76ers GM Daryl Morey is one of the pioneers who brought Moneyball-type thinking to basketball during his tenure with the Rockets.
His interview with Patrick on Invest Like The Best is insightful and entertaining. I want to zoom in something Morey says:
You are weighing championship odds. And generally, we look over a three year time horizon with that. You could really pick any time horizon, but three years seems to work best with the data. And we basically do a sharp ratio like you would in investing, which is like here’s how championship odds increase, here’s the variance of that move.
Is it on the efficient frontier of return to risk basically and Shane [Battier], obviously, fit that for us.
None of our information is anywhere as good as the financial models. Actually, our underlying data is more predictive, quite a bit predictive. I talk to a lot of quants on Wall Street, and I tell them our signal to noise ratio using whatever measure you want….And they go like — yes, they go like, whoa, you guys are — that’s incredible. And I’m like, yes, but you remember, we have to be best of 30. You guys just have to beat the S&P by 2% and you are geniuses. So each industry has its own challenges.
We’re like a pure play. It’s the lifeblood of our business, whereas in other businesses, I’d say execution probably matters a lot more. In all aspects, including coaching, a well-executed, slightly suboptimal strategy generally will be the best strategy poorly executed. I mean you know that.
That’s generally true in basketball as well. But I would say in our realm of decision-making, it’s really almost a pure decision-making thing. This draft pick beats that draft pick. This free agent for $5 million beats that free agent for $5 million. It’s more of a pure play.
Sports is actually way simpler than most of the people you talk to, way simpler. Our sport, it changes, but not much. Our data is pretty good. Our competitors aren’t coming out with new products. Our competitive dynamics are known.
They’re hard, but they’re — no, we don’t have the Rumsfeld problem of unknown unknowns, like some start-up in stealth mode that might emerge, like, that’s why academics have done more and more papers about sports.
Because if you’re trying to isolate how to make good decisions, sports is really the right area to do that in
This is a great section because it highlights how different domains just have different size error bars. Sports signals are stronger than investment signals. The counterbalance to that fact is when Morey says:
I talk to a lot of quants on Wall Street, and I tell them our signal to noise ratio using whatever measure you want….And they go like — yes, they go like, whoa, you guys are — that’s incredible. And I’m like, yes, but you remember, we have to be best of 30. You guys just have to beat the S&P by 2% and you are geniuses. So each industry has its own challenges.
Umm, beating the SP500 by 2% consistently is rarified air even if that number sounds small. Morey admits that only a handful of teams have the requisite talent to even compete for the title. So your probability of winning the championship is either 0 or likely much better than a professional fund manager beating the SP500 by 2%.
Asset managers win by being good salespeople (a friend called this the Matt Levine model — being a good hedge fund is about gathering assets when you get hot and keeping them when you get cold. It’s a scheme for getting rich that has a lot less to do with returns than the industry will admit. Come to think of it, being a valuable sports franchise probably has more to do with the logo and stadium than actually winning…it’s not that winning and returns don’t matter, it’s the gap between how much they matter and how much we think they matter).
I’m guessing Morey threw the 2% number out there without much thought. He was actually making a deep point that if an adversarial game is technically easier (say checkers vs chess) the competition enjoys the same low-difficulty advantage and you are in the same place of having a low chance of winning. But I was curious…how hard is it to beat the SP500 by 2%?
I’ll admit a question like this is in my friend Nick Maggiulli’s wheelhouse so when he reads this he’ll almost certainly have a more complete answer. But I decided to take a quick stab at it.
I pulled up the portfoliovisualizer.com fund screener and filtered for US equity large-cap funds with at least a 5-year history benchmarked to the SP500 total return (this is an appropriate benchmark for a large-cap US equity fund.)
My criteria for beating the SP500 without getting lucky was the fund needed an information ratio (IR) of .50 or greater. An information ratio is outperformance normalized by tracking error. Tracking error is the standard deviation of the difference in returns between the fund and the SP500. If a fund outperforms by 2% per year but the tracking error is 10% (ie an IR = .2) that feels like noise vs a fund that outperforms by 2% with only 4% tracking error [I realize I’m using a simple, satisficey method for separating signal from noise, so if you are an allocator who just threw up in their mouth, brush your teeth then email me with an education so I can learn too!].
What did the screen turn up?
- 45 out of 677 funds had IR of .5 or greater (caveat: the IRs use a 3-year lookback)
- 8 funds out of 677 had at least .5 IR AND outperformed the SP500 total 3-year returns by 200 bps
- Only 3 funds outperformed by 200 bps for 5 years (the IR ratio is still a 3- year lookback)
Daryl your point is well-taken but beating the SP500 by 2% with skill is 90s Bulls-level for public fund managers.