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How Advisors Can Understand, and Use, Smart Beta Strategies

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Tony Davidow’s role at the Schwab Center for Financial Research is not to build products or sell them, or to dogmatically argue for passive or active strategies, but to research investment strategies, especially “smart beta” ones, and educate advisors about their role in client portfolios.

“Our view is that there’s a role for active and passive strategies; we haven’t given up on active managers,” said Davidow in a Nov. 5 interview leading up to Schwab’s annual Impact conference, being held in Washington from Nov. 10-13.   

“Not all alternatives are created equal,” Davidow said, and while he says there are many smart beta strategies available to advisors, those strategies yield “very different results over time.” Moreover, in looking at passive strategies, both traditional index investing and smart beta strategies, such as the fundamental indexing approach pioneered at Research Affiliates by Rob Arnott and Jason Hus, “both market cap and fundamental strategies are complementary.”

For example, under some market conditions, market-cap weighted strategies will perform better, he pointed out, such as what he calls the ‘Apple effect.’

“If you’re overweighting the biggest companies in the index, sometimes you’re rewarded, like Apple in the first three quarters of 2012.” However, over the last quarter of 2012 and the first of 2013, when Apple’s share price declined, so too did the underlying S&P and the market-cap weighted mutual funds and ETFs based on that index. “Much of the return differential is explained by the Apple effect,” Davidow said.

There’s another benefit to advisors in using both passive and active approaches: keeping clients invested in the market. “There are some advisors who can and will make tactical calls” as market conditions change, but Davidow says “most advisors want to keep their clients engaged,” and using smart beta can reduce a portfolio’s volatility over time, so its more likely advisors’ clients will “stay committed to the plan.”

So that’s why “there’s a role for market cap and fundamental” index investing, and also a role for advisors to identify “those strong active managers who can play defense in troubled market times. If you believe there will be shocks to the market, wouldn’t you want a manager who can play defense?” 

So what’s the value of smart beta strategies, and are advisors interested in those strategies, especially in ETFs based on fundamental indexing? “There’s so much interest in this because it shows excess return; it stacks up well from an alpha perspective relative to market cap and active managers.” But it’s not just “excellent returns but also risk-adjusted returns” that smart beta can provide, and if they’re “delivered in an ETF or mutual fund, they tend to be cost effective.”

That interest is reflected in the “roughly $156 billion in assets following RAFI strategies,” referring to Arnott’s Research Affiliates Fundamental Indexes. Now that RAFI-based strategies have not just strong academic research but “now a track record” of performance, the demand for those strategies has been particularly strong, expecially among institutional investors.

Davidow says that BlackRock’s latest research shows that the total number in smart beta—which includes fundamental, equal weight and low volatility indexing—has reached $180 billion, with $45 billion attracted to those strategies in 2013 alone. 

As vice president for alternative beta and asset allocation strategist at the Schwab Center for Financial Research, Davidow says his educational efforts among advisors has had a “warm reception” that is “overwhelmingly positive.” That’s not only because many advisors are thinking about the overall cost of investing strategies and re-exploring the active versus passive debate, but more important, looking at “how to improve the client experience” with these lower volatility strategies.

Turning to the broader universe of exchange-traded funds, Davidow said that “we believe there’s more room for innovation,” including in fixed income and alternatives, an opinion he says is shared throughout the industry. “It’s clearly a different environment than the early days” of ETF investing, before returning to his theme of benefiting the end investor.

“In the next wave” of ETF introductions, he said, “if we can improve the experience of the end client, that client will be enriched and will invest further. We’re still in the early innings of ETF innovation.”

Check out Schwab’s Sonders: Market Remains ‘Quite Cheap’ on ThinkAdvisor.