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Larry Swedroe Feb 24, 2016
In second place, at least as of November 2015, was BlackRock, the largest provider of index ETFs. Their iShares ETFs had $1 trillion in assets as of September. In third place was WisdomTree Investments, another provider of passively managed ETFs. In fourth place appeared Dimensional Fund Advisors (DFA), a leading provider of nonindexed, passively managed mutual funds. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
Thus, they will continue to play the active game. It’s the losers from Group B, those with either less skill or bad luck, who will abandon active management in favor of passive strategies. We can then conclude that the remaining players in the pursuit of alpha are more than likely to be the ones with the most skill. After all, if an investor’s outperformance was based on good luck, the good luck will eventually disappear and they will join the losers in Group B and eventually abandon the game. As less-skilled investors abandon active strategies, the level of competition among the remaining participants will increase.
The following example from my book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, comes from game theory. It helps to explain why the level of competition is likely to continue to increase, persistently raising the hurdles for successful active management.
You are given a choice to play or not to play the game. If you don’t play, you will get paid based on the average score of all the players who do decide to participate. The best free-throw shooter in the league shoots about 90%, while the average player shoots just 73%, and you shoot 83%. Should you compete, or accept the average score of those who participate?
Since you shoot an above-average percentage, it seems like you should play. However, the fact that you are above average is irrelevant because all the players with a below-average shooting percentage should choose not to play. And, anticipating this occurrence, all the players with above-average scores should decide not to play as well. Logically, only the player with the best percentage should choose to compete, and everyone now has an expected return of $90,000.
What does this scenario have to do with investing? As we have discussed, it seems likely that those abandoning active management in favor of passive strategies will be investors who have had poor experiences with active investing. As less-skilled investors flee active strategies, the level of competition among the remaining players will increase.
Charles Ellis, one of the most respected people in the investment industry, noted the following in a recent issue of Financial Analysts Journal. He wrote 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 Technology, 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, Eduardo Repetto, the co-CEO of DFA, holds a Ph.D. from Caltech and worked there as a research scientist, and DFA’s co-CIO Gerard O’Reilly also has a Caltech Ph.D. in aeronautics and applied mathematics. And my co-author, Andrew Berkin, the director 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.”
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. Yet no one has hit .400. Why? While batting averages were the same in the two eras, the standard deviation has dropped dramatically, from 40.6 points in 1921 to 26.1 points in 2003. Batting .400 is now a more than five standard deviation event, with a probability of less than one in a thousand in a given year. In other words, no one hits .400 anymore because the average baseball player of today is far better than the average player of a hundred years ago.
The paradox of skill means that while today’s athletes are more skillful, they are not likely to produce the kind of outlier results that the legends of yesteryear achieved. We see the same phenomenon in the game of active management, where the quest for alpha has become ever more frustrating as the level of skill among competitors rises.
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