss, enhanced transparency as just defined has reduced and will continue undermining the incomes of ballplayers as well as investment pros whose “edges” entail primarily their patrons’ imperfect understanding of their true as distinct from perceived skills.  In a baseball context, “patrons” as just used is defined broadly to include team owners and managers as well as fans — all of whom can easily and inexpensively access meaningfully large chunks of the roughly seven terabytes of data per game (including but by no means not limited to video bits and bytes) that major league baseball’s Statcast system collects via cameras and radar installed in every MLB stadium. That’s a quantum of data equivalent to the contents of 700,000 copies of Webster’s Collegiate Dictionary — and literally millions times the number of data points some of us learned how to record manually on paper scorecards back in the day.

Manual recording of Red Sox labors vs. Yankees 8/18/2006

Continuous Improvement.  Imagine if fiduciaries could evaluate investment pros as quickly, cheaply and thoroughly as baseball managements can evaluate players’ every movement  (or non-movement) using Statcast.  I’m unsure such enhanced scrutiny would produce uniformly better returns, but I’m sure that it would alter managers’ as well as clients’ behaviors, just as such scrutiny has altered how pro baseball gets played, who gets to play it, and for how much.  I’m sure too that even if investment pros’ labors remain as crudely understood as pro baseballers’ were before Statcast came along, future technological advances will compel investment pros seeking sustained excellence to change their stripes on a regular if not continuous basis.  How do I square the assertion just made with Ben’s championing of repeatable processes in Things Fall Apart? I’m not sure I can, or want to, his and Rusty’s invitation to contribute to ET being rooted in their laudable desire to foster diverse viewpoints under ET’s banner.  By my lights, choiceworthy processes in money management display the same cardinal virtue that my all-time favorite player displayed when fielding caroms off Fenway’s fabled Green Monster: such processes are less “repeatable” or static than they are adaptive and ever-changing.  The player in question, of course, was Carl Yazstremski, a Long Island native whose exceptional work ethic arguably made Puritan New England (a/k/a Red Sox Nation) a fitter venue for his sporting labors than his original home turf.  “I loved the game,” Yaz said after his 23-year career came to an end in 1983.  “But I never had any fun.  All hard work, all the time.”

Carl Yazstremski awaiting a carom off Fenway’s Green Monster in the 1967 World Series

Ernie Had It Right.  Like the best opening frame this Bosox fan has ever witnessed — a 50-minute masterpiece in which the Bosox scored 14 runs on 13 hits against the visiting Florida Marlins at Fenway in June 2003 — this initial installment of Notes from the Diamond has developed proportions more expansive than might reasonably have been expected.  As noted at page 1, readers can expect future installments to be shorter — but no less replete with pearls of wisdom from wizards of the diamond, including a gentleman who changed his stripes not once qua young Johnny Bench but multiple times en route to his own induction at Cooperstown.  Nicknamed “Mr. Sunshine” for his upbeat disposition, Ernie Banks (1931 – 2015) is forever known for his catchphrase, “It’s a beautiful day for a ballgame … Let’s play two”.  With so many useful parallels between baseball and investing to be drawn — and with so many members of ET Nation including yours truly wondering what comes next for the business of investing and their own roles within it — I’m keener than ever to craft the next note in this series … and the next.  Let’s play 108, why don’t we?

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[1] Workman’s first and to date only major league at bat went poorly, with a whiff plus two called strikes producing a blindingly quick out.  If the Red Sox, for whom Workman has played on-and-off since 2013, make the World Series in 2018, the odds are good that team manager Alex Cora will call on Workman to do some relief pitching.  That said, I’d bet my family’s most prized baseball-related possession — a ball inscribed for my children by Elden Auker — that Cora doesn’t let Workman bat, ever.  The last living pitcher to have faced Babe Ruth, Auker (1910 – 2006) showed his mettle early in his 10-year major league career: Ruth was the first batter Auker faced in the pitcher’s big league debut in 1933, striking out on just four pitches.

[2] Most readers know that Joe DiMaggio holds the record for consecutive games with a hit: 56 in 1941.  Some may be unaware of another seemingly unbreakable record, held by the best hitter in baseball in the 1940’s or indeed any other epoch: in 1949 Ted Williams reached base safely in an astounding 84 consecutive games.

[3] The all-time career leader in triples with 309, Crawford played before “live era” or post-1910 baseballs made home runs far more frequent than triples.  Gibson notched the all-time best single season earned run average (ERA) of 1.12 in 1968, a year before pitching mounds were lowered by a third to their current height of 10 inches.  Steinhardt made big bucks for himself and his clients during the first half of his career via block trading methods that were either illegal at the time or have since been outlawed.  And Lynch turbocharged his returns via the lawful exploitation of corporate disclosure protocols benefiting big institutions like Fidelity that post-2000 securities law reforms have rendered nugatory, including especially Regulation FD.

On Deck:

What baseball’s steroid era and private equity’s salad days have in common



Chili P is My Signature: Things that Don’t Matter #5

Jesse After His Chili P Phase

Walter: Did you learn nothing from my chemistry class?
Jesse: No. You flunked me, remember, you prick? Now let me tell you something else. This ain’t chemistry — this is art. Cooking is art. And the shit I cook is the bomb, so don’t be telling me…
Walter: The shit you cook is shit. I saw your setup. Ridiculous. You and I will not make garbage. We will produce a chemically pure and stable product that performs as advertised. No adulterants. No baby formula. No chili powder.
Jesse: No, no, chili P is my signature!
Walter: Not anymore.
Breaking Bad, Season 1, Episode 1

“There was only one decline in church attendance, and that was in the late 1960s, when the Vatican said it was not a sin to miss Mass. They said Catholics could act like Protestants, and so they did.“
— Rodney Stark, Ph.D.

She should have died hereafter;
There would have been a time for such a word.
To-morrow, and to-morrow, and to-morrow,
Creeps in this petty pace from day to day
To the last syllable of recorded time,
And all our yesterdays have lighted fools
The way to dusty death. Out, out, brief candle!
Life’s but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more: it is a tale
Told by an idiot, full of sound and fury,
Signifying nothing.
— William Shakespeare, Macbeth, Act 5, Scene 5

“I can’t do it if I think about it. I would fall down, especially if I’m wearing street shoes,” he said, laughing. “It wasn’t something I did because I wanted to. I didn’t even know I did that until someone showed me a video.”
— Fernando Valenzuela about his unique windup to the LA Times (2011)


Baseball was in the midst of a crisis in 1981.

In the years prior, competition for talent in larger markets had driven player salaries higher and higher. This caused owners to seek increasing restrictions on free agency. The players’ union went on strike in June, right in the middle of the season. Fans were furious, and mostly with the owners, as is the usual way of things. We still hate millionaires, of course, but we positively loathe billionaires. While the strike ended by the All-Star break in early August, work stoppages and disputes of this sort have often been the signposts of baseball’s long, slow march to obscurity against the rising juggernaut of American football and the sneaky, if uneven, popularity of basketball. It was not a riskless gamble for either party, and as future strikes taught us, the aftermath could have gone very badly.

But not this time. You see, baseball had a secret weapon to quickly bring fans back after the 1981 strike: a “short fat dark guy with a bad haircut.” His name was Fernando Valenzuela.

Fernando was an anomaly in another long, slow march — that of baseball’s transition from a pastime to something more clinical, more analytical, more athletic. We were at a midpoint in the shift from the everyman-made-myth that was Babe Ruth or the straight-from-the-storybook folk hero like Joe DiMaggio to the brilliant, polished finished products of baseball academies today. Only a few years after 1981, we would see the birth of the new generation of uberathletes in Bo Jackson, a man who many still consider among the most gifted natural athletes in history. Only a decade earlier, the top prospect in baseball was one Greg Luzinski. The two weighed about the same. Their body composition was just a little bit different.

Fernando was certainly a physical throwback of the Luzinski variety, but so much more. He was a little pudgy. His hair was, long, shaggy and unkempt. More to the point, everything he did was inefficient, out of line with trends in the league. His windup was long and tortured, with a high leg kick that reached shoulder level in his early years and chest level in his older, slightly chubbier years. It featured an unnecessary vertical jerk of his glove straight upward near the end, and most uniquely, a glance to the heavens that became a signature of Fernando-mania. To stretch the inefficiency to its natural limits, his most effective pitch was a filthy screwball, a pitch that had been popular for decades but had already significantly waned by the early 1980s. Fathers and coaches taught their sons that it would hurt their arms (which a properly thrown screwball does not do), and by the late 1990s the pitch that ran inside on same-handed batters was all but extinct, except in Japan, where a very similar pitch called the shuuto continued to find adherents.

There were many reasons he captured the national imagination. He was a gifted Mexican pitcher in Los Angeles, a city full of baseball-obsessed Mexican-Americans and migrant workers. He was also truly marvelous as a 20-year old rookie in 1981. His stretch of eight games between April 9th and May 14th still ranks as one of the most dominant in history. Eight wins. Eight complete games. Five shutouts. Sixty-eight strikeouts. And that was how he started his career!(1)

But more than anything, I think, it was the pageantry and the spectacle of it all. The chubby, mop-top everyman who came out of nowhere with a corny sense of humor, who threw from a windup out of a cartoon, who threw a pitch that nobody else threw anymore. It was inefficient and ornamental and just so unnecessary — and we loved it. I still do. It was even how I was taught to pitch growing up. My father told me and instructed me to throw with “reckless abandon”, and so in my windup I would rotate my hips and point my left toe at second base before kicking it in a 180-degree arc at a shoulder level, nearly falling to the ground from the violent shift in weight after every pitch.

Alas, the efficiency buffs who disdained such extravagances were and are mostly right. While Valenzuela had a long and decent career, the greatest pitchers of the modern era — Roger Clemens, Pedro Martinez and especially Greg Maddux — all thrived on efficient mechanics and a focus on a smaller number of high quality pitches.(2) While a screwball is nice, and in many ways unique, it also isn’t particularly effective as a strikeout pitch in comparison to pitches with more vertical movement like, say, curveballs, split-finger fastballs or change-ups, or pitches that can accommodate lateral movement AND velocity, like sliders and cut-fastballs.

There’s a lesson in this.

As humans, especially humans in an increasingly crowded world where we can be instantly connected to billions of other people, the urge to stand out, to carve out a different path, can be irresistible. This influences our behavior in a couple of ways. First, it drives us to cynicism. Think back on the #covfefe absurdity. If you’re active on social media, by the time you thought of a funny #covfefe joke, your feed was probably already filled with an equal number of posts that decided that the meme was over, using the opportunity to skewer the latecomers to the game. Those, too, were late to the real game, which had by that time transitioned to new ironic uses of the nonsense word. A clever idea that is shared by too many quickly becomes an idea worthy of derision. And so the equilibrium — or at least the dominant game theory strategy — is to be immediately critical of everything.

It also makes us inexorably prone to affectation. We must add our own signature, that thing that distinguishes us or our product; the figurative chili-powder-in-the-meth of whatever our form of productive output happens to be.  Since we are all writers of one sort or another now, we feel this acutely in how we communicate. When part of what you want to be is authentic in your communication, our introspection becomes a very meta thing — we can talk ourselves into circles about whether we’re being authentic or trying inauthentically to appear authentic. But we’re always selling, and while our need for a unique message has exaggerated this tendency, at its core it clearly isn’t a novel impulse. People have been selling narratives forever. But if there’s a lesson in Epsilon Theory, surely it is that successful investors will be those who recognize, survive and maybe even capitalize on narrative-driven markets — not necessarily those whose success is only a function of their ability to push substance-less narratives of their own.

Perhaps most perniciously, our urge to stand out is also an urge to belong to a Tribe — to find that small niche of other humans that afford us some measure of human interaction while still permitting us to define ourselves as a Thing Set Apart. The screwball, the chili powder, the fancy windup, the obscure quotes about Catholicism from sociology Ph.D.s in your investing think-piece — instead of a barbaric yawp, it becomes a signal to your tribe. When pressed, our willingness to rip off the steering wheel and adopt a competitive strategy becomes dominant, a necessity. Lingering in the back of our heads as we go all-in on our tribe is the knowledge that our tribal leaders, no matter who they are, will sell us down the river every time.

In our investing lives, when we build portfolios, we know full well how many options our clients or constituents have, so these three competing impulses drive our behaviors: cynicism, affectation and tribalism. The cynical, nihilistic impulse shouts at us that nothing matters enough to justify risking being fired, and so we end up choosing the solution that looks most like what everyone else has done. That’s the ultimate equilibrium play we’re all headed toward anyway, right? The affectation impulse requires that we add a little something to distinguish us from our peers. A dash of chili powder. A screwball here or there, or an outlandish delivery to delight and astonish. Our tribal impulse compels us toward the right-sounding idea that makes us part of a group (I’m looking at you, Bogleheads). More frequently, we’re motivated by a combination of all three of these things in one convoluted, ennui-laden bit of arbitrary decision-making.

The real kick in the teeth of all this is that many of the things we are compelled to do by these impulses are actually good and important things, even Things that Matter. But because of the complex rationale by which we arrive at them (and other biases besides), we often implement the decisions at such a halfhearted scale that they become irrelevant. In other, worse cases, the decisions function like the tinkering we discussed in And They Did Live by Watchfires, potentially creating portfolio damage in service of a more compelling marketing message or to satisfy one of these impulses. In both cases, these flourishes and tilts are too often full of sound and fury, signifying nothing.

Too Little of a Good Thing

What, exactly, are we talking about? Well, how about value investing, for starters?

I think this one pops up most often as a form of the tribal impulse, although clearly many advisors and allocators use it as a way to add a dash of differentiation as well. Now, most of us are believers in at least a few investing tribes, each with its own taxonomy, rituals, acolytes and list of other tribes we’re supposed to hate in order to belong. But none can boast the membership rolls of the Value Tribe (except maybe the Momentum Tribe or the Passive Tribe). And for good reason! Unlike most investment strategies and approaches devised, buying things that are less expensive and buying things that have recently gone up in price can both be defended empirically and arrived at deductively based on observations of human behavior. The cases where science is really being applied to investing are very, very rare, and this is one of them. Rather than pour more ink into something I rather suppose everyone reading this believes to one extent or another, I’d instead direct you to read the splendid gospel from brothers Asness, Moskowitz and Pedersen on the subject. Or, you know, if you’re convinced non-linearities within a population’s conditioning to sustained depressing corporate results and lower levels of expected growth mean that such observations are only useful for analysis of the actions of an individual human and can’t possibly be generalized or synthesized into a hypothesis underpinning the existence of the value premium as an expression of market behavior, then don’t read it. Radical freedom!

What is shocking is how ubiquitous this belief is when I talk to investors, and how little investors demonstrate that belief in their portfolios. We adhere to the tribe’s religion, but now that it’s not a sin to skip out, we only attend its church on Christmas and Easter. And maybe after we did something bad for which we need to atone.

Value is the more socially acceptable tribe (let’s be honest, momentum has always had a bit of a culty, San Diego vibe), so let’s use that as our case study. Since I’m worried I’m leaving out those for whom cynicism is the chosen neurosis, let’s use robo-advisors to illustrate that case study. They’re instructive as a general case as well, since they, by definition, seek to be an industry-standard approach at a lower price point. Now, of the two most well-advertised robos, one — Wealthfront — mostly ignores value except in context of income generation. The other — Betterment — embraces it in a pretty significant way. I went to their very fine website and asked WOPR what a handsome young investment writer ought to invest in to retire around 2045. Here is what they recommended:

Source: Betterment 2017. For illustrative purposes only.

Pretty vanilla, but then, that’s kind of the idea of the robo-advisor. But I see a lot of registered investment advisors and this is also straight out of their playbook. It’s tough to find an anchor for the question “I know I want/need value, but how much?” As a result, one of the most common landing spots I see is exactly what our robot overlords have recommended: half of our large cap equities in core, and the other half in value. We signal/yawp a bit further: we can probably also afford to do it in the smaller chunks of the portfolios, too. Lets just do all of our small cap and mid cap equities in a value flavor. As for international and emerging equities, we don’t want to scare the client with any more line items or pie slices invested in foreign markets than we need, so let’s just do one big core allocation there.

I’m putting words in a lot of our mouths here, but if you’re an advisor or investor who works with clients and this line of thinking doesn’t feel familiar to you, I’d really like to hear about it. Because this is exactly the kind of rule of thumb I see driving portfolio decisions with so many allocators that I speak to. But how do we actually get to a portfolio like this? If you think there’s a realistic optimization or non-rule-of-thumb-driven investment process that’s going to get you here, let’s disabuse ourselves of that notion.

Could plugging historical volatility figures and capital markets expectations into a mean/variance optimizer get you to this split on value vs. core? In short? No. No, we know that this is an impossible optimizer solution because the diversification potential at the portfolio level — what we call the Free Lunch Effect in this piece — would continue to rise as we allocated more and more of our large cap allocation to a value style (and less and less to core). In other words, while the intuition might be that having both a core and value allocation is more diversifying (more pie slices!), that just isn’t true. In a purely quantitative sense, you’d be most diversified at the portfolio level with no core allocation at all!

Free Lunch Effect of Various Allocations to Large Cap Value vs. Large Cap Core in Example Portfolio

Source: Salient 2017. For illustrative purposes only.

If your instinct is to say that doesn’t look like much diversification, however, you’d be right as well. Swinging our large cap portfolio from no value to nothing but value reduces our portfolio risk by around 8bp without reducing return (i.e., the Free Lunch). That’s not nothing, but it’s damn near. The reason is that the difference between the Russell 1000 Value Index and the Russell 1000 Index or the S&P 500, or the difference between your average large cap value mutual fund and your average large cap blend mutual fund, is not a whole lot in context of how most things within a diversified portfolio interact. Said another way, the correlation is low, but the volatility is even lower, which means it has very little capacity to impact the portfolio. Take a look below at how much that value spread contributes to portfolio volatility. The below is presented in context of total portfolio volatility, so you should read this as “If I invested all 32% of the large cap portion of this portfolio in a value index and none in a core index, the value vs. core spread itself would account for about 0.1% of portfolio volatility.”

Percentage of Portfolio Volatility Contributed by LC Value-Core Spread

Source: Salient 2017. For illustrative purposes only.

Fellow tribesmen, does this reflect your conviction in value as a source of return? Some of you may quibble, “Well, this is just in some weird risk space. I think about my portfolios in terms of return.” Fine, I guess, but that just tells the same story. Consider how most value indices are constructed, which is to say a capitalization weighted splitting of “above average” vs. “below average” stocks on some measure (e.g., Russell) or multiple measures (e.g., MSCI) of value. We may have in our heads some of the excellent research on the value premium, but those are almost always expressed as regression alphas or as spread between high and low quintiles or deciles (Fama/French) or tertiles (Asness et al). In most cases they are also based on long/short or market neutral portfolios, or using methodologies that directly or indirectly size positions based on the strength of the value signal rather than the market capitalization of the stock. There are strategies based on these approaches that do capitalize on the long-term edge of behavioral factors like value. But that’s not really what you’re getting when you buy most of these indices or the many products based on them.(3)

So what are you getting? For long-only stock indices globally, probably around 80bp(4) and that assumes no erosion in the premium vs. long-term average. Most other research echoes this – the top 5 value-weighted deciles of Fama/French get you about 1.1% annualized over the average since 1972, and comparable amounts if you go back even further. Using the former figure, if you swung from 0% value to 32% value in your expression of your large cap allocation — frankly a pretty huge move for most investors and allocators — we’re talking about a 26bp difference in expected portfolio returns. Again, not nothing, but if our portfolio return expectations are, say, 8%, that’s a 3.2% contributor to our portfolio returns under fairly extreme assumptions.

Does this reflect your conviction in value as a source of return? No matter how we slice it, the ways we implement even fundamental, widely understood and generally well-supported sources of return like value seem to be a bit long on the sound and fury, but unable to really drive portfolio risk or return. Why is this so hard? Why do we end up with arbitrary solutions like splitting an asset class between core and value exposure like some sort of half-hearted genuflection in the general direction of value?

Because we have no anchor. We believe in value, but deep down we struggle to make it tangible. We don’t know how much of it we have, we don’t even know how much of it we want. We struggle even to define what “how much” means, and so we end up picking some amount that will allow us to sound sage and measured to the people who put their trust in us to sound sage and measured.

I’m going to spend a good bit of time talking about how I think about the powerful diversifying and return-amplifying role of behavioral sources of return like value as we transition our series to the Things that Matter, so I’ll beg both your patience and indulgence for leaving this as a bit of a resolutionless diatribe. I’ll also beg your pardon if it looks like I’ve been excessively critical of the fine folks who put together the portfolio that has been our case study. In truth, that portfolio goes much further along the path than most.

The point is that for various behavioral reasons, our style tilts like value, momentum or quality occupy a significant amount of our time, marketing and conversations with clients, and — by and large — signify practically nothing in terms of portfolio results. In case I wasn’t clear, yes, I am saying that value investing — at least the way most of us pursue it — doesn’t matter.

The Magically Disappearing Diversifier

The time we spend fussing around with miniscule style tilts, however, often pales in comparison to the labor we sink into our flourishes in alternatives, especially hedge funds. Some of this time is well-spent, and well-constructed hedge fund allocations can play an important role in a portfolio. When I’m asked to look at investors’ hedge fund portfolios, there are usually two warning signs to me that the portfolios are serving a signaling/tribal purpose and not some real portfolio objective:

  1. Low volatility hedge funds inside of high volatility portfolios that aren’t using leverage
  2. Hedge fund portfolios replacing Treasury or fixed income allocations

Because of the general sexiness (still, after all these years!) of hedge fund allocations to many clients or constituents, the first category tends to be the result of our affectation impulse. We want to add that low-vol, market-neutral hedge fund, or the fixed income RV fund that might have been taking some real risk back in 2006 when they could lever it up a bajillion times, not because of some worthwhile portfolio construction insight, but perhaps because it allows us to sell the notion that we are smart enough to understand the strategies and important enough to have access to them. Not everyone can get you that Chili P, after all. In some cases, sure — we are signaling to others that we are also part of that smart and sophisticated enough crowd that invests in things like this. In the institutional world, where it’s more perfunctory to do this, it’s probably closer to cynicism: “Look, I know I’m going to have a portfolio of low-vol hedge funds, so let’s just get this over with.”

For many clients and plans — specifically those where assets and liabilities are mostly in line and the portfolio can be positioned conservatively, say <10% long-term volatility — that’s completely fine. But for more aggressive allocations, there is going to be so much equity risk, so much volatility throughout the portfolio, that the notion that these portfolios will serve any diversification role whatsoever is absurd. They’re just taking down risk, and almost certainly portfolio expected returns along with it. Unless you feel supremely confident that you’ve got a manager, maybe a high frequency or quality stat arb fund, that can run at a 2 or 3 Sharpe, it is almost impossible to justify a place for a <4% volatility hedge fund in a >10% target risk portfolio. They just won’t move the needle, and there are better ways to improve portfolio diversification, returns or risk-adjusted returns.

The second category starts to veer out of “Things that Don’t Matter” territory into “Things that Do Matter, but in a Bad Way.” More and more over the last two years, as I’ve talked to investors their primary concern isn’t equity valuations, global demographics, policy-controlled markets, deflationary pressures, competitive currency crises, protectionism, or even fees! It’s their bond portfolio. The bleeding hedge fund industry has been looking for a hook since their lousy 2008 and their lousier 2009, and by God, they found it: sell hedge funds against bond portfolios! Absolute return is basically just like an income stream! There seems to be such a strong consensus for this that it may have become that cynical equilibrium.

No. Just no.

It’s impossible to overstate the importance of a bond/deflation allocation for almost any portfolio. This is an environment that prevails with meaningful frequency that has allowed the strong performance of one asset historically: bonds, especially government bonds (I see you with your hands raised in the back, CTAs, but I’m not taking questions until the end). The absolute last thing any allocator should be thinking about if they have any interest in maintaining a diversified portfolio, is reducing their strategic allocation to bonds. I’ll be the first to admit that when inflationary regimes do arrive, they can be long and persistent, during which the ability of duration to diversify has historically been squashed. The negative correlation we assume for bonds today is by no means static or certain, which is one of the reason I favor using more adaptive asset allocation schemes like risk parity that will dynamically reflect those changes in relationship. But even in that context, the dominance and ubiquity of equity-like sources of risk means that almost every investor I see is still probably vastly underweight duration.

Now many of us do have leverage limitations that start to create constraints, and so I won’t dismiss that there are scenarios where that constraint forces a rational investor not to maximize risk-adjusted returns, but absolute returns. I’m also willing to consider that on a more tactical basis, you may be smarter than I am, and have a better sense of the near-term direction of bond markets. In those cases, reducing bond exposure, potentially in favor of absolute return allocations, may be the right call. But if you have the ability to invest in higher volatility risk parity and managed futures, or if you have a mandate to run with some measure of true or derivatives-induced leverage, my strong suspicion is that you’ll find no cause to sell your bond portfolios in favor of absolute return.

Ultimately, it’s hard to be too prescriptive about all this, because our constraints and objective functions really may be quite different. To me, that means that the solution here isn’t to advise you to do this or not to do that, except to recommend this:

Make an honest assessment of your portfolio, of the tilts you’ve put on, and each of your allocations. Do they all matter? Are you including them because of a good faith and supportable belief that they will move the portfolio closer to its objective?

If we don’t feel confident that the answer is yes, it’s time to question whether we’re being influenced by the sorts of behavioral impulses that drive us elsewhere in our lives: cynicism, affectation and tribalism. In the end, the answer may be that we will continue to do those things because they feel right to us and our clients. And that may be just fine. A little bit of marketing isn’t a sin, and if your processes that have served you well over a career of investing are expressed in context of a particular posture, there’s a lot to be said for not fixing what ain’t broken. There’s nothing wrong with an impressive-looking windup, after all, until it adversely impacts the velocity and control of our pitches.

What is a sin, however, is when a half-hearted value tilt causes us to be comfortable not taking advantage of the full potential of the value premium in our portfolios. When the desire to get cute with low-vol hedge funds causes us to undershoot our portfolio risk and return targets. Perhaps most of all, when we spend our most precious resource — time — designing these affectations. We will be most successful when we reserve our resources and focus for the Things that Matter.

(1) Please – no letters about his relief starts in 1980. If MLB called him a rookie, imma call him a rookie.

(2) Probably the only exception in this conversation is Randy Johnson, who, while mostly vanilla in his mechanics, would probably get feedback from a coach today about his arm angle, his hip rotation and a whole bunch of other things that didn’t keep him from striking out almost 5,000 batters.

(3) As much as marketing professionals at some of the firms with products in this area would like to disagree and call their own product substantially different, they all just operate on a continuum expressed by the shifting of weightings toward cheaper stocks. Moving from left to right as we exaggerate the weighting scheme toward value, the continuum basically looks like this: Value Indices -> Fundamental Indexing -> Long-Only Quant Equity -> Factor Portfolios

(4) Simplistically, we’re just averaging the P2 and half of the P3 returns from the Individual Stock Portfolios Panel of Value and Momentum Everywhere, less the average of the full universe. An imperfect approach, but in broad strokes it replicates the general half growth/half value methodology for the construction of most indices in the space.

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Salient and Other Just-So Origin Stories (by Jeremy Radcliffe)


I grew up in Houston wanting to be a general manager of a professional sports team. My 7th-grade buddies and I were some of the first ever fantasy sports players back in the mid-80s, except back then it was called Rotisserie Baseball (Daniel Okrent literally wrote the book on how to play, and his first league draft was held at Rotisserie Bird and Beef in NYC — here’s a great article on the origin story of what is now a multi-billion dollar industry).

Unfortunately for me, I didn’t have playing experience like Billy Beane or happen to work for a private equity gazillionaire who bought a team (Andrew Friedman, another Houstonian who ran the Devil Rays and now the Dodgers) or develop a deep understanding of statistics (Daryl Morey and Sam Hinkie of the Rockets), so I was never able to parlay my Apple IIe player value spreadsheets into a real-life GM job. However, I get to play GM in this business that we’ve built at Salient, and Ben’s not the only talent I can claim (some) credit for “drafting.” Thousands of you have already read “A Man Must Have a Code”, the fantastic debut piece from the head of Salient’s asset management business, Rusty Guinn, and we’re going to be featuring a select group of these other Ben-approved colleague-contributors.

I will never forget the first piece I read from Ben under the Epsilon Theory banner — it was called “How Gold Lost its Luster, How the All-Weather Fund Got Wet, and Other Just-So Stories.” By the end of the first page of the note, Ben had used quotes from J. Pierpont Morgan, Bob Prince of Bridgewater, and references to Rudyard Kipling, George Orwell and Stephen Colbert to highlight the power of narratives.

The asset management firm that I co-founded in 2002, Salient, manages a risk parity strategy similar to Bridgewater’s All-Weather Fund, and I’d flirted with being a gold bug for a few years, so I was naturally drawn to this note; before I’d made it to the second page, I was hooked. I felt like I was reading the pre-ESPN, pre-HBO version of Bill Simmons, when he was the Boston Sports Guy. Ben was mixing pop culture, literature, history and science, all in an effort to help his readers understand what was driving our post-crisis financial markets.

And it wasn’t flash — it worked. I finally understood why I had been so puzzled – and wrong – about gold price movements for the preceding couple of years. And Ben’s comments on the All-Weather Fund evinced a solid understanding of the strategy, which was and has remained rare for financial media types.

So I called Ben and asked him to meet with me. He knew Salient, since we had been an investor in a hedge fund he managed while at Iridian, and after we flew him down to Houston to meet with our team, we convinced him to join our firm and help our portfolio managers better understand the macro side of the markets, and to continue to write Epsilon Theory to help investors across the world with the same thing.

Somehow, we’ve been working together now for more than three years, and the new Epsilon Theory site, developed in-house by our fabulous creative team, not only includes all of Ben’s previous notes with customized image collages, but serves as a home base for a broader group of contributors and readers as Epsilon Theory develops into a community for those of us interested in understanding what drives markets.

This new Epsilon Theory site is separate from our Salient mothership at, but Ben remains a bigger part of Salient than he’s ever been, whether that’s in helping some of our other portfolio managers understand these markets or managing money himself on behalf of our clients. We’re committed to growing this Epsilon Theory community as a stand-alone site and hope you’ll not only continue to read and listen to Ben, but start to sample some of the other content we’ll be adding to the site, and of course help us grow this community of truth-seekers by spreading the word and inviting others to join us.

As far as what you can expect from me going forward as a contributor to Epsilon Theory, it’s important to me to follow the advice of Bill Belichik and “do my job” — so I promise to not to confuse the talent scout with the talent. However, if I have a skill set relevant to Epsilon Theory beyond talent-spotting, it’s in sharing or synthesizing some of the interesting news, articles and points of view I come across in my daily readings. I’ll be curating concise versions of my deep dives into a wide range of Epsilon Theory-esque subjects, and I hope you’ll come along for the ride.

Just to give you a taste of the type of rabbit holes I’ll be going down, check out “The War on Bad Science” starting with Wired’s profile on John Arnold. The Houston billionaire and his wife are challenging the fundamental structure of how scientific research is conducted, and their foundation’s work has broad implications across the scientific spectrum, from nutrition to psychology. This thing goes deep, and it has the potential to shatter many of our preconceived, scientifically-approved notions of the world.

Stay tuned, friends.

With gratitude,


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