Moneyball may have missed out on winning Best Picture at the Oscars a few years back, but the story of how Billy Beane changed baseball by using statistical analysis to predict tomorrow’s big winners is every numbers-geek’s dream. And it has more to do with the success of your clients’ portfolios than you might think.
Billy Beane’s goal was to build a winning team by using statistical data to pick players who can do just one thing: get on base and score runs. As an advisor, your goal isn’t much different. You look at each client’s specific needs, and then put together a portfolio designed to achieve their goals. Of course, in today’s volatile market environment, managing risk and building the ‘right’ portfolio is harder than ever. If your client has a long time horizon ahead, the challenge is minimal. But what about retirees whose portfolios can’t afford another downswing in the market? And what if their time horizon is so short that a high level of liquidity is an absolute must?
Just like in Moneyball, the answer sits smack in the middle of the numbers. By looking at the data differently—and looking at different data—it’s possible to apply a traditional investment concept in a whole new way. The tool? The fixed income ETF. The difference? By taking a fresh approach to evaluating and benchmarking bonds, fixed-income ETFs seek to take the guesswork out of bond selection.
But wait. Let me jump back. It’s not even the seventh inning yet and I’m way ahead of myself. First let’s look at what has, for some, has made ETFs feel all too risky as a solution for the investors who need them most: older retirees.
- First, the traditional ETF ratings system is almost like old-world baseball scouts. Agencies sometimes focus on past performance rather than future benefit. By looking backward instead of forward, you could fail to look at the single most important factor in a bond’s level of risk: each entity’s ability to pay existing bonds in the future. Add in reporting delays, political influences, and industry pressures, and it’s clear these ratings are far from perfect.
- Second, the benchmarking system—specifically the practice of benchmarking against common benchmarks—is a problem. Some are made up of thousands of bonds to produce seemingly predictable measures, but many of those bonds are either not available for sale today or they’re available only in small numbers and are inaccessible to investors. As a result, the data can be outdated. It’s a situation that begs for a more reliable benchmark that applies to the real world.
- Third, aside from the risk issues, most ETFs are just plain confusing. Every fund manager claims to have a “secret sauce” that makes their “smart beta” better than yesterday’s “strategic beta.” Plus, while the funds themselves may be transparent, the processes used by the fund managers are not, making it difficult to downright impossible to complete due diligence or properly understand risk for every bond in each fund. So how do you even go about selecting the right fund for a specific client?
These are very real issues, and yet steering away from ETFs as a whole is a clear case of throwing the baby out with the bathwater. Luckily, there’s a better way to take advantage of the benefits of fixed income ETFs. The solution is credit-scored index funds. Taking a lesson from Billy Beane, these funds rethink how bonds are rated, reevaluate how bonds are selected, and remove complexity to deliver a more passive, conservative, and consistent approach.
They begin by rethinking the way bonds are rated. Bonds aren’t ballplayers, but by throwing out the old ratings systems and instead taking an objective look at the credit score of each entity to determine their overall strength and how well each business is managed, it’s much easier to assess and mitigate risk. Think of it like letting go of the star pitcher with the bad arm and a drinking problem to make room for a more consistent, reliable player. Less flash. More substance.
Rather than indexing a vast pool of unknown bonds, they include only real-world, investable bonds. Credit-scored ETFs are designed to support scalable, measurable portfolios, by using factual data, including management efficiency, profitability, and solvency to assess the quality of each issuer. Just like that, judgment calls based on theory are now decisions based on facts.