The four cardinal “smart beta” virtues, or how to use Plato as an investment philosophy

Etienne Vincent, head of THEAM’s global quantitative management, explains how the four main recurring sources of outperformance in the equity markets, extensively developed in the “smart beta” concept, can be likened to the four cardinal virtues described by Plato, the Greek philosopher. This can help us to better understand the link between quantitative management and behavioural finance, and the benefits of a comprehensive approach. This style diversification principle can be applied simply by combining THEAM’s smart beta “low volatility” and “guru” strategies.

According to Plato, “Human virtues are firm attitudes, stable dispositions, habitual perfections of intellect and will which govern our actions, order our passions and guide our conduct. They bring ease, self-mastery and joy…” The four cardinal virtues are, in order of priority: prudence, temperance, justice and courage.

In the world of equity investment, we also seek “stable dispositions” – investment styles that bring “ease, self-mastery and joy”, aiming to offer recurrent outperformance for a given level of risk.

The best known among these is without doubt value investment, popularised by Eugène Fama and Kenneth French, which is about investing in the cheapest shares relative to the underlying company, for example in terms of valuation multiples. In the Platonic sense of “giving morally to each what is universally due to him”, this is a form of justice. The premium placed on the value approach to investment may be explained by the behavioural bias of those investors who let themselves be dazzled by talk of a company’s growth and neglect the importance of financial data when valuing it.

Value investment shares with its corresponding virtue, justice, an absoluteness which makes it relatively insensitive to fads (and bubbles). Therefore, this is very effective after crises, when investors return to the fundamentals. However, justice also has a weakness: it can be blind. Some companies are cheap for good reason (a change of economic environment, for example): continuing to blindly overweight such shares leads investors into the so-called “value trap”.

A good way of avoiding this trap is to invest only in shares with good momentum, i.e. with strong recent medium-term performance. This is because an inexpensive share, but one that is already beginning to rally, is unlikely to be about to vanish. Considered on its own, this “momentum” investment style results in positive average performance, provided trends are not followed too quickly or for too long. The momentum style corresponds to Plato’s moderation (or ‘temperance’) virtue since it is a form of humility that involves accepting that “others” may have been able to see something that has escaped us. Therefore, it can be useful to “do what everyone else does”, even without an explicit good reason. The main justification for this style’s outperformance is the recognition, resulting from an analysis of human decisions, that we take time to decide but that we do not then easily change our minds. As a result, fads, including in investment, are self-sustaining up to a certain point.

The momentum style shares with its corresponding virtue a reassuring “flexible” aspect. However, moderation can also turn into indecision (excessive portfolio turnover) or to frivolity, which consists in letting oneself be led astray by fads (or bubbles) until the trend reverses …

The other pair of Platonic virtues and their corresponding investment styles is much less well known. Courage “allows constancy in the pursuit of the good, strengthening the resolve to resist temptations and overcome obstacles”. In equities, this underlies the strategy of trusting in expectations of future returns (RoE) and investing accordingly. This is often described as the quality style, which corresponds to Plato’s virtue of courage. It comes down to exploiting the fact that investors tend to underestimate the importance of an activity’s profitability in its capacity to develop. Even if it performs less strongly (this is the last of the virtues), it has the merit of looking to the future.

Courage can, however, become recklessness without the first of Plato’s virtues – prudence – which is its safeguard. Prudence “disposes practical reason to discern our true good in every circumstance and to choose the right means of achieving it”. With respect to equities, prudence is about overweighting the least volatile shares, based on the advice of Robert Haugen, who discovered the ‘low volatility’ anomaly. Over the long term, this style is not only the most profitable but also the least risky. This performance is explained by a whole series of decision-making biases pushing investors to over-buy popular, volatile stocks and neglect overlooked ones that actually offer greater chances of upside surprises. Practised in isolation, unfortunately, this low volatility style turns into risk-aversion, i.e. very low exposure to the equity markets (weak beta).

Overall, what is striking is the extent to which these styles are actually complementary rather than conflicting or interchangeable for each carries intrinsically the seed of its dangers in its own qualities. A strategic allocation that is well organised according to these four styles allows us to compensate for these dangers, i.e. to potentially achieve a far better overall performance for a given level of risk. So this approach could be said to be a good source of “ease, self-mastery and joy.”

Here is a simple and practical example of how to apply this philosophy based on existing and completely transparent smart beta “low volatility” and “guru” strategies applied to a global universe of developed and emerging country equities.

Since 2002, there has been little respite on world equity markets, with three serious crises in succession: the bursting of the internet bubble in 2002, the financial crisis of 2008 and the euro crisis of 2011. The worst was that of 2008 when the MSCI All Country index fell by 42%. However, over this period as a whole, this classic index nevertheless rose on average by 6.6% per year thanks to good years of recovery such as 2003 and 2009, which saw rebounds of more than 30%, and intervening years that saw ’normal’ growth of around 10%. Overall, this is higher than the risk-free rate of classical financial theory, which states that the risk taken by the shareholder should be rewarded compared with that of the mere lender. This risk is measured by volatility, i.e. the average variation over a year in one direction or the other. . This measure has amounted to 17% since 2002.

The first of Plato’s virtues, prudence, should logically have made it possible to do better during such a difficult period: a “low volatility” strategy combined in the Parvest Equity World Low Volatility and Parvest Equity World Emerging Low Volatility funds would have resulted in an additional performance of 2.6% for 3.2% of lower risk over the whole period. This strategy is based solely on the low volatility factor, since it selects in a wholly deterministic way the 10% lowest-risk shares in each world sector. While this strategy’s prudence would have enabled clear outperformance during tough years such as 2002 or 2008, it would, however, have distinctly underperformed in rising markets, as in 2009 or to a lesser degree 2013, precisely because of this prudent approach.

This can be compensated for by Plato’s three other virtues (justice, temperance and courage) which are combined in the more “aggressive” strategy of the Parworld Quant Equity World Guru fund. This strategy – also entirely deterministic – selects shares which are both cheap (value) with good momentum and whose underlying businesses are profitable (quality). This mixture makes it possible to distinctly outperform the market (by 13.2% annually on average over this period), especially in a bull market, but at the cost of a higher risk than the starting index (3.3% greater volatility).

The chart below makes it possible to assess, over 12 years, the result of different possible weightings between these two strategies, from 100% defensive to 100% aggressive. For an intermediate weighting of 50% on each strategy, we find a risk level similar to that of the original market, but with over double the average annual yields . Who could now possibly claim that there is no morality in finance?

Although these two strategies directly oppose each other in terms of their level of risk relative to the market, it is interesting to observe that they do not cancel each other out: the tracking error, which measures the extent to which a strategy departs from its benchmark, comes out at 5.8%, or close to the level of active management practised by a human manager. This illustrates once again the benefit of combining virtues rather than trying to choose among them.

Similar results can be obtained by changing the universe of shares used, even if the MSCI All Country index, comprising nearly 2 300 equities, is one of the most consistent for applying this method globally.

Risk and yield over 12 years, different combinations of low volatility and guru strategies for the global universe of developed and emerging country equities.

Parvest Equity World low volatility and Parvest Equity World Emerging low volatility are sub-funds of the PARVEST UCITS IV compliant SICAV registered under the Luxembourg law.

The value of investments and the income they generate may go down as well as up. Investors are warned that the capital invested may not be fully recovered, the funds described being in risk of capital loss.