It took a while for “Moneyball,” the data-driven approach to baseball described in Michael Lewis’ thusly-titled book and the subsequent movie, to establish its place in a sport traditionally driven by folklore and stereotypes. Fans know its working pretty well given the way modestly financed teams now compete with and beat wealthier old-school franchises. And now, Moneyball’s Wall Street cousins are elbowing their way into the middle of the old passive-active club.

The Passive-Active Dichotomy Is Ringing Hollow

When listening to so-called passive and active debaters mix it up, do you get the sense that both seem to be missing something important? The passive crowd has become befuddled to the point that it’s not sure how to react to the phenomenon of humans using brains to make decisions. Meanwhile, active investors wonder if doing anything more disciplined than casting spells and reading tea leaves means they’ve been taken in by the undead, or, rather, the uninvestors (the passive crowd).

What’s a contemporary strategist to do?

The Lay of the Land – Really

I think the only way to understand who is doing what is to ditch the now-stale active-passive dichotomy and recognize a new threesome that includes Moneyball-type newcomers. Here’s a proposed new set of classifications.

Top Down (or Index Based)

I refer here to investors who choose stocks based on their inclusion in some sort of broad and possibly generic category. Major index funds are an example. So, too, are sector funds or country/region funds.Broad-based size-related categories would qualify. Another example would be with general style-specific funds, such as ETFs that track Value or Growth indexes.

The idea, here, is that the investor is not deeply concerned with individual company-stock characteristics and what works or doesn’t work. That is not passivity: This investor determines (subconsciously if not openly) that certain broad categories of stocks have significant common elements that outweigh security-specific variations. In other words, small-caps have certain return-risk qualities, by virtue of size, that warrant (or do not warrant) having exposure to the group – and that this is so regardless of which small-caps companies cut guidance, announce stocks buybacks, outgrow peers, etc. We wouldn’t care what particular stocks are in the group; we just want them to be small caps, and that the group be defined in a credible way (in other words, a small-cap group consisting of issues with market caps above $100 billion would not cut it.) Other examples would be Healthcare-sector equity ETFs, Developed Europe ETFs, etc.

Top Down investors would be successors to the ones many traditionally referred to as passive. The innovation here is that these investors acknowledge and take accountability for the sort of top-down decisions they make; a decision to track broad index like the S&P 500, a preference for tracking a broader total stock market index; a decision to track the Russell 2000 Value Index, etc.

Notwithstanding different top-down choices they make, these investors lack of faith in one’s ability to successfully choose individual stocks through any method. They prefer, instead, to focus on big-picture classifications that distance themselves from the characteristics of individual stocks. If you’re in one of the big generalist robo-advisers like Wealthfront or Betterment, these are the principles that are guiding your portfolio (not just stocks, fixed-income too). That’s fine if it’s what you prefer. Just don’t get caught up in rhetoric in which firm’s cry “passive” in an effort to avoid responsibility for the performance they deliver (they seem willing to sacrifice praise if things go well, although I doubt their marketers would object if same were to heaped upon them; the big thing is to avoid blame if things go sour).

Moneyball Investing: Factor-Based (or Rules Based)

These are data geeks, disciplined investors who are similar to the top-down crowd in that they believe in and use objective rules to guide their choices. Both categories of investors determine the rules for portfolio inclusion (or deletion), click “Go” or something like that, and accept whatever stocks enter and exit the portfolios after the computers devote as many nanoseconds as are needed to doing the grunt work.

The difference between Indexers and Factor Based investors is that the latter believe in the merits of stock selection and come up with many different sets of detailed factor-based rules in an effort to point them toward issues with characteristics they believe will be associated with superior risk-return characteristics. Smart Beta funds do this by weighting stocks to the extent they have or lack desired characteristics. Smart Alpha is a broader term that includes Smart Beta and also an approach that focuses not on weighting but the presence or absence of particular characteristics and/or on how a stock ranks for a characteristic on a best-top-worst scale. (This latter approach is what I do on Portfolio123.)

An example is my Cherrypicking The Blue Chips Smart Alpha strategy. While an Indexer might be satisfied to choose stocks in the S&P 500, my factor-based Moneyball approach selects just 10 stocks from that index on the basis of a variety of indicators with the largest concentrations being in Value and Sentiment.

This is the group that was traditionally referred to as Active. These investors may use rules, but they are not necessarily articulated in an objective and precise way, and they may use different set of rules at various times. Others, however, may have a completely eclectic approach that varies from one decision to another.

There is also a hybrid approach in which one starts with a rules-based model but instead of investing in the resulting set of stocks, uses the list as a set of ideas for research and application of judgment. I wrote two books based on this approach before I got to Portfolio123, back when I only had access to screening and no ability to rank or test in a disciplined automated way. I’ve come across many money-managers who still work this way. And based on rhetorical tidbits I’ve noticed here and there, I suspect that even Jim Cramer and/or those with whom he works operate in this manner.

There are legendary geniuses that have succeeded magnificently as active investors, Warren Buffet being a prime example. Arguably his teacher, Ben Graham, is in this category (although much of what I see in the Graham & Dodd classic leads me to suspect he and Dodd might have joined the Moneyball crowd had they had the available technology).

The downside, here, is that it’s incredibly difficult to succeed this way. Every investor has to believe in his or her own personal genius (or in the genius of the network of analysts or others with whom he or she consults). That’s what it takes to get out there and put money on the line. The reality is that few among us are as brilliant as we like to think we are or wish we could be. The reams of literature you may have encountered suggesting you can’t beat the market comes from studies involving practitioners of this approach.

The other negative here involves image. There are more successful and less successful practitioners of every approach. But it does seem that the worst of the worst investors, the ones who go from riches to rags or seem likely to send you on that path, come from this group.

It’s About The New Kid On The Block

Aside from cleaner definitions, the big change here is the insertion of a third category in between what has traditionally been known as Passive (renamed Top Down) and Active (renamed Subjective). The new kid on the block is Moneyball-like Factor-Based Investing.

This is the group that was traditionally referred to as Active. These investors may use rules, but they are not necessarily articulated in an objective and precise way, and they may use different set of rules at various times. Others, however, may have a completely eclectic approach that varies from one decision to another.

There is also a hybrid approach in which one starts with a rules-based model but instead of investing in the resulting set of stocks, uses the list as a set of ideas for research and application of judgment. I wrote two books based on this approach before I got to Portfolio123, back when I only had access to screening and no ability to rank or test in a disciplined automated way. I’ve come across many money-managers who still work this way. And based on rhetorical tidbits I’ve noticed here and there, I suspect that even Jim Cramer and/or those with whom he works operate in this manner.

There are legendary geniuses that have succeeded magnificently as active investors, Warren Buffet being a prime example. Arguably his teacher, Ben Graham, is in this category (although much of what I see in the Graham & Dodd classic leads me to suspect he and Dodd might have joined the Moneyball crowd had they had the available technology).

The downside, here, is that it’s incredibly difficult to succeed this way. Every investor has to believe in his or her own personal genius (or in the genius of the network of analysts or others with whom he or she consults). That’s what it takes to get out there and put money on the line. The reality is that few among us are as brilliant as we like to think we are or wish we could be. The reams of literature you may have encountered suggesting you can’t beat the market comes from studies involving practitioners of this approach.

The other negative here involves image. There are more successful and less successful practitioners of every approach. But it does seem that the worst of the worst investors, the ones who go from riches to rags or seem likely to send you on that path, come from this group.

It’s About The New Kid On The Block

Aside from cleaner definitions, the big change here is the insertion of a third category in between what has traditionally been known as Passive (renamed Top Down) and Active (renamed Subjective). The new kid on the block is Moneyball-like Factor-Based Investing.

It isn’t discussed much in the literature because it’s so new. It barley existed until the 1980s. It wasn’t until the late 1990s and early 2000s that it became feasible and accessible to greater numbers of investors (directly through platforms such as Portfolio123 or indirectly through ETFs based on RAFI- or Wisdom Tree-type Smart Beta or Invesco PowerShares-type quant models.