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The charismatic Mauboussin, whose fully formed thoughts pour out of him with barely an “um,” asked me rhetorically how that could work. Gould wrote a book to explain the paradox, focusing on why the last baseball player to hit above .400 was Ted Williams in 1941. The answer, Mauboussin explained, was that the quality of the players was uniformly better than in the past, so all those great batters were hitting against equally talented pitchers. That meant the difference between the best players and the average players had narrowed.

“The standard deviation of batting averages has gone down,” says Mauboussin. “If Ted Williams was a 4-standard-deviation event in 1941, then he would have hit .380 in 2011. Awesome, but still less.”

In investing the paradox of skill means that many managers are producing similar results. In other words, alpha is going down. Mauboussin refers to the writings of Charley Ellis: “He said that before the 1970s we institutions competed against mom and pop. You can get the money from them all day; my positive alpha is an individual’s negative alpha.” If Ellis was starting to see the paradox of skill play out five decades ago, I was convinced that alpha might barely be kicking in 2013.

Mauboussin says that from 1967 to 2012 the standard deviation of excess returns for U.S. large-cap mutual funds has declined from about 16 percent to less than 8 percent (see chart). He explains that investors should go after areas of the market in which they can be the most skillful (remember all those institutions playing against individuals in the middle of the last century). If standard deviation declines — meaning many managers’ investment results are about the same — the game is over.

“There has been a steady decline in standard deviation in excess returns exactly as Stephen Jay Gould predicted for baseball,” Mauboussin says. “People will grind toward peak performance, and the difference between the best and the average is narrowing, so the results get really clustered.”

The elusiveness of alpha cuts to the core of capitalism itself. Good ideas — whether the iPhone’s touch screen or convertible bond arbitrage — get copied. “It’s creative destruction,” says AQR’s Asness, adding that good ideas actually remain good ideas for far longer in finance than in other industries. In part, that’s because it is harder to tell whether the good idea is the result of a brilliant insight or just luck.

There was a lot less creative destruction of good investment strategies when individual investors still ruled the markets. In the past 50 years, Ellis says, volume on the New York Stock Exchange has increased more than 2,000 times, with exchanges around the world experiencing similar growth. At the same time, the balance of trading in the U.S. has gone from 90 percent individuals to about 90 percent institutions, according to Ellis. And not just any institutions: professional mutual fund companies, hedge fund firms and others earning high fees that could then be plowed into technology, research and expensive analysts to follow companies and trends. The U.S. mutual fund industry alone went from $3 trillion in assets in 1995 to $15 trillion at the end of 2012. Foreign investors also have entered markets as cross-border capital flows have been encouraged and investors diversified out of their home countries. These investors have been able to arbitrage away inefficiencies that existed among markets that previously were entirely separate. Stock picking itself has become professionalized. In 1987, 15,500 people held the designation of chartered financial analyst from the CFA Institute; both Ellis and Duncan point me to the fact that there are now 110,000 CFA holders worldwide.

Alpha has fallen victim to technology. In the 1990s the growth of personal computers, telecommunications networks and the Internet drove stock market returns as investors flocked to companies in those sectors. But the still-nascent technologies had a much more permanent impact on the way investors discovered information about securities. The Internet made once-arcane sources of data available to everyone. The rate at which valuable information could be found, disseminated and acted upon rose exponentially. An analyst could no longer look smart simply by watching Wal-Mart Stores’ parking lots for clues about trends in discount retail sales.

In 1996 the stage was being set for high frequency trading, another dangerous thief of alpha. That year regulators enacted order-handling rules designed to introduce fairness after the Nasdaq Stock Market price-fixing scandal. The rules created electronic communications networks (ECNs) that could publish stock prices alongside exchanges. In 1999, Regulation of Exchanges and Alternative Trading Systems went live, allowing ECNs to act as markets without having to register as exchanges. Two years later high frequency traders got their shot when the exchanges began quoting prices in decimals rather than fractions. Bid-offer spreads shrank, and competition increased dramatically, as lightning-speed traders moved in and out of transactions, picking off tenths of pennies.

“The more integrated — fewer trade restrictions and capital controls, supportive technology, to name a few — the greater the efficiency of the local market,” says State Street’s Duncan. High frequency traders have forced money managers to implement expensive trading operations to protect the alpha in their good investment ideas from being picked off by more-nimble computer algorithms.

In 2000, Yale’s Swensen published Pioneering Portfolio Management, which laid out his thesis for a portfolio that looked entirely different from the general template — 60 percent equities, 40 percent bonds — traditionally used by institutional investors. Swensen extended diversification to include private equity, hedge funds, real estate and commodities.

The time was ripe for Swensen’s method. The dot-com bubble had burst, and investors were feeling the effects of real-time information on alpha in the public markets. Regulation Fair Disclosure was enacted in 2000, prohibiting public companies from releasing information to select groups like Wall Street analysts. By then Harvard, Princeton University and Stanford University were using Swensen’s model; soon other big investors were copying it. Allocations to alternatives, as well as for investments in emerging and frontier markets, grew. According to State Street and Tufts’ Fletcher School, pension funds in Organization for Economic Cooperation and Development countries raised their allocations to alternatives from 6 percent to 19 percent of total assets under management between 2000 and 2012.

Investors using the endowment model didn’t fare well in the credit crisis. Correlations went to 1, meaning every asset class dropped at the same time. Many endowments that had jumped on the Swensen bandwagon had to issue bonds to generate cash even as the public markets were reeling. But the troubles with the endowment model had little to do with the validity of Swensen’s thinking on portfolio diversification. “It’s an idea thousands of years old,” says André Perold, co-founder and CIO of HighVista Strategies, a Boston-based firm that manages $3.6 billion in endowment assets for institutions and private investors. “Chinese merchants famously divided cargo among several vessels when traveling dangerous rivers.”

But now there are more vessels traveling the same dangerous river. During the five years since the financial crisis, the vast majority of endowments have lagged the performance of a simple, traditional 60-40 portfolio. Perold, a professor emeritus of finance and banking at Harvard Business School, says diversifying into foreign equities, real estate and commodities didn’t reduce volatility; it actually increased it.

The problems had everything to do with the fact that everyone had been copying Swensen’s investment moves in hopes of achieving a similar outcome. But everybody dancing the same dance was merely a symptom of something larger going on in the investment world. Alpha was dying, and investors were hot for an edge. Ellis cheekily alleges that most of the copycats jumped right to the end of Swensen’s 2000 book — the “how to” section — skipping the first ten chapters on ways to protect principal and build an approach suitable to their institutions.

Perold takes me through his thinking on correlations-as-1-risk. Alpha can exist in a highly correlated world, but active investors need to hedge out the macro risks to reduce the correlations. “If you weren’t able to hedge your macro risk, it made alpha generation hard,” he explains. “Most active investors aren’t that good at that.” So when hedge funds make a bet in a world where correlation is high, they are just taking on more risk than they otherwise would. Their results then are much more random. Perold argues that alpha isn’t really dead, but if investors can’t identify managers with the skill to find it, it might as well be.

Looking back at the numbers, market return — beta, not alpha — has been declining in certain asset classes for some time. According to State Street and the Fletcher School, the mean return for both U.S. and non-U.S. equities was more than 11 percent between 1973 and 2010. For government and nongovernment global bonds, the mean return was 8 percent. But the story is different for the period between 1998 and 2012: Average annual returns for the S&P 500 and World Equity indexes, proxies for U.S. and global stocks, were 2.6 percent and 2 percent, respectively.

Investing in a low-return environment is extremely difficult. Returns for both stocks and bonds are expected to be in the single digits, at best, for the next several years, if not for the rest of the decade. Even a great alpha generator will deliver less if the pie is smaller. “A bull market covers a lot of sins,” says AQR’s Asness, whose firm’s view is that equity markets are expensive and bond markets are “wildly” expensive, leading to paltry returns going forward: “Whether it’s alpha or not, investors will feel like it’s tougher.”

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