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.)
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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.