Open Market Musings

I don’t bring this up very often, but before I wrote here, I had a job trading interest rates. I won’t bore you with the technical details, but I’ve been drawing on that experience a lot recently in thinking about how teams operate when signing free agents, so I thought I’d lay out my recent thoughts here. None of this is quite fully formed yet, but I think I’m on the way there, and I’d love to hear some feedback and see if I can better formulate my point as a result.

Speaking broadly, there are two main ways to get a return on your investment in finance. First, you could lean into the efficiency of the market. You’ve probably never heard of most of the companies that do this: Virtu, DRW, Jump, Hudson River, Susquehanna, Two Sigma. They’re all major players with virtually no broader name recognition. They’re broadly considered “high-frequency traders,” which means they buy and sell an absolutely massive number of stocks and bonds every day, trying to make a tiny profit on each one.

This is the “efficient market” you learned about if you took an economics class in college. If you’re trying to buy one share of a stock and I’m trying to sell one, a high-frequency trader will hope to sell to you at $100.00, buy from me at $99.99, and pocket the penny of difference. Do that a billion times, and pretty soon you’re talking about real money. It’s more complex than that — obviously, given the amount of brain and computing power all of these companies exert — but you can broadly think of them as profiting because there’s a well-accepted price for any given security at any given time, which means they can make money off of tiny deviations from that fair price.

There are some important assumptions implicit in thinking of the world this way. Markets need to be continuous; if only one stock trade could be made every day, I don’t think you’d see many people looking to make a penny on a stock trade. If you can’t freely buy or sell the thing you’re trading, you’ll have a hard time running a strategy where you, as some people derisively describe it, pick up nickels in front of a steamroller.

Markets need to be fungible; every share of a company is interchangeable (ignoring dual-class stock, get out of here you filthy finance pedants). You don’t hear of high-frequency artwork traders because, well, that doesn’t make any sense. If someone wants to buy a share in a company, they’re looking for any share, not one particular one with their name on it. Every piece of art is different, give or take some Andy Warhol prints, so art doesn’t fit this criteria. You can’t buy any old Van Gogh and sell it to someone looking to buy Starry Night. You can do that with stocks and bonds, which is why these high-volume, low-margin trading outfits work.

Finally, markets need to be near-frictionless. If you had to pay 15 cents every time you traded a stock, you couldn’t make money by looking for single-cent opportunities. Transaction costs matter quite a lot when you’re operating in bulk. Think of houses: there are huge transaction costs associated with buying and selling them. The higher the transaction costs, the less likely a market is to have high-frequency efficiency.

That general idea — there’s a fair price for everything, and profit is made on the marginal differences between transaction price and fair value — is a really popular way of thinking about the world. It’s easy to see why: it’s so cleanly logical that it feels intrinsically right. Why shouldn’t there be a fair value for everything, be it a security, a pair of headphones, or a baseball player’s open-market contract?

In practice, the world mostly doesn’t work that way, though. Pretty much nothing is continuous, fungible, and frictionless. You can’t buy Oreos for three bucks and sell them to someone who wants Chips Ahoy for four dollars; they’re different cookies. If you buy a house, you can’t resell it two minutes later for $1,000 more and pocket that money. The real world is very much unlike financial markets, and that’s all to the better. A commodified world would be no fun to live in — every house exactly identical, every foodstuff a dead ringer for the thing on the next shelf up.

Yet plenty of baseball analysis treats the free-agency market as if it were the New York Stock Exchange. Pundits, myself occasionally included, judge deals based on expected surplus value as though there’s some kind of constantly updating scoreboard and trading setup that lets you mark every contract to market and gain or lose based on that. You can’t sign a reliever to a one-year, $7 million deal, then make a million dollars because someone else is willing to offer a similar reliever a one-year, $8 million deal. So why do we focus on whether a deal was “good” or “bad” by appealing to some nebulous concept of surplus value?

The market for free agents more closely resembles the second way that people try to turn a profit in finance, the one I haven’t mentioned yet. In my experience, it works better in less liquid markets, ones where there isn’t a ready price for everything all the time with buyers and sellers lined up to transact. That doesn’t mean only famous works of art; there’s plenty of room between a share of Coca-Cola and a Renaissance masterpiece. The less frequently something changes hands, and the fewer market participants there are estimating its value and vying to buy or sell it, the less the market price has to say about its expected value.

In finance, that might mean that the price of some dated treasury bond is “wrong” because someone showed up to sell a ton of them and there weren’t many buyers handy, or that the market for lending euros to borrow dollars for three months in six months’ time can get out of whack from time to time. The specifics aren’t important; the point is that the less fungible and less liquid something is, the less you can rely on the language and concepts of efficient markets to evaluate it, and the more you need to apply your own value framework instead.

Baseball players aren’t financial assets. You could maybe argue that the contracts they sign in free agency are, but that’s not really right either. That doesn’t stop people from talking about contracts that way, but even if you make the bad faith argument that we should think about all of this in dollars and cents, the language everyone is using doesn’t make much sense to me.

Trying to decide whether to sign a free agent depends on countless different factors, both large and small. Competitive window matters. The players already on your roster matter. How you plan on working with that free agent to get the most out of them matters. Two teams could have completely different ideas on how much they’d be willing to pay Shelby Miller, to pick a random example, and both be correct in their own context. Free agents have agency, too — that’s why we call them free agents. They’re not required to accept the highest-dollar contract; they can do what is in their best interest, whether that’s developing skills for the future, living in a city they like, or just making the most cash.

In fact, the so-called surplus value in a given contract is pretty far down the list of relevant points in most free-agent signings, in my eyes. Baseball players aren’t anything close to fungible. They’re all unique, and the needs of the 30 teams participating in free agency are unique. Reducing the discussion of free agency to an accounting of dollars and cents compared to some model misses most of the point of the exercise.

That doesn’t mean that no contract is an overpay, or that none is a bargain. You can consider many factors in harmony and say, nope, the Royals probably shouldn’t have signed Carlos Santana two years ago. But it does mean that a lot of knee-jerk reaction to deals that focuses on whether a team overpaid or underpaid to secure a given player’s services are missing the point. As an example, I’ve seen a lot of back and forth about the deal signed between José Abreu and the Astros. Most of the reasons not to like the deal are that if you count up the public-side projected WAR and the dollars he signed for, the equation looks a little bit off.

That might be true. It also doesn’t matter a ton in the context of the Astros, I’d argue. First base was the easiest place for them to upgrade and also the place where they had the least clear internal replacements. They’re smack dab in the middle of a World Series contention window, so adding extra talent is at its most important. I wouldn’t evaluate this deal differently if it were for $6 million less, but I bet a lot of people would.

The amusing part of all of this financializiation of baseball, at least to me, is that it mostly misses the point. The hard part of portfolio management isn’t finding something that is worth more or less than the value your model spits out. Model-building is hard — just ask Dan Szymborski — but model interpretation is hard, too. Looking at a bunch of confusing inputs and figuring out what to pair with what so that the overall basket you end up with makes sense is really hard, particularly when you’re dealing with something with as many variables as a baseball team.

The hardest part of figuring out how to put a team together isn’t figuring out which player’s contract to scrimp and save a million dollars on; it’s literally everything else other than that. How can you assemble the best 26-man roster? Which pitchers are best suited to learn from your team’s pitching development group? How can you balance depth with top end? How can you make trades with an eye toward avoiding 40-man roster crunch? If you make a big splash in free agency now, how will that affect your roster composition in two years? All of that stuff is really hard to optimize, and bears thinking about.

Dollars-and-cents thinking about baseball isn’t going away. It’s the inescapable legacy of Moneyball; everyone wants to play GM, and the easiest way to play GM is by counting money and wins. I think the general public is relatively good at those aspects of baseball now, because we’ve spent the last 15 or so years laser-focused on them. The rest of what a front office does is harder to slap a number on, and so it’s relatively ignored.

I don’t have an obvious conclusion to all of this rambling, aside from saying that I’m trying to focus more on the less-visible aspects of team construction these days. Sure, some teams just need a great hitter and have five places on the diamond where they can play them. But that’s not the case for most contenders, and it’s particularly not the case when you consider the players in their farm system, the age and contract status of their existing major league team, and plenty of other factors to boot. I’m not saying that I have all the answers, but I do think that treating free agency more like a qualitative puzzle and less like a quantitative equation is a worthy endeavor, and I’m going to try to do more of it.