Reading coverage of this year's Scripps National Spelling Bee in the U.S., I was struck by how neatly the evolution of this Super Bowl of spelling seems to align with the concepts put forth by Michael Mauboussin and co-author Dan Callahan in "Alpha and the Paradox of Skill."[1] In this paper, the authors state that:
In many competitive interactions it is the relative level of skill that matters, not the absolute level of skill. In many fields, including investing, the dispersion of skill is shrinking, which leaves more to luck.
They go on to frame this concept using a familiar example from the world of sports:
The late Stephen Jay Gould, an evolutionary biologist at Harvard University, wrote about this to explain why no hitter in Major League Baseball has had a batting average over .400 since Ted Williams hit .406 in 1941. He showed that the coefficient of variation (standard deviation divided by the mean) declined steadily over the past century, which is consistent with a declining variance in skill and stable variance in luck. Gould concluded that the skill of modern players is better than ever but that the spread of skill has narrowed. Follow-up studies in baseball support this hypothesis.
The same phenomenon seems to be affecting the world of competitive spelling. Based on my admittedly unscientific research, the absolute level of skill of Scripps spellers appears to have increased with time. In 1925, Frank Neuhauser took home the first National Spelling Bee trophy. His final word? "gladiolus"(from Latin).
This year, there were an unprecedented eight co-winners, dubbed the "Octochamps." These eight superb spellers went toe-to-toe for 20 rounds outlasting the remaining 554 competitors and successfully spelling final words such as "erysipelas"and "aiguillette."(A complete list of former champions and winning words can be found here.) Knowing one's flowers doesn't cut it anymore, as today's spellers appear to be more skilled than their predecessors.
Multiple winners have been named in three of the past five contests. Is this evidence that the relative level (that is, standard deviation) of spellers' skill has narrowed with time? Again, this is an unscientific thought experiment on my part, but it seems this might be the case.
What might this mean in the context of investors' pursuit of alpha? According to Mauboussin & Callahan:
These analyses introduce the possibility that the aggregate amount of available alpha--a measure of risk-adjusted excess returns--has been shrinking over time as investors have become more skillful. Investing is a zero-sum game in the sense that one investor's outperformance of a benchmark must match another investor's underperformance. Add in the fact that in aggregate investors earn a rate of return less than that of the market as a consequence of fees, and the challenge for active managers becomes clear.
The supply of available alpha seems to be shrinking, getting more difficult to come by each day. This is not because active managers are bad at their jobs. It's because, in aggregate, they are more skilled than ever before--on an absolute basis. Meanwhile, their relative skill level has narrowed. The net result is a fiercely competitive field fighting over a diminishing prize. This phenomenon is by no means unique. These days, being able to spell the name of a bacterial infection on ESPN will only get you one-eighth of a trophy. (Each of this year's winners actually won US$50,000 and received their own trophy)
[1] Mauboussin, M., & Callahan, D. 2013. "Alpha and the Paradox of Skill."(Zurich: Credit Suisse). //research-doc.credit-suisse.com/docView?language=ENG&format=PDF&source_id=em&document_id=805456950&serialid=LsvBuE4wt3XNGE0V%2b3ec251NK9soTQqcMVQ9q2QuF2I
