The Scripps National Spelling Bee and the Pursuit of Alpha

This ETFInvestor weekly update was originally sent to subscribers on May 29, 2015.

After I started (and finished) reading Larry Swedroe's "The Incredible Shrinking Alpha"[1] last night, I tuned into ESPN to watch SportsCenter's coverage of...the Scripps National Spelling Bee. Having been primed by what I had just read, I was struck by how neatly the evolution of this Super Bowl of spelling seemed to align with the concepts put forth by Michael Mauboussin and co-author Dan Callahan in "Alpha and the Paradox of Skill."[2] 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 has increased with time. In 1925, Frank Neuhauser took home the first National Spelling Bee trophy. His final word? "gladiolus" (from Latin). This year's co-winners, Gokul Venkatachalam and Vanya Shivashankar split the top prize after outlasting the remaining 283 competitors and successfully spelling their final words "scherenschnitte" and "nunatak," respectively. (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 are clearly more skilled than their predecessors.

It is also interesting that this is the second consecutive year that there have been two winners to emerge from the field. The reason? The event's organizers ran out of words for the contestants to spell. 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 does all of this mean in the context of the 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 is 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 an obscure German word on national television will only get you half a trophy.

[1] Swedroe, L. & Berkin, A. 2015. "The Incredible Shrinking Alpha." (St. Louis, MO: Bam Alliance Press).

[2] Mauboussin, M., & Callahan, D. 2013. "Alpha and the Paradox of Skill." (Zurich: Credit Suisse). http://analystreports.som.yale.edu/internal/F2013/MJ/Alpha%20and%20the%20Paradox%20of%20Skill.pdf

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