Trader tales: The Incredible Shrinking Alpha

“There are many myths about active investing [being] the winning strategy,” Larry Swedroe, the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners, tells Opto.

In an effort to debunk some of them, he has co-authored The Incredible Shrinking Alpha: How To Be A Successful Investor Without Picking Winners, alongside Andrew Berkin, who is head of research at Bridgeway Capital Management. The book looks at how to develop an investment plan to consider risks.

In the expanded second edition, Swedroe looks to warn the public about “just how much the odds are stacked against you if you choose active management”. He adds, “I also wanted to explain why the ability to generate alpha, outperform, has been collapsing.”

“I also wanted to explain why the ability to generate alpha, outperform, has been collapsing.” – Andrew Berkin

The book tells readers how they can implement systematic investment vehicles, such as (but not limited to) index funds into their own strategy. For Swedroe: “The chapter that explains how academics have been busy converting what was once alpha into a common trait (beta) or characteristic that can be accessed systematically at much lower costs and with greater tax efficiency, is the key to understanding why alpha is shrinking.”

The following excerpt is taken from the start of chapter three of The Incredible Shrinking Alpha, which is titled The Competition Is Getting Tougher, published with permission.

The paradox of skill

What so many people fail to comprehend is that in many forms of competition, such as chess, poker or investing, it is the relative level of skill that plays the more important role in determining outcomes, not the absolute level. What is referred to as the “paradox of skill” means that, even as skill level rises, luck can become more important in determining outcomes if the level of competition is also rising.

Charles Ellis noted in a 2014 issue of the Financial Analysts Journal that “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition… They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.” Legendary hedge funds, such as Renaissance Technologies, SAC Capital Advisors, and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases.

For example, Gerard O’Reilly, the co-CEO of Dimensional Fund Advisors (DFA), has a Ph.D. from Caltech in Aeronautics and Applied Mathematics. Eduardo Repetto, the CIO of Avantis Investors, has a Ph.D. from Caltech and worked there as a research scientist. And coauthor Andrew Berkin, the Head of Research at Bridgeway Capital Management, has a Caltech B.S. and University of Texas Ph.D. in physics, and is a winner of the NASA Software of the Year award. According to Ellis, the “unsurprising result” of this increase in skill is that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees.”

“The increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them” – Charles Ellis

Analogous examples are seen in the sports world. For instance, from the advent of the modern baseball era in 1903, seven players achieved a batting average over .400 a total of 12 times. But the last to do so was Ted Williams, who hit .406 in 1941. Yet, today’s players are superior athletes—they are demonstrably bigger, faster and stronger, use superior training techniques, and have better diets.

However, all players have these advantages. The result is that as average skill increases, it becomes more difficult to outperform by large margins—the standard deviation of outcomes narrows. In the first 20 years of the modern era (1903–1921) the average hitter batted about .250–.260. During that period, the .400 mark was reached four times. Since 1950, batting averages have been fairly stable in that same .250–.260 range. This is true despite the fact that both the pitching and defense have also improved, as have the fielder’s gloves. For example, every single year from 2010 through 2019 the average hitter batted no lower than .248 (the lowest average since 1969) and no higher than .257. And the highest average in the last 50 years was .271. Yet no one has hit .400. Why?