Anthony Davidow is an optimizer. That’s not just a personality attribute; it’s also an essential requirement of one whose job title is “alternative beta and asset allocation strategist” of the Schwab Center for Financial Research.
While anyone who professionally allocates assets (which finance theory holds accounts for 90% of portfolio performance over time) is all about optimization, Davidow is the only financial exec this author has ever heard of whose title includes “alternative beta.”
And those two words seem to signal a key part of his asset allocation approach. Which is to say, Davidow really likes smart beta, the popular term for indexing that weights holdings by criteria other than price.
(Research Affiliates’ fundamental indexes may be the best known smart beta products, though Russell and S&P also fashion smart beta indexes, which include equal-weight- and low-volatility-based strategies as well.)
Few people have the professional opportunity to express their point of view in their job title (imagine a “Director of Hope and Change” or “Vice President of It’s Morning Again in America”), but Davidow somehow pulled that off.
Having had the opportunity to sit down with Davidow at the Schwab Impact conference in Denver this week, I at first listened to some familiar arguments about “alternative beta,” Schwab’s preferred description of the investing strategy.
Davidow told me that by weighting securities based on fundamental factors (such as price-to-sales ratios or cash flow) rather than market capitalization (which emphasizes the largest companies), smart beta indexes end up tilting toward value stocks that perform well over the long haul. This both enhances long-term returns and boosts Sharpe ratios — a measure or risk-adjusted return.
But the Schwab quant offered a fresh and bracing perspective when he pointed to a “universe comparison” evaluating different investment options found on page 9 of a whitepaper he authored called “An Evolutionary Approach to Portfolio Construction.”
Pointing to the S&P 500 Index up high on a vertical chart showing investment performance over the past decade, one could readily perceive that a plain-vanilla market-cap index fund had the merit of beating nearly 75% of its peers.
That is a huge achievement, and the reason for the great enthusiasm among passive investing advocates like Vanguard’s John Bogle.
Even if one believed in the existence of brilliant active managers, the sheer time and effort it might take to find those who might consistently outperform and to continually monitor their performance might not be worth the trouble; that level of due diligence might be appropriate for a large pension fund like Calpers, just not for ordinary investors.
But then Davidow pointed to the highest ranking performer on the universe comparison — a position occupied by a smart beta index, which blew away the market-cap weighted index by 232 basis points over the same 10-year period (and had more favorable risk characteristics to boot, sporting a 0.5 Sharpe ratio compared to the S&P’s 0.4).
Beating 75% of all investment managers in the universe consistently — as market-cap indexes do — is already an achievement, but adding a further 200 basis points in excess return relative to a very large universe is an optimizer’s dream come true.
“[The smart beta approach is] giving you what active managers strive to deliver but often fail to deliver—that elusive alpha,” Davidow sums the matter.
Q.E.D., right? End of argument. Well, not exactly. Davidow’s enthusiasm for smart beta made it difficult at first for me to assimilate his repeated assurances that both active and passive (including both market-cap and fundamental indexes) strategies play a role in an optimal portfolio.
But like I said, Davidow really is an optimizer. There are times, he explains, that one really wants the cheapness of traditional market-cap indexes, or the avoidance of tracking error with respect to a benchmark index.
And there are occasions as well to benefit from the best active managers, particularly those who can help their shareholders dodge some of the pain of falling markets as well as capture excess return in inefficient markets (such as international small-cap).
Add to those reasons varying investor preferences and sensitivities and one can now understand why Davidow insists that portfolio construction is both an art and science.
Davidow offers his own optimal allocation combining these three approaches on page 11 of his above-referenced whitepaper, allocating higher weights to passive strategies in the efficient large-cap sector, and higher percentages of active strategies in the international portfolio segment.
The result of this model portfolio is more stable excess returns than a strictly active or strictly smart-beta approach alone would generate — based mainly on the fact that the higher performing and superior Sharpe ratio of the fundamental strategy comes at the price of prolonged pain during down markets.
Still, despite this professed preference for a combined approach, I made my own tally of Davidow’s total allocation to each of his portfolio segments (domestic large, domestic small and international large).
I found that he has significantly greater room for smart beta in his portfolio than its two rivals (out of the 300 percentage points across three portfolios, 130% went to smart beta, 95% to active and 75% to market cap).
The sum may be greater than its parts, but smart beta is clearly first among equals.
And Davidow’s title, “alternative beta and asset allocation strategist,” is an apt one.
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