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TIME2READ

Important information This statement is intended for professional investors. Robeco Institutional Asset Management B.V. (trade register number: 24123167) has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This document is intended to provide general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com.

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WINTER EDITION 2014

This document is solely intended for professional investors

FOREWORD

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Dear Clients and Friends It’s already the end of the year, and everyone will be looking forward to relaxing at home with families and friends, or planning a holiday. So it’s the ideal time to catch up on some reading in our latest edition of Time2Read, a compilation of our best stories in 2014.

This year has been one of records; US stock markets hit all-time highs, while some government bond yields reached all-time lows. While strong stock markets are obviously welcome for equity investors, the continued low interest rate environment was also challenging for fixed income investors in the ongoing search for yield. We have written many articles discussing these issues in depth.

It was also a year in which the dislocation of markets became stronger, as the US economy strengthened above expectations while the Eurozone continued to try to solve its problems. China’s slowdown proved to be less severe than expected, and emerging markets began to recover, as all eyes turned to fears over ‘Abenomics’ in Japan.

Over the course of 2014, our experts have dissected the opportunities and pitfalls that such disparate market conditions have presented. As we celebrated our 85th anniversary, some of our stories outlined how our ‘pioneering but cautious’ stance has made us ideally placed to expand our specialisms in quantitative and sustainability investing, while remaining deeply rooted in research.

Happy reading!

Hester Borrie Head of Global Distribution & Marketing, Robeco Group

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Contents 2015 Fasten your seatbelts! We could be in for a bumpy

Hedge funds

ride next year.

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The quality differences are huge, making selection extremely important.

40

Balancing act China is slowing a bit and that’s fine.

54 The female factor

5-year outlook

Women have a positive effect on corporate

Emerging markets equities are Robeco’s

leadership, especially in Asia. Why?

top picks.

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CONTENTS

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Foreword

6

Outlook 2015: increasing volatility

10

Country allocation will be key

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Online retail. Who are the winners?

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The added value of women

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Eurozone: new crisis?

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Will robots do all our work?

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Factor investing: 7 lessons

27

The success of quant

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Factor investing: between active and passive

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Investing in health care

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Harvesting the value premium

40

The (non) usefulness of hedge funds

43

The flip side of technological progress

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Valuing ESG impact

46

The many parallels between sailing and investing

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Factor investing works for corporate bonds too

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From hype to disillusionment

54

No hard landing for China

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ESG implementation remains a challenge

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Apple: new gadgets won’t make that much money

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What drove investors in 2014?

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New insights in asset allocation

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5-year outlook: equities are the top picks

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OUTLOOK 2015

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2015: the year of increasing volatility Fasten your seat belts! We could be in for a bumpy ride – global unrest and – Divergence between US and other developed economies more pronounced – Chinese growth set to slow somewhat – Abe’s new gamble casts doubts on Abenomics – Earnings growth to impact equity returns again – High-yield bonds lose their shine

a looming Fed rate hike could make 2015 a particularly volatile year for the financial markets.

| BY LÉON CORNELISSEN AND PETER VAN DER WELLE

Uncertain 2015 Despite a further strengthening in the global economy there are plenty of reasons why the outlook for 2015 is uncertain. Will the Ukraine crisis stabilize? Will the situation in the Middle East escalate further? Will the Eurozone avoid a new economic crisis? Will China continue to be the growth engine for the world economy? Will the US economy continue to defy weak growth elsewhere? And perhaps most importantly of all: what will the likely global impact be of the Fed’s first rate hike, expected in the third quarter of 2015?

Fortunately, central banks still have sufficient firepower to absorb economic disappointments. The ECB could engage in fully-fledged QE, while the Fed could hint that it will delay its first rate hike. The low oil price is also a positive development — as a rule of

thumb, a fall of 20% in the oil price translates into an uptick of 0.4% points in world economic growth.

‘The ECB could engage in fullyfledged QE’ The paths of the US and Europe diverge The US economy is experiencing a selfsustained recovery and growth is likely to have reached a cruising speed of around 3.0% in 2015. With the unemployment rate dipping below 6.0%, it will only be a matter of time before we finally see convincing wage growth stimulating consumption and the housing

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market. Time for the Fed to start raising interest rates, then. But whether this first step will be followed by further hikes will depend on how the US recovery progresses. The main risk is weakness in the rest of the world (China, Eurozone, Japan).

This is in stark contrast to the Eurozone where there is still no sign whatsoever of a robust recovery. In fact, while the Fed has already brought its QE to an end and is looking towards a first rate hike, the ECB recently lowered the discount rate to minus twenty basis points and launched a program to buy covered bonds and asset-backed securities to the tune of EUR 1 trillion. We expect the Eurozone economy to strengthen to a growth rate of around 1.5% in 2015, with unemployment continuing to decline slowly. Inflation will probably pick up slightly, thanks to the weakening of the euro and slow pickup in growth.

Abe takes a gamble As expected, the three percent hike in the sales tax has led to a slowdown in the Japanese economy – in fact, a more severe one than was generally predicted – casting doubt on the additional 2% tax hike planned for October 2015. However, in a surprise move the Japanese central bank (BoJ) voted to substantially increase its program of quantitative easing (buying JPY 80 trillion worth of government bonds a year). This led to an immediate further weakening of the yen.

Two weeks later, in a move not guaranteed to please the BoJ, Prime Minister Abe postponed the tax hike to 2017 and announced an

election, calling the LDP’s commitment to Abenomics seriously into question. With a government debt ratio of 240% of GDP, unease about the long-term fiscal sustainability of Japan will increase. We expect the yen to weaken further in 2015 boosting economic growth somewhat and causing slight inflation (imports). Bond yields are set to stay low.

However, business investment is likely to remain slow as long-term real growth prospects remain weak.

China steams ahead Growth of the Chinese economy weakened in 2014 and will probably turn out to be slightly lower than the official target of 7.5%. The authorities have resisted the temptation to announce a massive stimulus package, but they have quietly increased stimulus measures to ensure that growth will not weaken too much.

Of course, Chinese policymakers are aware that the economy has to rebalance and that a lower structural growth rate is unavoidable.

Their priority is to avoid social instability and thus foster employment growth. We consider it likely that the Chinese government will choose a slightly lower growth target of 7.0% for 2015.

Inflation is expected to remain benign, partly thanks to the decline in the price of oil.

Back to normal The central banks ‘put’ for financial markets, exercised through unconventional monetary policy, has played a significant role in bringing asset volatility down to below intrinsic levels, disrupting the traditional link between financial and economic risks. This has resulted in the

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phenomenon where bad macro-economic news is interpreted by financial markets as being positive for asset prices. The return to conventional policy will be bad news for the markets. In this scenario, volatility will be waiting in the wings — especially if the Fed’s policy maneuvers prove to be more hawkish than market expectations. A renewed link between financial and economic risk would move markets from being liquidity driven to being more growth driven. Asset-specific volatility should return to normal levels, as should correlations between different asset classes — especially equities and sovereign bonds.

‘The return of conventional policy will be bad news for the markets’ Moderate equity returns Volatility has a strong and negative correlation with equity returns; the removal of excess liquidity by the Fed will therefore be associated with downward pressure on returns because financial markets will have to learn to stand on their own two feet again. This volatility is however expected to be of limited duration and scale, and its effects on the markets will partly be counterbalanced by the easy money mode of the ECB and the BoJ. It’s a question of give (ECB and BoJ) and take (Fed).

After the solid returns of the past 5 years, with equities returning 13% on average, we expect performance next year to be more moderate.

Supported by increasing sales growth and healthy profit margins, global equity returns are likely to be around 5%-7%, below their long term historical averages of 8%. Given our return expectations, equities are our favorite asset class for 2015.

Government bonds vulnerable We think the deflation scare will ebb somewhat next year, but will not vanish altogether. We expect a rebound in inflation expectations as oil prices stabilize which could cause bond yields to gradually increase during 2015 towards levels that would be appropriate with modest reflation. In our base scenario, a gradual normalization of the global economy makes government bonds more vulnerable at current levels, in spite of the fact that inflation will show only a very modest increase.

more conservative stance as the rally in high yield matures. Looking ahead, this risky asset class requires vigilance as the Fed starts its tightening cycle and liquidity risk is not fully reflected in the market. But coupons are still relatively attractive, especially after the spread widening we have seen. In relative terms, this has also made high yield better value than investment grade. The prospects for high-yield corporate bonds remain favorable on the basis of fundamental factors. Default rates continue to decline and the market expects this trend to continue in 2015.

Still, we note that this asset class is losing some of its shine. The reward for credit risk has dropped to 438 basis points and therefore lies below the 10-year average of 610 basis points.

But on a risk-corrected basis we prefer highyield bonds over investment grade credits for 2015.

Strong dollar

‘Given our return expectations, equities are our favorite asset class for 2015’ High yield still attractive High-yield bonds remain an attractive asset category in the current environment of below-trend growth and very moderate inflation, but we have gradually adopted a

We take a positive view on the US dollar, due to the varying growth rates of the US and the Eurozone, the differences in monetary policy between the two, and the reduction in the so-called ‘twin deficits’ in the US. The yen is likely to weaken further to reflect the consequences of BoJ balance sheet expansion.

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OUTLOOK 2015

INTERVIEW WITH HANS RADEMAKER

HANS RADEMAKER Chief Investment Officer Robeco

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‘Differences in monetary policy will lead to structurally higher volatility’ Active and dynamic asset allocation will become increasingly important in 2015, says Hans Rademaker, Chief Investment Officer at Robeco.

As 2014, a year which has become increasingly volatile, nears its close, we speak to Hans Rademaker about the outlook for the next year. Rademaker, who has been on Robeco’s Management Board since 2010, prefers to take a long-term view when it comes to investments.

But that doesn’t stop him from giving his outlook for 2015. Structural economic growth is a key theme for investors. He also expects market volatility to be higher going forward and a higher divergence in asset-price performance. Therefore active and dynamic asset allocation will become increasingly important.

How would you describe the financial markets in 2014?

– Country allocation will be key in realizing good performance – Active and dynamic asset allocation are more important than ever – The divergence in monetary policy is a new theme – Investors no longer just look at risk and return, but also at sustainability – Factor investing will continue to grow

It was the year of an unexpected further downtrend in interest rates. January started with low rates, but these declined further, which helped to stimulate the prices of all major asset classes around the world. In the last two months we have seen higher volatility in the bond and equity markets and there has been a correction. Still, this did not come as a complete surprise. My expectations at the beginning of 2014 were that valuations for a range of asset classes looked stretched and that there could be a correction.

What is on clients’ minds?

An important question is how clients can still achieve decent bond returns in a period where interest rates approach zero. They want a form of capital preservation with an acceptable return at an acceptable level of risk. And they also want to know how long the period of low interest rates will last.

Another related issue is the increasing divergence in monetary policy in the major economies. The Fed and the Bank of England are moving towards more restrictive monetary policy while the ECB and the Bank of Japan will probably continue to be extremely accommodative in the near future.

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OUTLOOK 2015

‘We have strategies that are well-suited to these market circumstances, because they have the flexibility to deviate from the benchmark’ What are the implications of this divergence in monetary policy?

I expect that the differences in monetary policy will lead to ongoing volatility and a higher divergence in performance for the various asset classes in the US, Europe and the rest of the world. Furthermore, because on average markets are no longer cheap, there will be less of a buffer to absorb any disappointments. The geopolitical situation has also changed. Tensions have risen and there are many flashpoints around the world; Iraq, Syria, North Korea, West Africa and Ukraine for example.

I expect there to be greater differences in country returns, also in emerging market equities. Country allocation will become an important element in realizing good performance. This difference in monetary policy has already had major implications for the currency markets. The dollar has risen this year while the euro and yen have weakened. I expect this process to continue.

How can investors cope with increased market volatility and divergence?

Active and dynamic asset allocation are more important than ever. Being prudent by keeping some cash reserves might also help investors to pursue the new opportunities created by these volatile markets. We have strategies that are well-suited to these market circumstances, because they have the flexibility to deviate from the benchmark. Take for example Rorento, our total return fixed income strategy, or Conservative Equities, our low-volatility strategy which aims to limit downside risk.

The old concept of diversification will become crucial again, because market volatility is on the rise and because I expect less correlation between asset prices next year. The time when you only had to decide whether the market was in a risk-on or risk-off mode is over. Diversification will lead to more robust investor portfolios.

Do you believe bond and equity markets are currently overvalued?

Based on objective valuation measures, many bond markets are expensive: interest rates and credit spreads are very low. For equity markets there is a more nuanced picture. Some mega caps, mainly IT stocks in the US, have very high valuations, while many mid-cap and small-cap stocks are more neutrally valued.

What will be the dominant investment theme in 2015?

Any signs of structural economic growth in the major economies will continue to be an important factor to monitor next year. The divergence in monetary policy is a new theme which will affect asset prices and create more uncertainty.

It has been much easier for the US to restructure its financial sector than it has been for Europe to clean up its balance sheets. However, Europe is capable of doing something; it has managed to keep the Eurozone together. But the decision-making process is slow in comparison to the US. It will be a sign of strength if the Fed starts raising interest rates because this indicates ongoing economic growth. In the short term, capital markets might become jittery, because the risk-free alternative is priced more attractively. However this reaction will only be temporary. Growth will help corporate income and this will easily cover any rise in interest payments.

What are the other main themes for next year?

Pension funds have realized significant asset growth because of their portfolio sensitivity to interest rates. They hold bonds to cover future liabilities. It would be a pity if these gains were to disappear when interest rates start rising, while there are other alternative investment strategies available. We want to start a dialogue with clients and help them to make the right decisions.

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And the importance of sustainability is clearly increasing. Investors no longer just look at risk and return, but also at sustainability. You might call it a third dimension within investing. And we are convinced it is possible to successfully combine these three dimensions.

‘Importance of sustainability is clearly increasing’ In sustainability we see a shift away from the passive monitoring of a portfolio’s sustainability profile to actively raising these profiles. You might call this form of activist investing impact investing. Some clients demand a more concentrated portfolio of around 30-35 stocks in order to have more impact on the sustainability of the companies they invest in. There is particular interest for this investment style in Scandinavia, the Netherlands and the UK.

What developments in quantitative investing do you foresee at Robeco?

There will be new developments in the field of factor investing. It is very important to Robeco, because we consider it a third way of investing, between active and passive. First, for Equities, our factor solutions offer diversified exposure to multiple factors. Investor interest in these solutions is set to increase. Second, factor investing will become more important to Credits as well. Third, in the long term I expect factor strategies to be increasingly implemented top-down over different major asset classes throughout the whole portfolio. This is a promising field for Robeco Investment Solutions.

Moreover, separate quantitative and fundamental strategies can be combined, which offers diversification. It also strengthens the concept of quantitative investing. For example, there are fundamental value strategies, which can also be combined with quantitative value strategies. Such combinations will have major implications for investors.

A new framework for asset allocation is being established.

What will be the trends in asset management next year?

Clients will make better-informed choices when they weigh the costs and benefits of different alternatives. High conviction strategies, with their more concentrated portfolios, will become increasingly popular in addition to indexing strategies. More and more, a combination of high

‘Factor investing.

It is very important to Robeco, because we consider it a third way of investing, between active and passive’ conviction and indexing strategies or a so-called investment barbell driven by an explicit cost budget will become popular. Investors no longer just look at risk and return, but also at sustainability. Factor investing will continue to grow at the expense of ‘benchmark hugging’ strategies that do not add value.

How is Robeco positioned compared with other asset managers?

We have a broad range of sound products which match clients’ needs.

The basic conditions for a good future performance are in place. The teams of analysts and portfolio managers function well and we are not a one-hit wonder or dependent on a single star portfolio manager.

These teams operate well on a human level and individual efforts can contribute to the overall result. We do not want to become ‘a large bureaucratic machine’ where people function anonymously. Robeco has a young talent program which offers plenty of challenges. And we have to keep innovating. For example, we will strengthen our efforts in quant allocation strategies.

All in all we have a lot of irons in the fire at Robeco and I am confident we can flourish in more volatile and divergent market conditions. We are a robust company.

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TREND INVESTING 1

‘More accurate delivery slots’

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Online is winning the shopping-cart war Consumers shop more frequently online. This is putting pressure on traditional grocery stores, says Robeco trend watcher Steef Bergakker.

But there are also companies set to benefit.

– Online offers convenience price differential is narrowing, market penetration is rising rapidly – Two types of shopping trip: the stock-up trip and the top-up trip – Analysts and investors underestimate the effects of online growth – Pure play online shops are leading the pack – Traditional grocery stores to suffer, small specialized retailers to benefit

Online retail sales are advancing strongly.

Digital items such as music, e-books are the main beneficiaries but other categories are also gaining ground. The only category where the penetration rate is still very low is the daily grocery shopping. But this is going to change, says Robeco trend watcher Steef Bergakker. He expects online grocery shopping to snowball and this to have a significant impact on food retailers’ market shares. Existing grocery store chains will find the going tough, while specialized online players and smaller niche retailers will benefit. The global equity fund Rolinco and the Robeco Global Consumer Trends Equities fund are happy to use his analyses.

Convenience and the shrinking price differential set to stimulate growth The advantage of online shopping is primarily the convenience of having items delivered to your home or to a collection point, says Bergakker. “You don’t have to find a parking place, push around a shopping cart and then cram everything into your car.” Price and delivery slots have prevented online shopping from becoming widely accepted, but significant progress has been made in these areas.

“Delivery slots are becoming far more accurate.

Ocado now delivers within 60 minutes, for AH.nl it takes two hours. These are major improvements compared to a couple of years ago. Then you still had to be available for up to half a day to receive your delivery.”

In addition, the price differences compared

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to physical shops are also going to disappear as a result of increasing economies of scale and heightened efficiency, expects Bergakker.

“Especially if you take the fuel costs for your trip to the grocery store into account. Up to now, people have assumed that it is expensive when compared to doing your shopping yourself, because of the high delivery costs.”

The value offered by the online shops - a combination of convenience, the shrinking price differential and a huge range - will be the determining factor, he concludes.

The stock-up trip and the top-up trip In order to evaluate the potential market for online shopping, Bergakker makes a distinction between two types of grocery shopping - the stock-up trip and the top-up trip. The online market has as yet scarcely penetrated the stockup trip market, but Bergakker expects this type to be vulnerable. It will be much more difficult for online players to gain ground in the top-up trip market.

The stock-up trip is a regular trip to replenish supplies, he says. “It is planned in advance and shoppers make lists. There is an interval between the time that something is purchased and the time that it is used. Items purchased are often non-perishables like tea, cat food and diapers.”

Then there is the top-up trip, adds Bergakker.

“A quick - ‘what shall we eat this evening?’ - trip to the store. Shoppers want inspiration, because they don’t yet know what they are going to buy.

They mostly purchase fresh products, or articles that they have forgotten, like toothpaste.”

Rapid advance in urban areas Online shopping’s market penetration will increase rapidly, says Bergakker. “We estimate about 50% for urban areas in 2025, which is above the market consensus. If this proves to be the case, then we are talking about a market of USD 600 billion in Europe and the US.”

‘The stock-up trip will virtually disappear’

This optimistic forecast is based on the assumption that the stock-up trip will virtually disappear, says Bergakker. “We think that in urban areas these will have become completely unnecessary by 2030. Then we are talking about more than half the money that people spend on shopping and a penetration rate of around 25%.”

The market for online shopping will grow more quickly than most analysts expect. “Investment analysts’ forecasts are quite varied, but we feel that most are rather conservative. Goldman

Sachs forecasts penetration of 10% for the US in 2025. This amounts to a market of around USD 120 billion.”

Pure play online companies set to emerge as winners After years of modifications, some online stores have managed to make their business models profitable, says Bergakker. Investors tend to overlook the importance of this. He gives two examples of successful listed online retailers. “Two parties really stand out. The first is US company Amazon, which has been running pilot programs for years for stock-up products. The company only recently decided to roll-out its online shopping service to twenty cities in the US. They have mastered the online business model.”

The other company is the British firm Ocado, the biggest pure play online retailer in the country, says Bergakker. “They are now making profits for the first time with their business model - a highly automated distribution warehouse where the boxes of shopping are packed.”

“They are going to roll out their online model with other retailers. And have recently concluded an agreement with British retailer Morrison, which up to now has had no online presence. They have purchased Ocado’s online model off the shelf.” Other parties will find it increasingly difficult to avoid having an online service, he predicts. “The possibility of buying an off-the-shelf online model acts as an extra stimulus.”

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‘Faster growth than analysts expect’

Negative effects on grocery store chains underestimated Investors underestimate the negative effects of online growth on grocery store chains, thinks Bergakker. “It is true that traditional players such as Ahold and Tesco are trailblazers when it comes to online shopping, but they are experiencing reduced sales in their physical shops, leading to stagnation in their consolidated net turnover.”

It is hard to effectively combine online and physical sales as they both have a totally different operational process and growth profile. “Hypermarkets and XL grocery stores will find it particularly difficult. Their existence is largely dependent on stock-up trips but this basis is being progressively eradicated. Even though parties such as Ahold recognize that this is a problem, it is still difficult to close shops. It’s not just a matter of the unused real estate; there are also consequences in terms of personnel and logistics.”

The top-up segment can be more effectively targeted with a convenience-store-on-thecorner formula. “For example, a range of fresh goods and ingredients to prepare an evening meal with a limited selection of products that you may need at short notice. These shops fulfil more or less the same role as the old grocery shop on the corner. They have a smaller surface area and are closer to the end customer.”

“This creates opportunities for specialized retailers with small shops such as The Fresh Market in the US.” I think that online grocery shopping will quickly become the norm, he concludes. “Certainly once price is no longer an issue.”

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OPINION

The added value of women Male entrepreneurs take more risk than women and are rewarded with more assets. But men are also more likely go bankrupt. Equity investors would be wise to take the ‘female factor’ into account.

– Stocks of companies with at least one woman on the management board perform better – In Asia the difference is most significant – Women look at problems in a different way and are quicker to acknowledge the risks

Recently I saw an article on the Fondsnieuws website, titled ‘European Assets reach EUR 56 trillion’. By the end of 2013, the net assets of Europeans had exceeded their pre-crisis peak, according to the Wealth Report Europe, published by Swiss private bank Julius Baer.

They also list the ten richest men and the ten richest women and then it really starts to get interesting. Eight of the men have earned their money themselves, while all ten women have inherited their wealth.

Too much risk Why is there such a big difference? What do men do better than women? I think that it all boils down to the fact that men take more risk. In the top 10 we only see those who have performed exceptionally well. The men took more risk and have been rewarded for this. But taking risk does not always result in success.

| BY MARK GLAZENER

The flip side of this statistical truth is that, according to figures published by the Chamber of Commerce, male entrepreneurs actually go bankrupt more often than female ones. Of course every entrepreneur is enthusiastic about a new idea, but women are more realistic and weigh up the pros and cons more carefully.

They research the feasibility of implementing their ideas more thoroughly.

The top ten richest European men include entrepreneurs such as Amancio Ortega Gaona (Inditex), Bernard Arnault (LVMH) and Stefan Persson (H&M). The top ten richest women include heiresses such as Liliane Bettencourt (L’Oréal), Susanne Klatten (BMW) and Charlene Carvalho (Heineken). As major shareholders, these women have significant influence over their companies. In the case of some, this is highly visible - Susanne Klatten at

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BMW, for example. But in the case of others, it is common knowledge that they are active behind the scenes - Liliane de Bettencourt and Charlene Carvalho-Heineken.

‘Women are more realistic and weigh up the pros and cons more carefully’ The ‘female factor’ Other research also confirms the positive influence of women. Recently Credit Suisse published a study, which concludes that the stocks of companies with at least one woman on the management board or supervisory

board perform 18% better than companies with only men in these positions. In Asia the difference is most significant: stock returns of companies with a woman on the board are as much as 55% better than those of the ‘men-only’ companies. Several studies demonstrate that this male-female diversity at board level has a positive effect on a company’s operations.

What exactly is this added value? Why do women have a positive effect on corporate leadership? I can only make an educated guess.

Perhaps women are more aware of how teams function and the relationships within teams.

Women also look at problems in a different way and are quicker to acknowledge the risks. Men are inclined to be less brash if a woman joins the group, because women do not accept this type of behavior.

The presence of women in top management positions results in better returns - that much is certain. So make sure you incorporate the female factor into your investment decisions.

‘Stock returns of companies with a woman on the board are as much as 55% better than those of the ‘men-only’ companies’

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OUTLOOK: EUROZONE

– ECB cannot act like national central banks – Labor costs are uncompetitive in some countries – EU banking union remains work in progress – Debt levels are too high with no real solution

Eurozone crisis may return The Eurozone has made great strides in the past five years since the financial crisis first hit, but fundamental problems still remain for the next five, says Robeco’s chief economist.

At the peak of the Greek debt default in 2011, the whole single currency project was briefly on the verge of collapse. In July 2012, European Central Bank (ECB) President Mario Draghi vowed to do “whatever it takes to preserve the euro, and, believe me, it will be enough”.

Certainly, there have been great improvements for the euro area. The risk premia of peripheral bonds over German Bunds have ended and peripheral equity markets have outperformed. So is it time to declare victory? Not so fast, says Léon Cornelissen, who gives four major problems that the Eurozone has yet to overcome.

1. The ECB is still not a true lender of the last resort It may look like one, and it tries to act like one, but the ECB is still not a true lender of the last resort in the same vein as a national central bank such as the Bank of England. The legality of the ECB’s proposed European bailout role using Outright Monetary Transactions (OMTs), which have yet to be activated, has been questioned by Germany.

In principle the ECB can buy an unlimited amount of government bonds that mature in 1 to 3 years, providing that the bond-issuing

| BY LÉON CORNELISSEN

countries agree to certain domestic economic measures. The German Constitutional Court challenged its legality, partly due to the open-ended character of the program. Its preliminary conclusion was that OMTs are illegal according to EU law. The Court referred the case to the European Court of Justice, asking the Luxembourg judges to add conditions to the OMT program to make it possible for them to reconsider their judgment.

These conditions could easily rob OMTs of their practical effectiveness.

Fortunately, the broad recovery in the Eurozone makes activating an OMT highly unlikely for the foreseeable future. But the instrument’s future remains in doubt, and with it, the possibility of the ECB acting as lender of the last resort.

2. Competitiveness problems remain Germany entered the euro in 1999 with an overvalued Deutsche Mark.

For years the German economy struggled, creating a climate for limited wage growth and structural reform. Compared with its European partners the rise of unit labor costs has been very modest. The post-Lehman crisis has led to a lowering of the differential vis-à-vis Germany for a number of countries, most markedly in Greece, but also significantly in Spain.

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There are two important exceptions, however: the more socialist France and Italy, the second and third-largest economies in the Eurozone, which have seen large rises in labor costs. It is therefore no wonder that both economies are struggling at the moment. This impedes an improvement in Eurozone employment and threatens domestic consensus on the need for euro-appropriate policies.

‘France and Italy have seen large rises in labor costs’

Rising labor costs will impede Eurozone competitiveness (indexed) 150 Forecast 140

130

120

110

100

3. Banking union is underfunded and incomplete The long-awaited banking directives mean centralized supervision of 131 Eurozone banks and the closure or restructuring of any that run into trouble. The ECB will also monitor more than 200 cross-border banks and have the further right to intervene in around 6,000 Eurozone lenders if necessary. Decisions on whether to wind up a struggling bank and how to share costs among creditors will be prepared by a single resolution board, made up of representatives from Eurozone governments plus five permanent officials.

90 2000

2002

Portugal

2004

Italy

2006

Ireland

2008 Greece

2010

2012

Spain

2014

France

Germany

Source: Thomson Reuters Datastream, OECD

This lack of competitiveness can be seen in high unemployment (in %) 30

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‘Banking union remains a structural problem for the Eurozone’ However, any board recommendation on winding up or restructuring will have to be approved by EU finance ministers. Ministers want a bank’s shareholders and creditors to pick up the bill for its failure, and new EU rules can force investors to forego their claims or see them converted into equity. As a safety net, governments will build up national resolution funds by imposing levies on banks. These funds will be gradually merged over 10 years into one European fund containing around EUR 55 billion.

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15

10

5

0 1992

1994

Euro area 11.7% Italy 12.6%

1996

1998

2000

Greece 26.8% Ireland 11.9%

2004

2006

Spain 25.1% France 10.4%

Source: Thomson Reuters Datastream, data to Apr 14

2008

2010

2012

Portugal 14.6% Germany 5.2%

2014

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All in all, the slow building of a rather limited fund means that the resolution mechanism lacks a convincing ex ante fiscal backstop, which could foster a passive attitude. The unfinished, incomplete and underfunded banking union remains a structural problem for the Eurozone.

4. Debt ratios remain high and fiscal governance lacks legitimacy Government gross debt ratios in the Eurozone have generally risen further and the weak and uneven recovery with very low inflation has not been able to offer relief. The average debt-to-GDP ratio for the Eurozone area is almost 100%. Greece is perhaps not surprisingly the highest at a colossal 177.2% while Sweden has a relatively modest 41.6% ratio.

The average size of government deficits is 2.5% of GDP, satisfying the under-3% limit for now, but there are still worrisome exceptions such as France (an estimated 4.4% in 2014) and Spain (5.6%). The union has created an impressive mechanism to force fiscal discipline by way of the so-called ‘two pack’, the ‘six pack’, the ‘fiscal compact’ and the macroeconomic imbalances procedure. In theory, the European Commission can impose sanctions (of a limited size) if its ‘recommendations’ on deficit reductions are not met.

In conclusion, none of the fundamental problems of the euro crisis have been sufficiently addressed. This means that at some time in the future the European debt crisis will likely return.

European leaders appear to be lulled back into complacency, aptly illustrated by their initial embarrassing inability to fill their own top jobs at the European Commission in July. The timing of a new crisis is impossible to predict and it may take a while, due to the current upswing masking structural problems and the (conditional) willingness of the ECB to buy bonds of distressed sovereigns if the need arises.

A new crisis could, of course, unleash a new determination to transform the currently incomplete monetary union into a more complete monetary and fiscal union. Time will tell.

On borrowed time: how national debt levels compare (in %) Belgium Greece Filand Spain

However, fiscal governance by the unelected European Commission lacks any democratic legitimacy. What is more likely is that the ‘sanctions’ machinery will turn out to be a ‘paper tiger’. The wilful violation of the Security and Growth Pact in 2003 by Germany and France does not augur well. An interesting test is currently posed by France, which recently announced that its general government budget deficit this year will be even higher than previously thought. Furthermore, France intends to push back the 3% deficit target from 2015 to 2017. France continues to miss its deficit targets even though interest costs have fallen. General government debt is likely to rise above 100% of GDP, while Germany’s ratio is set to decline to under 72%.

Austria Germany Portugal Italy France Netherlands 0 2013

20

40

60

80

100

120

20-year average

Source: Thomson Reuters Datastream, European Commission

140

160

180

200

THE NEW HYPE

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WALL•E-fication No-one could have failed to notice the explosion in articles over the last week on the theme of robotization and job losses. The subject had been in the air for some time already, but when The Economist decided to do a special report on it, it was clearly pushed into the spotlight. In the Netherlands, the debate was also triggered by a speech

by Lodewijk Asscher, Dutch Minister of Social Affairs and Employment. Since then, every self-respecting columnist has aired an opinion on the matter. Sadly they failed to provide many fresh insights: most columnists simply kept regurgitating the I’m-a-techno-optimist-and-this-is-nothing-new mantra. In all of these articles you could see the same line of reasoning: hadn’t the past shown that job losses in the farming sector were offset by the arrival of industry and that the services sector then took up the baton?

BY LUKAS DAALDER |

The question is this: is what we are witnessing now simply history repeating itself? The answer partly depends on the degree to which labor and machines can complement one another, or are just each other’s substitutes. In other words, does robotization actually create jobs (programmers, technicians), or does it cost jobs (such as in farming and industry in times gone by)? The correct answer is of course that both processes apply, and I might as well use a crystal ball to try and predict whether it will on balance generate or eliminate jobs in the future. We simply do not know, so the standard reaction of many is to look to the past: nothing to see here people, move on please.

And yet I think there really is something interesting to say about it. Firstly, it is clear that in the segment in which technology competes with labor, technology always wins. Computers are faster, more reliable, more submissive and cheaper than people. Secondly, the battleground on which computers take on human workers is constantly expanding.

One month ago, I used the example of a self-driving car, which would be a boon for efficiency and safety, but it begs the question as to what happens to professional drivers. Historically, new demand for low-skilled jobs has always arisen in the wake of new technology. However, once we arrive at a point where chauffeurs become obsolete due to the advent of selfdriving cars, I think that the bottom of the labor market will clearly be losing the battle against machines.

But is that a bad thing? Aren’t we simply on the road to WALL•E-fication of our society? What I mean by that is of course not that lonely robot that is eternally clearing up man’s mess, but the end game when robots have taken all the work off our hands. I admit it’s utopian, but it does rather change the dynamic of the problem. Instead of denying the job losses, or worse still, calling for regulation to stop all progress, we would then need to think about how to transition to that new world. Difficult, certainly, but at least it generates some new ideas.

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FACTOR INVESTING 1

What history teaches us: 7 lessons for factor investing Long-term historical data will give you insights for the future, says Professor Elroy Dimson. Investors should take the long view and be aware of factor exposures.

– Long-term historical data will give you insights for the future – Every professional investor can follow the Norway model – Value investing shows a longterm perspective is important – Beware of accidental exposures to factors – There are obstacles in implementing factor exposures – Factors carry risks, and returns are uncertain – Equity and interest rate exposures are more important than factors

Long-term financial market performance is at the heart of Professor Elroy Dimson’s research. He is co-author of ‘Triumph of the Optimists’ and the annual ‘Credit Suisse Global Investment Returns Yearbook’ with Paul Marsh and Mike Staunton, both also academics at the London Business School. Dimson is chair of the Strategy Council of the Norwegian Government Pension Fund, which invests Norway’s oil and gas revenues and is the largest sovereign wealth fund in the world. Dimson gave a lecture to approximately 140 professional investors. Afterwards we took the opportunity to speak with him separately and asked him for seven key takeaways for professional investors related to factor investing.

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Long-term historical data will give you insights for the future

When you average over a long period of time, you learn a bit more about asset prices, delving into something which is fundamental and permanent. On the other hand, you are looking at more out-of-date data. So there is a trade-off here. Still, because most things in investments are quantitative in nature, using more data wins compared to throwing away older observations.

Should one expect the future to look the same as the past? No, because the past contains all sorts of events which may not recur. You can extrapolate from history to get answers to some sorts of questions. You can predict future outperformance of equities compared to other asset classes. But there are dangers. Those

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PROFESSOR ELROY DIMSON

who predicted continued outperformance of small caps compared to large caps, when the superior historical performance of small caps was documented in the early eighties, were disappointed in the second half of the eighties and nineties.

2

Every professional investor can follow the Norway model

There are three different models that investors can follow. One is the Yale Model developed by David Swensen, which explains how investment managers can bridge their deficit in target returns by hiring managers who can exploit market opportunities. The Yale Model is also about adding greater illiquidity to the investment portfolio to earn liquidity premiums which are unavailable to other

investors. The Yale model is difficult to replicate because it is complex, opaque, and relies on deep knowledge.

The second model, the Norway model, which is named after the Norwegian Government Pension Fund, relies extensively on publicly traded securities, large-scale diversification, and beta or market returns. Every investor can seek to mimic this model by buying diversified equity funds, which give exposure to thousands of shares. This equity exposure and level of diversification is similar to the Norway Fund, and can be achieved at low cost.

The third model, the Canada Model, relies on large-scale private equity positions which are managed in-house. It is difficult to replicate because of the scale of the required investments.

3

Value investing shows the long-term perspective is important

Currently, value investing is stimulated by the ‘hunger for income’. When you go through periods of huge out- or underperformance it is always good to take a long-term view. There are periods when value does badly as well as periods when value does well. In the second half of the nineties, value investing struggled.

Dedicated value portfolio managers from that period rarely lasted to see great success in the 2000s, when value became profitable again. Their jobs disappeared because they did not have good track records compared to the market–cap benchmarks, which led to fund outflows. These managers moved on to other positions.

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premiums’, because it accepts the fragility of future returns. To some investors, a focus on factors might suggest that you would just keep earning these rewards; that it is some sort of money machine.

4

Beware of accidental exposures to factors

Portfolio managers need to be aware of accidental exposures, which can have a material influence on performance. Even if a manager does not follow a factor strategy, their way of operating can lead to exposure to factors. For example, an asset manager who reports to clients might sell his losers at the end of the quarter or year in order to window-dress the portfolio. The advantage is that a manager has less explaining to do as to why a ‘loser’ is part of the client’s portfolio. This strategy gives increased exposure to momentum stocks, and it might be good for the portfolio’s performance. On the other hand, he might sell out of value stocks, because these stocks often attract bad publicity. In that case stocks are being taken out of the portfolio which, on a forward-looking basis, may offer aboveaverage expected returns.

5

There are obstacles in implementing factor exposures

To get major exposures to factors in a large fund you will face obstacles in implementation. The reason is governance issues. If you increase factor tilts, you increase your tracking error and with it your chance of underperforming a conventional benchmark. It is hard to persuade a client and consultants why an underperforming fund should be retained.

A fund’s governance should be prepared for short- and medium-term underperformance when implementing factor exposures.

6

Factors carry risks, and returns are uncertain

The sustainability of factor returns depends on where factors come from. If these factors are anomalies, we might arbitrage them away. But if they are a reward for risk, they will continue to be employed. I still prefer the term ‘risk

7

Equity and interest rate exposures are more important than factors

For a large institutional investor, it is difficult to do anything more than add these factor premiums as side bets or tilts. The equity premium is more important, although you can still tilt your existing portfolio to get exposure to factors.

The Norway Fund has a major exposure to the worldwide stock market and to interest rates.

Current interest rates are low and the Fund has a large bond portfolio. It would be nice to find premiums to hugely augment these sources of return, perhaps by having a long/short factor portfolio on the side. But for the largest fund in the world, extreme factor exposures would be impossible to implement. Some smaller investors may find it possible to take on larger factor weightings.

Conclusion The conclusion of the seven takeaways is that the past can help to give insights into current events and the future. Or as the ‘Credit Suisse Global Investment Returns Sourcebook 2014’ puts it: ”While current events may appear different from the past, there are lessons to be learned and parallels to be drawn, especially when we look back across time and countries.”

QUANT 1

– Market inefficiencies are caused by behavioral biases of investors – Robeco is one of the top quant players in the world – Quant strategies have a more attractive risk-return profile

No room for egos

Robeco’s assets under management in Quant Equities recently surpassed the EUR 20bn milestone. On this occasion, we asked Peter Ferket, CIO Equity Rotterdam and closely involved in Robeco Quant Equity since the late 1990s, how he explains the success of quant equity investing and Robeco’s role as a thought leader in this field.

The Quant Equity team is one of the four investment teams under Ferket’s responsibility, but his involvement started much earlier. “From 1999 to 2007 I headed the Quantitative Research department, working together with researchers like David Blitz, Pim van Vliet, and Wilma de Groot,” Ferket explains. “As of April 2003 I combined this role with the position of Portfolio Manager Enhanced Indexing within the Equity department. The Enhanced Indexing products were the first truly quant managed equity products. Since the end of last year I have been the portfolio manager of RobecoSAM Quant Sustainable Global Equities, combining two key strengths of Robeco: sustainability research and quantitative investing.”

PETER FERKET Head of Equity Robeco

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‘We do quant investing because we believe in it, not because the market likes it’

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How to define quant equity investing Quant investing takes many shapes and forms. What unites them is that they are evidence- and rules-based. “Quant strategies are always the result of thorough empirical research including back-testing of investable strategies. In day-to-day portfolio management pre-defined rules are strictly followed. There is a possibility to deviate from these rules, but only to neutralize undesired risk exposures.”

What is important, says Ferket, is to understand why a certain quant strategy works. “By now we all know that the market is not efficient, but there are different explanations as to why it is not. At Robeco we believe market inefficiencies are caused by behavioral biases of investors, such as greed, fear and anchoring, and by investment restrictions. For example, if investors are not allowed to leverage their positions, they will tend to have a preference for high beta stocks to achieve outperformance.”

Robeco does not believe in the other prevailing explanation, which is that the premiums resulting from inefficiencies are a compensation for risk. According to this line of thought, value companies are said to have a premium because they are more risky as more of them go bankrupt.

“We want to harvest the factor premiums without unrewarded risk,” says Ferket. To this end, Robeco’s researches have added distress risk to the variables and have residualized momentum, which means that they have eliminated unrewarded risks and focus on stock-specific momentum rather than market momentum.

Very popular among investors The investment industry has changed dramatically. Whereas active asset management was more or less the standard some twenty years ago, passive strategies, such as ETFs and index funds, have made an enormous advance. They give both retail and institutional investors the opportunity to obtain close to the market return at relatively low cost. “Over the past decade, active strategies have had a difficult time beating the benchmark,” says Ferket. “When they did outperform, this was usually because they – intentionally or not – had above-benchmark exposure to factors such as value, momentum or low-volatility, and because they invested in a disciplined manner.” This paved the way for a

different way of investment, factor investing. This type of investment was more often than not done in a quantitative way, as this increased the strategies’ outperformance potential and quant approaches tend to be disciplined and evidence-based. The result was a big advance of quant equity investing and Robeco came out as one of the winners.”

‘As simple as possible and as complex as needed’ Robeco’s success in quant equity investing What explains Robeco’s success in this field? “Quality and experience, I would say,” Ferket notes. “We were one of the trendsetters in quant investing. We have been conducting high-quality research since the end of the 1980s and have had practical experience with the implementation of this research in investment products since 2002. We pay much attention to the continuous improvement of our data. We have a smart portfolio construction algorithm, which optimizes performance and reduces transaction costs.”

“What’s more,” Ferket goes on to say, “we have reputable, highquality people. Ever since I started as Head of Quantitative Research 15 years ago, I have seen our researchers and quant portfolio managers show huge personal and professional growth. We are consistent and persistent. We do quant investing because we believe in it, not because the market likes it, and persevere when things go against us.”

“Researchers and portfolio managers cooperate very well. They frequently publish in sophisticated, academic journals. It is important to us to keep all this experience and knowledge in house. We succeed because our people like to be part of a winning team. Robeco is one of the top quant players in the world and I am proud that we are almost always one of the same five to ten asset managers that end up in the (semi-) finals of a manager selection process.”

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‘Our researchers must accept that their research does not always lead to concrete change’

they invest. Some are attracted by the good returns or enhanced risk profile. It is our duty to keep explaining when we expect a strategy to do well, and when we don’t. A client needs to know that, for example, in a strong bull market, Conservative Equity products usually lag behind the market, although they will still yield decent returns.”

Is quant equity investing a hype?

Enhance the models while maintaining a stable investment process

Ferket does not consider quant equity investing to be a hype. “On the contrary: I think we are just at the beginning. Over the past years, a lot of assets shifted to purely passive products as investors were disappointed in active management. These passive products however are market-cap weighted investments, which is not necessarily the smartest way of investing. As a result, part of the assets in passive strategies moved to quantitative strategies, such as factor investing, enhanced indexing and semi-passive solutions.”

Ferket sees two important advantages of quant strategies over passive investments. “First of all, they have a more attractive risk-return profile.

In the expected lower return environment (with returns averaging 6% to 7%), an excess return of 50 to 150 basis points – or even more - is quite a lot. Second, passive strategies are also passive in terms of sustainability or ESG integration. There are several institutional clients, especially in the Netherlands and Scandinavia, who look for asset managers who integrate ESG information in their investment process. We have seen quite some interest, for example, in Robeco Quant Sustainable Global Equities, which offers the market return with enhanced sustainability.”

Most of clients’ quant assets are in the core part of their portfolio and tend to be beta-driven strategies. The satellite part of the portfolio will increasingly be filled in with fundamental high-conviction, alpha-driven products, such as Robeco’s Stars products.

Pitfalls Of course every type of investing has its own vulnerabilities. “It is very important to explain to your clients how you invest,” Ferket emphasizes.

“Not all our retail clients fully understand the quant products in which

Robeco’s guiding principle is: Keep it as simple as possible and as complex as needed. “We do not change for change’s sake,” Ferket notes.

“This means that our researchers have to accept that research will not always lead to adjustments in the strategy. There is no room for egos.

Several of our researchers have a PhD. The research required to achieve that, tends to make one humble. And I think this contributes to our success. We have put much effort and research into dynamic allocation, for example, but we have not found that it improves the risk-return profile of our strategies. Two years of research have therefore not led to any concrete changes. Of course, it has greatly deepened our insights.”

“We keep our strategies as ‘simple’ as possible, at least at first sight,” Ferket continues. “The true sophistication lies within our products. I think it’s great that we have solid, reliable people who are truly passionate about their profession and have an inner drive to understand how the market works and how we can benefit for our clients.”

The future of quant investing or the sustainability of anomalies Ferket is a strong believer in the sustainability of quantitative equity strategies. “Fear and greed are human emotions that will not disappear,” he states. “Investment restrictions won’t either. In addition, I do not expect everyone to make use of the biases or move to quant investing.

Passive investments will not go away, nor will fundamental active strategies. Granted, once factor investing becomes more mainstream the premiums may become smaller, but they are here to stay.”

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FACTOR INVESTING 2

‘To assess performance and risk of active managers’

How does factor investing fit into the debate of active versus passive?

We interviewed two experts with different perspectives: one working for an index provider while the other represents an active management house. Altaf Kassam is MSCI Head of Index Applied Research EMEAI, while Joop Huij is a Senior Quantitative Researcher at Robeco.

INTERVIEW WITH ALTAF KASSAM & JOOP HUIJ ALTAF KASSAM MSCI Head of Index Applied Research EMEAI

– Factor investing is a third way of investing – Different approaches to factor investing – The optimal solution is investorspecific – Factor investing isn’t a hype

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How factor investing fits into active vs passive Since the financial crisis, investors have become more critical about the role of active management and trackers have gained in popularity. The debate about its role is not just held by pension funds, but also by fund distributors and financial regulators. Can factor investing bridge the divide between active and passive investing?

It does not replace market-cap passive investing, nor does it fully replace active management. Factor investing has some of the features of passive investing, such as investing systematically at low cost. It also has some of the features of active management by aiming to generate returns above the market cap-weighted index.

How would you define factor investing?

JOOP HUIJ: I agree that it will be the third pillar in the portfolio. There are, however, very different approaches to factor investing. For instance, factor investing can be implemented by tracking factor indices, which means the use of a transparent rules-based approach, and it can be implemented using proprietary models and processes. This is the way that our factor funds are constructed.

ALTAF KASSAM: It is investing in equity indexes whose components’ risk and return is defined by similar characteristics, or weighting indexes differently from market capitalization to capture specific characteristics.

JOOP HUIJ: Our definition is similar but I would like add the words ‘systematic approach’ and ‘investing strategically’.

What factors do you identify?

JOOP HUIJ: To us it is important that there is strong evidence for the existence of a premium. We identify value, momentum and low-volatility as the three key factors, because these three convinced us most.

ALTAF KASSAM: We currently identify value, momentum, low-volatility, quality, yield and low-size as factors offering long-term risk-adjusted outperformance. We are always evaluating new factors.

How does factor investing fit into the debate of active versus passive?

ALTAF KASSAM: It is a third way of investing: between active and passive.

What is the role of factor indices in the discussion on factor investing?

ALTAF KASSAM: We see them used for passive investments, where people track our factor indexes closely and put money in them. But they can also be used for active management to measure performance, in some cases providing a more suitable benchmark than market capitalization indexes.

They can also be used to assess the performance and risk of active managers to try and understand how much of this might be attributed to factor exposure, and how much might be skill.

JOOP HUIJ: Besides what Altaf mentioned, they can be used to better inform investors. For instance, the Robeco Momentum strategy can be evaluated both to a market-cap weighted index and against a

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momentum index. Suppose for example that in a particular year the Robeco Momentum portfolio underperformed the market index by 2% and that the momentum index underperformed the market index by 5%.

In that case you could say we destroyed value to our clients given that we had a 2% lower return than the market. However, you could also say that, given the difficulties the momentum factor had in that year, we actually added 3% by following the Robeco approach.

What should investors take into account when implementing factor investing?

JOOP HUIJ: There is not a one-size fits all factor solution but the optimal

solution is investor-specific. A pension fund typically has very different goals and objectives than a large sovereign wealth fund or a family office. When implementing factor investing, one should therefore take ones goals but also ones preferences into account. The current portfolio and how the portfolio is positioned with respect to certain factors is also to take into account in implementing a factor investing portfolio.

ALTAF KASSAM: There is not one factor that performs better than the market-cap weighted index over all time periods. There is cyclicality in all factors. Often, factors can underperform the market for several months, if not years. And also factor indexes will have higher turnover than market-cap indexes, which means higher costs of implementation.

Finally, liquidity is more of a concern with factors than with the marketcap weighted index. Factor indexes generally have lower capacity than market-cap weighted indexes.

What is the best way to combine factors within a portfolio?

JOOP HUIJ: It is most important to be well diversified across different

factors. We believe that this is crucial to make factor investing a success.

While the factors earn a premium over a longer period of time, there are periods in which an individual factor, or even several factors, lag the market. A well-diversified factor portfolio can absorb these periods of factor underperformance. Our research shows that an equal weighted allocation to value, momentum and low-volatility provides good

diversification. One can deviate from this if more emphasis should be given to decrease the risk of the portfolio, in which case more should be allocated to the low-volatility factor. Or, if higher expected returns are to be achieved, more weight should be given to value and momentum.

ALTAF KASSAM: We have looked at simple, equally weighted

combinations. But we also checked whether combining factors based on risk, valuation or momentum makes sense. Our current research indicates that just combining factors with equal weights is a strategy which is quite hard to beat. So maybe some of these more sophisticated measures do not add much value.

What is your opinion on timing factors?

ALTAF KASSAM: One answer could be that factors should be held strategically for the long term. You do not need to time factors to produce excess returns over a market-cap weighted index as long as you have a long enough investment horizon. We recently published a paper that looks at 40 years of data on factor index history. The research shows that historically, if you hold factor indexes 3 to 5 years, the chance of outperforming the market-cap weighted index is above 75% for most factor indexes. And with a longer time period, the chance of outperformance grows to almost 100%. Many of our clients come to us and ask us about timing factors and we started developing strategies based on the economic cycle. It really depends on your tolerance for risk, your time horizon and whether you have any views on the macroeconomic environment as well.

JOOP HUIJ: Timing factors is extremely difficult and we therefore believe

one should be very humble in trying to time the factors. All the potential added value of factor investing can easily evaporate by incorrectly timing factors and the extra turnover as a result of timing factors. In our research we do see some potential for timing factors and we try to benefit from this in how we rebalance across factors in our factor investing solutions. However, only a relatively small part of our riskbudget is allocated to the timing of factors and we use our timing in such a way that turnover is actually reduced as opposed to increased.

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‘Timing factors is extremely difficult’ What is the future of factor investing? Will it be adopted widely?

ALTAF KASSAM: We still think there is a place for passive and active

investing. On the passive side, if you don’t have a view on factors in terms of risk and return, you should remain in market-cap passive.

Even our biggest clients who invested billions in factor indexes haven’t moved all of their equity allocation into factor investing. I don’t see that happening. At the same time, active managers should still be able to add value through skill, market timing and concentrated stock portfolios.

These are things we don’t do when we build our indexes. I do believe factor investing will be widely adopted. Growth rates are substantial, but it won’t fully replace all the other forms of equity investing.

JOOP HUIJ: Professional investors are increasingly looking at factor

investing and what factor investing can do for them. Moreover, we see an increasing number of investors actually implementing factor investing in one way or another. Given the vast amount of evidence in favor of it and the fact that it is becoming more accepted by the industry, we strongly believe factor investing is not a hype and here to stay.

‘Factor investing is not a hype’

JOOP HUIJ Senior Quantitative Researcher Robeco

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TREND INVESTING 2

‘Focus on health-care costs offers opportunities’ Health-care costs must be brought under control, says Robeco trend analyst Steef Bergakker. This creates opportunities for companies.

– It is vital that high health-care costs are reduced – Better diagnostics lead to cost savings – Less chronic diseases as a result of prevention and cure – Challenging times ahead for the producers of unhealthy products and large pharmaceutical companies – Rolinco approach: timely response to trends

For many years, health-care costs in the western world have grown more rapidly than the national revenue. In many of these countries, health-care costs already amount to more than 10% of GDP. According to Steef Bergakker, this trend needs to change. “A critical point has been reached. Costs are becoming too high in the developed countries.

This has become a particularly urgent issue as a result of the financial crisis and its aftermath, which put extra pressure on government budgets.“

disease. A cure obviously has our preference from a humanitarian point of view, and it is also cost effective.”

Population aging is an important underlying reason for rising costs. “Older people are major consumers of health care, and they make up a steadily increasing part of the population.

However, the main reason for the rising costs is that we are getting steadily better at treating increasing numbers of diseases. It not always about finding a cure, but more often about ways of slowing down the progression of a

Despite the massive challenges this presents, it is possible to have better and less costly health care. “It is a combination of many factors.

This is not about just one thing. A significant piece of this puzzle is the ability to chart someone’s DNA profile. But there are more pieces. Take bioinformatics (the application of ICT in biology) which has resulted in a greater understanding of biological processes.”

Bergakker sees opportunities here for companies that help reduce costs. “A critical mass of possibilities has emerged which can make the system more effective and efficient.

We are looking for companies that offer solutions to increase productivity by preventing or curing disease or by raising the efficiency of health-care services.”

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‘Opportunities for companies that help reduce costs’ Better diagnostics lead to cost savings Productivity in health care can be increased by improved diagnostics, says Bergakker. “A lot of time and money is wasted finding out exactly what is wrong with a patient.” Better diagnoses can be made through breakthroughs in genetic research, he says. “Many diseases have genetic origins. Analyzing patients’ genetic material is hugely important. The costs required for this have dropped from several billion dollars to a thousand dollars per patient. If you combine this with molecular tests of body fluids, it is possible to make immense progress in attacking diseases”.

In future, patients will be required to go to a hospital less frequently for a diagnosis. They will visit a specialized clinic or send material to a laboratory at an earlier stage, expects Bergakker. “If diseases can be diagnosed at an earlier stage, patients can be treated better and more cheaply in specialized clinics or even by their general practitioners. There will then be less necessity for treating large groups of people in hospitals.” And this will make a big difference to the costs, he says. “Being admitted to hospital now often costs more than USD 1,000 per night. Hospitals have high fixed costs because they focus on treating all ailments. Specialists, expensive equipment and high overheads are responsible for these high cost levels.”

Less chronic disease as a result of prevention and cure Bergakker also has high expectations regarding the prevention of diseases, under the motto

‘prevention is better than cure’. Three-quarters of the costs relate to chronic diseases, he says.

“Many of these diseases develop as a result of high-risk behavior (drinking alcohol, eating excessive amounts of unhealthy food such as sugary products). This behavior leads to cardiovascular disease and diabetes. Because these diseases are usually only detected in an advanced stage, hospitalization is often necessary owing to the complications that then result. This explains the high costs.”

Smart phones and portable devices will play an important role in future in preventing chronic disease as they enable individuals to monitor their vital body functions themselves, he believes. “For instance, to measure blood pressure, glucose levels or your heartbeat.

Being able to alert a doctor sooner can in many cases prevent the necessity of an expensive hospital visit and increase the chances of successful treatment.”

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In addition, Bergakker expects costs to decrease as a result of the increasing ability to cure disease rather than just treating the symptoms and complications, which is now often the case.

While this slows down the progression of the disease and makes it bearable, it also entails high costs for treating a chronic condition.

“Improved diagnostics and more effective therapies focused on the underlying causes mean that it is possible to cure illness.”

Finally, he believes that productivity can be increased by improving the efficiency of the entire health-care system. “Gains stand to be made through the introduction of ICT solutions on a large scale. Take electronic patient files, for instance: at the moment a great deal of time is still spent entering patient data, while this should only need to be done once.”

Challenging times ahead for producers of unhealthy products and large pharmaceutical companies Bergakker also looked at those companies on which this can be expected to have a negative effect. “Companies that make potentially unhealthy products can expect to face more difficult market conditions. Take, for instance, producers of food products that contain large amounts of sugar. They may be confronted with future regulation that will adversely affect earnings growth, and thus run extra risk. Mexico, for example, has recently already levied a sugar tax.”

Another group of companies facing challenges in the future are the traditional, large

pharmaceutical companies, he said. “I expect the market for drugs to become fragmented as a result of our improved understanding of genetics and the different strains of disease.

In the past, many diseases used to be lumped together. However, on closer inspection, they have been found to be governed by different biological processes. Another factor is that response to drug treatment can vary considerably from one person to another, which demands a more personally tailored approach.”

“In short, the business model of a single drug for a large end market no longer works. Large pharmaceutical companies will have to apply a different business model with lower overheads, as they run up excessively high fixed costs. This is the result not only of their R&D costs, but also of their large sales force. “

‘Large pharmaceutical companies will have to apply a different business model’ Rolinco approach: timely response to trends The global equity fund Rolinco is happy to apply Bergakker’s analyses. According to him, the moment has come to invest in companies that help lower the costs of health care.

These are: – companies that are active in prevention, such as providers of portable equipment – suppliers of cheaper versions of medical apparatus – cheaper centers of treatment – providers of customized medicines “Investing means responding to trends at the right time. Don’t get in too soon, but be ready to take advantage when stock prices accelerate. Now is a good time to invest in this trend with a time horizon of three to five years.”

‘Be ready to take advantage when stock prices accelerate’ It’s not too late to step in, says Bergakker.

“People are far less aware of the trend towards decentralization of health care.

Decentralization impacts suppliers of medical equipment. Devices are getting smaller, cheaper and easier to use. Take MRI scanners, for example.”

“A total of twelve companies and 19% of the Rolinco portfolio (as per 2014Q1) are linked to health care. We focus on companies that are well positioned, and not on the sectors they are in.”

VALUE INVESTING

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Efficiently harvesting the value premium Value is one of the oldest factors in the world. Graham and Dodd already laid the intellectual foundation in the 1930s for what would later be called value investing and Basu published the first academic study in 1977 documenting the existence of the value premium.

– Gaining an attractive premium of 2-3% with a rules-based approach – A rules-based approach allows you to stick to your investment style and avoid value traps – Our active approach is designed to capture the value premium more efficiently

Value investing, buying stocks with a low price to fundamentals, carries the prospect of gaining an attractive premium of 2-3% to the market. But gaining the value premium is not as easy as it seems. It changes over time and selecting the right value stocks is challenging.

To profit from it you need to have sound value investing principles and stick with them. So what should you take into account? Robeco Quantitative Value Portfolio Manager Maarten Polfliet explains how to reduce unrewarded risks, the integration of other factors when selecting stocks and the importance of a broad investable universe.

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What is the investment belief behind Robeco Quantitative Value?

How is your value strategy different from others?

It combines two investment approaches; investing in stocks where you can harvest the attractive value premium and applying a rulesbased approach. We apply the value concept of buying stocks that trade at a low price relative to their realized fundamentals rather than investing in concepts based on future expectations and predictions as is the case with growth stocks. In the end, a bird in the hand is worth two in the bush.

We take a systematic approach to capturing the value premium. A rules-based approach helps because it allows you to stick to your investment style. Based on our experience in analyzing factor exposures it is important to realize that although many investment funds or smart-beta indices carry the ‘value’ label, they aren’t value strategies at all. Their actual exposure to the value factor is low.

Broadly diversified portfolios based on a rules-based approach are a perfect way to systematically profit from the sound principles of value investing. This means you sometimes buy stocks that everyone else is selling, and sell stocks that everybody else is buying. This social pressure can cause anxiety. That is why we use a rules-based approach; this has no barriers of fear, keeps you on track and ensures that you fully exploit the value premium.

Often the value premium is seen as a reward for risk and indeed generic values strategies can be tilted towards stocks with a high distress risk, also known as default risk. These stocks are cheap for a reason. With our approach we avoid such value traps. Because our research shows you do not need to invest in high-risk stocks in order to capture the value premium. That is why we included criteria to avoid high distress risk, poor financial strength and companies with an aggressive accounting base to achieve

sound earnings power in our selection of value stocks. This allows us to reduce unrewarded risks without sacrificing returns. Beside this we integrated low-volatility and momentum factors into our quantitative value strategy. This is because we do not want to invest against these two proven factor premiums. Take price momentum for example. A concern with a value approach is buying too early. A stock may seem to be attractive from value perspective.

But if its price continues to decline due to further weakening in fundamentals it isn’t attractive to have in your portfolio.

Some investors worry that value investing is currently too popular.

Is it easy to select suitable stocks for your portfolio?

The investable universe we can select from is so broad that there is always a segment with relative low price to fundamentals. There are still a lot of companies out there with an attractive valuation. Moreover, value investing

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is a long-term game. It is normal for interest in value stocks to fluctuate. Sometimes investors are interested, and at other times they are disappointed. For example if value lags the market that is driven by momentum and growth stocks.

‘Avoiding negative momentum prevents you from buying too early’ If value investing always works, it will be arbitraged away, but it doesn’t. Interestingly, even though the value premium has been documented many times since the 1970s, the factor continues to perform. So it works over time, but the interest is irregular.

And how is your approach different from smart-beta funds?

Our active approach is designed to capture the value premium more efficiently than the value oriented smart-beta indices. We aim for a better risk-return profile by avoiding unrewarded risks and unnecessary turnover, and going against other proven factor premiums. Furthermore, we would like to stress that although these smart-beta index strategies look-and-feel like passive they are active strategies at heart.

Finally the construction of those smart indices results in a tilt towards large caps. This is a pity

for investors because it holds them back from the value stocks opportunities within the smalland mid-caps segment of the market. Our way of constructing a portfolio is different. We can chose from a broad investable universe of more than 3,000 stocks and objectively compare large, mid and small cap stocks to select the most attractive value stocks. Due to our approach of avoiding unrewarded risks and the integration of low-volatility and momentum factors we can be very selective and create a high conviction value portfolio with a higher active share. Our current portfolio has around 200 stocks resulting into a much deeper exposure to the value premium.

Your strategy is young. What is Robeco’s experience with value investing?

The strategy is new, but Robeco’s experience with all its ‘ingredients’ is extensive. Value factors have been part of all our quantitative equity models since the early 1990s. It is the same for the momentum variables which we take into consideration in this value approach.

And we have had experience with the low volatility factor since as early as 2006. So application of the value anomaly and the other factors are at the heart of Robeco’s quantitative equities investing.

Where does investor interest for your strategy come from?

It is mostly coming from institutional investors who want to strategically allocate to the value factor. Allocating to this is part of their ‘investment belief’ based on the

sound principles of value investing and the tremendous amount of evidence for value as one of the largest factor premiums. Often they want to combine it with investments in other factors: either Robeco Conservative Equities or Momentum, but also factor strategies managed by other managers.

Diversification is important because factor premiums are not constant over time. But the precise mix of value, momentum and low volatility can be different. Are you interested in absolute performance or relative performance?

Some investors only chose the value and momentum factors because they focus on outperforming the market cap weighted index.

While others also include low volatility which has more of absolute risk-return focus. It all depends on investor preference.

Interest in the quality factor is increasing. What is your opinion of this?

Investors are looking for new factors after value, momentum and low-volatility, but is quality really new? The old value school always looked at safety, stability and profitability in addition to a low price to fundamentals. At our quantitative equity strategies we have been exploiting variables related to quality for many years. Beside this there is still a lot of discussion among academics on what the quality factor is precisely. We are monitoring the discussion and continuously check, as we have always done, which variables perform and which do not.

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HEDGE FUNDS

What real use are hedge funds in an investment portfolio?

Hedge funds are generally known for their unconstrained, – Hedge funds are not a separate, independent asset category – They offer little in terms of diversification benefit – They differ widely as to type and style – And: the quality differences are huge

INTERVIEW WITH THIJS MARKWAT

THIJS MARKWAT Researcher Robeco

aggressive investment style, their high costs and divergent return profile. But what does this mean in practical terms? What real use are hedge funds in the portfolios of institutional investors such as pension funds?

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Researcher Thijs Markwat and his Robeco colleagues Rolf Hermans and Roderick Molenaar investigated the added value of hedge funds in investment portfolios. The researchers relied on data with a limited history (20 years). In addition, they had to take the specific issues with hedge-fund data into account. But our interview with Markwat reveals a number of significant conclusions.

Why examine the usefulness of hedge funds for pension funds?

There is no real consensus about the added value of hedge funds. Until 2008, the general thinking was that extra gain could be derived from them. But the financial crisis overturned this premise. For some time now, the discussion about the real advantages of hedge funds and the circumstances in which these apply has dominated the academic literature. This prompted us to check the figures.

How keen currently are pension funds to invest in hedge funds? And what is the trend?

On average, Dutch pension funds invest 3% of their assets in hedge funds. The amount of assets invested in hedge funds as a percentage of total investments has fallen since November 2008. This is the result of increased risk aversion, disappointing results and the Dutch regulator DNB’s more stringent requirements relating to expertise in managing investment portfolios.

How much money is involved in hedge funds in the Netherlands?

In absolute terms, the level of investments in hedge funds is increasing.

While Dutch pension funds made investments in hedge funds amounting to EUR 14 billion in the first quarter of 2007, by the third quarter of 2013 this had increased to EUR 27 billion. On a global scale this amounts to roughly EUR 2,400 billion.

Are hedge funds a separate asset class, like bonds, real estate, etc.?

No, we should really avoid considering them as a separate, independent asset category. The reason for this is that they mainly invest in other asset

classes such as equities or bonds. There is therefore still a strong link with the underlying investments.

Of what interest are hedge funds to pension funds?

Hedge funds themselves often claim that their return profile differs from that of standard asset categories. But our empirical research shows that hedge funds as a whole in fact show good performance in positive market conditions and poor performance in negative conditions. So overall, hedge funds offer little in terms of diversification benefit.

One of the most important findings from our research is that hedge funds cannot be categorized as the same group. They differ widely as to type and style. Their focus varies from strategies based on investing in forward contracts - ranging from currencies to pork bellies (managed futures) - to strategies that speculate on extreme events such as (hostile) takeovers or corporate bankruptcies (event driven). Some styles work better than others as a means of securing diversification in a total portfolio.

Which hedge funds offer diversification benefits?

There are three investment styles that have a low correlation with other categories: Equity Market Neutral, Global Macro and Managed Futures. Our research shows that the last of these categories provides the best protection against extreme declines in equity returns. Although - calculated over the entire period - Equity Market Neutral has a low correlation with equities, this category in fact shows poor returns in crash periods. For this reason we do not consider Equity Market Neutral to be a positive addition to an investment portfolio.

What is the outlook for hedge fund returns?

Hedge funds used to be used to help drive up portfolio returns. But expectations may have been too high. Return is not the only thing that counts. After deducting costs - which are really quite substantial for hedge funds - the resulting expected returns amount to 2%-3% above the riskfree interest rate. For comparison: in the longer term, ordinary shares may realize returns of 4%-5% above the risk-free interest rate. A particular advantage for institutional investors is the possibility of benefiting from a divergent risk/return profile.

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Which institutions would do better not to invest in hedge funds?

In our opinion they don’t pay off for the smallest-scale pension funds.

In absolute terms, these funds’ deposits are likely to be small. As a result, typically, the minimum deposit commonly required by hedge funds to obtain effective diversification over several managers will not be available. In addition, a pension fund must have (or hire) board executives and members of the investment-advice committee who know how the hedge fund’s strategy works and are able to monitor it. If this expertise has to be hired externally, the costs accruing to smaller funds are often excessive relative to the gains.

Which factors should pension funds consider before investing in hedge funds?

They should take a good look at the current composition of their investment portfolio. If a pension fund already has quantities of illiquid investments in sectors such as real estate and private equity, then it is better to avoid investing further large amounts in hedge funds.

Sometimes they also have a ‘lock up’ mechanism preventing capital withdrawal for a fixed period. Funds must further ask themselves if they can ensure effective selection and control of hedge funds.

What is the best way for a fund to find a high-quality hedge fund?

Our research shows that the results realized by hedge funds vary significantly, making selection extremely important. In other words: the quality differences are huge. For this reason it is best to hire people who can ensure good selection, though clearly there are also costs attached to this. And you should never select a hedge fund in isolation, as this results in excessive risk. For the category of managed futures, you will need at least two providers, and for global macro allocation our research shows that it is actually desirable to have three to four managers.

THE NEW HYPE

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TECHNO-OPTIMISTS If you ask any number of economists who disagree with the gloom-mongers’ fears of secular stagnation why they disagree, one argument is likely to dominate their answers: technological progress. The self-driving car, the advances in genetically-modified crops and the quantum computer: according to the techno-optimist, we are on the brink of a number of major technological revolutions. And these will quickly reduce the current period of low productivity to a temporary and insignificant dip.

BY LUKAS DAALDER |

Take, for example, self-driving cars. The productivity gains that can be achieved are undeniably huge. We’ll no longer sit non-productively in our cars or get stuck in traffic jams anymore. Trucks will travel non-stop from Rotterdam to southern Italy. Automobiles will be able to drive more quickly and closer to each other; asphalt will be used far more effectively.

Accidents will be a thing of the past. I have not read any serious research studies on this topic, but it wouldn’t surprise me if the potential savings for the Netherlands run into billions of euros per year. With all these advantages - it’s not so much a question of when the the first self-driving cars will be admitted to our highways, but how long it will be before it becomes illegal to drive a car yourself. If you subscribe to this train of thought, fear of long-term stagnation seems misplaced, doesn’t it?

But there is a flip side to this. What are we going to do with all the truckers, the Uber drivers, not to mention the bus personnel? What about the loss of employment among road workers, garage owners and non-life insurers? What jobs will be available for these people?

Only at this point does the distinction between the techno-optimists and the gloom-mongers become apparent. The techno-optimist falls back on the old story - the jobs that are lost in one sector (industry) are offset by the advent of opportunities in another (services). The optimist does not know exactly what the unemployed bus driver’s new role will be, but isn’t it true that 10% of all the jobs that exist today, did not exist five years ago?

Then the gloom-mongers. They also expect ongoing technological innovation, but they wonder whether it will be good for everyone. Take the self-driving car - who will benefit from that? The increasing degree of automation means that there is a risk that a small elite group may gain all the productivity advantage, while the middle classes are structurally eroded. In this scenario, secular stagnation is compatible with continuing technological progress.

I don’t think anyone is in doubt that technological progress is necessary if we are to avoid secular stagnation. Necessity is no guarantee, however. And at the moment too many optimists are presenting technological progress as an infallible miracle cure - something which I feel does not positively contribute to this debate.

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ESG INTEGRATION 1

Valuing ESG impact at Robeco Global Equity More and more investors recognize the importance of ESG integration.

– True ESG integration goes well beyond screening and engagement – it encompasses all stages of the investment process – Material ESG factors can have a substantial impact on business models and value drivers – quantifying this impact can be done – Taking into account ESG factors leads to more in-depth analysis of companies and therefore a better valuation of the business model

However, many parties tend to focus on screening and exclusion. While lots of ESG efforts are being made, the connection to business models and valuation tends to be missing. In this article we discuss how the Robeco Global Equity team tackles the challenge of linking ESG to value drivers.

Many asset managers indicate that they integrate ESG into their investment processes.

The most advanced parties tend to have the following elements: – – – –

Signatory to UNPRI and similar initiatives Voting and engagement activities Screening & exclusion Dedicated ESG staff

These are all very useful and are part of Robeco’s toolbox as well. However, in our view they do not go far enough. True ESG integration goes one step further. The European Sustainable Investment Forum (Eurosif) defines ESG integration as follows:

“This type (of strategy) covers explicit consideration of ESG factors alongside financial factors in the mainstream analysis of investments. The integration process focuses on the potential impact of ESG issues on company financials (positive and negative), which in turn may affect the investment decision.”

This definitely goes well beyond screening and engagement, and implies the use of ESG information in all stages of the investment process, including the investment case and the valuation models used in investment decisions.

At Robeco Global Equity, we do this because we firmly believe in the impact of ESG factors on the valuation of companies. In addition, we are in a unique position to quantify this impact as we have access to extensive, high-quality

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combined in our proprietary valuation tool: the Value Dynamic Framework (VDF), which is a discounted cash flow (DCF) model that explicitly takes invested capital into account.

Quantifying the impact of ESG factors on companies’ valuation takes place in three steps. The first step is to focus on the most material issues, i.e. those ESG issues that may substantially affect the company’s business model and value drivers – either positively or negatively. The second step is to analyze the impact of these material factors on the individual company. The third step is to translate the associated competitive advantages and disadvantages into adjustments to value driver assumptions in valuation models.

data obtained from the RobecoSAM Corporate Sustainability Assessment. This is based on questionnaires sent to over 2800 companies each year.

Quantifying the impact of ESG factors For every investment we do, the analyst makes an in-depth ‘investment case’ of the company,

which states his or her opinion on the industry, company strategy, the product portfolio, competitiveness of the franchise and a SWOT analysis. To quantify stock potential we identify four value drivers: revenue growth, margin development, invested capital needed and risk (as defined by a discount factor). To assess the fair value of a stock, these four factors are

A chemicals company Value driver

Sales growth

Margins

Cost of capital Target price

Benchmark

IGlobal chemicals: 4%

15% EBITDA margin in 2013

8%

Company adjustment ex ESG

Exposure to low-growth EU recovery: >+200bp segments: -50bps

Na

€ 124

ESG adjustment

Innovation management: +100bps

Innovation management, Environmental management & Product stewardship: >+100bps

Na

€ 19 (+15%)

Total

4.5%

>18% by 2017

8%

€ 143

The table below shows an example of how the ESG impact may be quantified for a chemicals company. In this case the ESG factors have a significant and positive impact on the value driver assumptions.

Even if the analyst decides to assign no impact to the value drivers (because the factors cancel each other out or the company is just average), these questions typically do give the analyst a deeper insight into the quality of company management and the risks involved.

With our proprietary Value Dynamic Framework valuation model, we have a firm foundation in traditional financial analysis, and we look forward to further enhancing it by quantifying the impact of ESG factors.

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QUANT 2

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Pioneers with a passion for data There are many such parallels between sailing around the world and success– Robeco is one of the original users of quantitative investing models – Quant expertise is also being used by Team Brunel – For Robeco and Team Brunel risk management is key

ful investing. Both combine technical know-how with careful risk management.

And both require teamwork to win over the long term. That is why our sponsorship of Team Brunel is a natural fit with Robeco’s way of working.

A pioneering spirit has long been embedded in Robeco’s DNA. We were the first to take sustainability investing seriously, among the first to invest in emerging markets and one of the original users of quantitative investing models.

Quant on the high seas

This article is written as part of a series to accompany our sponsorship of Team Brunel, the Dutch entry in the Volvo Ocean Race.

Quant expertise is also being used by Team Brunel to help with data collection and navigation, and to minimize risks. “We use quantitative analysis by collecting facts just like Robeco does before considering an investment,” says Bouwe Bekking, skipper of the Team Brunel boat. “We try to get as many facts and numbers as possible. We have to sail through 360 degrees and have to cover all the possible angles for every wind direction, each one requiring different sails.”

“There are so many angles involved when sailing over the ocean – the wind, the weather, the size of waves – that we use as many combinations of data as possible to match it to the real conditions of the day. We put it all in the model and then implement this information to predict velocities in all sailing conditions. The more combinations we can check out to see how fast the boat will go, the better.”

“Obviously the faster you go at sea, the more you need proper risk management, or the chance of you hitting an iceberg or a whale becomes very large. It’s the same with investing,” says Peter Ferket, head of equity investments. “We want to take active risks, and we look for opportunities, but at the same time risk management is key to avoiding the bad parts of the market.”

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‘Data is a crucial part of our campaign.

If we don’t have the right numbers, we’re going to make wrong decisions’ “Our quantitative investment approach is deeply embedded throughout the organization to support this. It is directly connected to the use of as much data and information as possible. But we don’t just look at a company’s past results; we regularly meet with management and look at companies’ qualitative information in order to blend insights that are both forward and backward looking.”

particularly in new terrain. This presents challenges for sailors and investors alike.

“Using data works well to sail from Alicante to Cape Town for example, but the real problem is in places like China where the data and charts are really bad,” Bekking says. “So we have to make risk calculations. For example, the draft of the boat is five metres, so we need to know how deep the water is and make calculations so that the keel is always higher.”

“We also use non-financial information in our assessment of a company to decide whether or not it is an attractive investment. Something that might look like a great opportunity on the surface needs a deeper look to avoid disappointments.”

“The bigger problem is the weather. In the northern hemisphere the weather forecasts are really accurate and you can even plan on how the wind will change on an hourby-hour basis. But once you get into the southern hemisphere, sailing for example from Abu Dhabi to China, models for weather forecasting are much less developed and can be completely wrong.”

“And we also consider environmental, social and governance (ESG) factors and quantitative analysis as risk indicators. So if a stock gets in the portfolio but drops in the ESG or quant rankings, then this is a signal for us to take a deeper look at the company.”

Coping with data in all conditions BOUWE BEKKING Team Brunel Skipper

Using quantitative and other research for risk management relies on accurate data,

“You then have to start making assessments; positioning yourself in relation to the competition but without being able to trust all the information. We have to decide: do we split from the others, and put all our eggs in one basket, or follow suit and take no risk in terms of positioning?”

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‘Typically we aim to perform in all conditions’

It’s a marathon, not a sprint Both Robeco and Team Brunel know that taking short cuts can be tempting, particularly if the circumstances are rough. But the Volvo Ocean Race is a marathon, not a sprint, and it is important to keep a steady hand on the tiller.

This applies both at sea and in the office.

“A short cut can save you time, but you need to be aware of the risks this can entail,” Ferket says. “Typically we aim to achieve good performance in all conditions; we don’t want to be the best when markets are rallying and then the worst when they fall. We want to be the best over a long period and also do well when markets are in decline.”

“It is similar to winning the Volvo Ocean Race. It’s no good winning one leg, and then performing poorly in the next one, or not even reaching the finish line. Our goal is to deliver added value over a three to five-year horizon, which consists of many different legs in different market conditions. Being the best this year and the worst next year doesn’t work for us.”

matter of life or death. “My worst nightmare is losing a crew member in a rough sea,” he says. “A boat is replaceable but a person is not.

There’s not much risk of hitting something – I’ve only ever seen one whale, the first time I went round the world in 1985, but there are icebergs in the Southern Ocean, and so safeguards are in place. We just keep north of the dangerous areas; our boats now go at 30 knots and hitting something would be like driving your car into a wall at 70kph. We’d be pretty smashed up.”

“We have tried to find the limits of this particular boat, as it’s a new design and all the safety margins have been set way higher than for the last one. And we’ve tested the crew, of course, to see how the new guys cope. Once we start racing, we will push even harder, and so any problems found beforehand will help us.

We’re really looking forward to the race.”

Risk management as a life saver

PETER FERKET

And while investing can be painful at times, for Bekking careful risk management can be a

Head of Equity Robeco

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FACTOR INVESTING 3

How factor investing also works for corporate bonds Two Robeco researchers have become the first to analyze the effect that – Factors used in equity investing also work in corporate bonds – Multi-factor portfolios proved to outperform the benchmark – Research was back-tested over 20 years using USD bonds – Strategies target low-risk, value, size and momentum factors

factor premiums can have on corporate bond investing. Patrick Houweling and Jeroen van Zundert show that the factors used successfully in equity market investing can also work in the corporate bond market.

Investors have long used the four main factors low-risk, value, size and momentum to pick stocks that on average have a higher-risk adjusted performance than others due to their characteristics. However, relating this quantitative investment style to corporate bonds is still in its infancy. Their research into the effects of value, for example, is so new that the industry does not yet even have a commonly agreed definition as to what ‘value’ means when applied to corporate bonds.

Starting a dialogue “The paper is meant to start a dialogue with investors after we received more and more questions about this,” says Patrick Houweling, quantitative researcher and portfolio manager for the Robeco Conservative Credits strategy.

“Some had already implemented factor investing on the equity side and wanted to

apply it to fixed income too, and in particular, to corporate bonds.”

“There are a couple of papers out there on low-risk and momentum credits, and we know of one paper on value, which is quite technical.

But we don’t know of any papers on size, and ours is the first one to apply the whole concept of factor investing to a single portfolio of corporate bonds.”

“We have assessed the benefits of combining multiple factors in a single portfolio to see what kind of returns you could get,” he explained.

“We also looked at the added value this generated in bonds versus those for the equity market factors. As far as we are aware, this is all brand new research.”

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‘The hardest part was that we didn’t have a base paper saying: this is the definition of the factor when applied to the bond market’

Houweling and his fellow quant researcher Van Zundert spent months writing a groundbreaking white paper, Factor Investing in the Corporate Bond Market, posted on 31 October 2014 on the Social Science Research Network (SSRN) academic website.

“The research on the equity side was already there, so we built on the same philosophy,” says Van Zundert. “This does not mean that we could simply copy and paste the equity factor definitions. For factors such as momentum, the idea is similar to equities by looking at past returns. But for the value factor we think that a fixed income investor will typically look at spreads instead of book-to-market ratios. So we only looked at bond market characteristics to capture the essence of the factors: how a bond investor would use them, and not an equity investor.”

“The hardest part was that we didn’t have a base paper saying ‘this is the definition of the factor when applied to the bond market’. We had to define it ourselves,” he says. “And there’s no single way to do it, so we tested a number of different measures one could come up with, such

as looking at price instead of spread for value, or looking at past 3-month returns instead of 6-month returns for momentum. Our findings are robust to such alternative definitions.”

Back-tested over 20 years As there are currently no funds with long track records in this field, their work was back-tested from a data set from 1994 to 2013 using US dollar corporate bonds. “We ran the tests over a big pile of historical data and tracked the factor portfolios through time to see if the effects are really there, to make sure that the higher returns were not just a lucky shot,” says Houweling. “The low-risk and momentum results were confirmed by other studies which had similar results on these factors.”

Applying the four factors to corporate bond investing is going into mostly uncharted territory.

One of the exceptions is Robeco’s Conservative Credits strategy. This strategy focuses on the low-risk factor, also taking momentum, value and size into account. “We don’t have a pure value strategy yet for corporate bonds, but we have done all the research so that we can deliver one,” says Houweling.

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‘We want to be able to offer a multi-factor solution if clients ask us to do so’ “It’s the same for multiple factors – we want to be able to offer a multi-factor solution if clients ask us to do so. That’s the stage where the market is at – people need time to get up to speed with factor investing in the corporate bond market. We expect a lot of activity next year on this topic.”

The research showed that investing in such a multi-factor portfolio doubles the Sharpe ratio that could be achieved versus investing in the market index. The annualized alpha of the multi-factor portfolio is 1.00% for investment grade and 3.21% for high yield, which is sizable given their market premiums of 0.59% and 2.46% respectively.

stocks can generate returns that are just as good as the ‘exciting’ ones, but without the higher risk. The study shows that the same is true for low-risk corporate bonds.

Momentum works on the principle that past returns indicate future returns: a stock doing well in the past is likely to continue to do well in the future. “What we find in corporate bonds is that this premise works in high yield but not for investment grade bonds,” says Houweling.

The size factor targets companies that have been overlooked by the market. “Smaller companies tend to be ignored by the vast majority of investors, so we can get a neglect premium,” says Van Zundert.

Value looks for companies whose market price does not reflect its fundamentals. “We look at the expected return that you would get after taking into account what the rating agencies say and what the spread curve indicates” says Van Zundert. “If the expected return of the bond more than compensates for the risk being taken, it is worth owning. You can say it is cheap then.”

How the factors work So how do the factors themselves work? “The themes that lie behind the factors used in equities are usually related to human behavior, or how markets function, or how regulators look at markets, and these explanations apply equally well to corporate bonds. Herding behavior, for example, which causes the momentum effect does not just apply to equities,” says Houweling.

Low-risk investing exploits an anomaly which has been proven to show that apparently ‘dull’

For their application in actual investment portfolios, the study recommends combining multiple factors instead of relying on a single factor. It is important to make sure that one factor doesn’t counteract another. “For example, we don’t want to buy the most expensive low-risk bonds or cheap high-risk bonds” says Houweling. “Therefore we also take value and momentum into account in a low-risk strategy. Also, we construct equal-weighted portfolios to benefit from the size premium.”

‘If the expected return of the bond more than compensates for the risk being taken, it is worth owning’ Trading costs But isn’t it more expensive to trade in corporate bonds, which are sold ‘over-the counter’ by financial institutions rather than over an exchange like equities? “Corporate bonds are less liquid than equities, and so transaction costs are higher,” says Houweling. “So we devoted a section of our research to finding out whether the returns were still higher than the transaction costs. If you have to replace a holding, for example, to keep exposure to the value factor, then how costly is that for the investor? We found that all these factors still delivered substantially higher returns after costs.”

“It’s important to recognize that some bonds are more expensive to trade than others, but even when we doubled the transaction costs to be on the conservative side in our analyses, we found that the returns were still there. So this is not just theoretical research – it would actually give you higher returns in your portfolio.”

THE NEW HYPE

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HYPE CYCLE

Source: www.gartner.com | © Gartner (August 2014)

Watch out everyone - the Internet of Things is about to enter the trough of disillusionment! Don’t worry if you have no idea what I’m talking about. As awful as it may sound, it probably won’t have too much impact on the broader stock market. But this graph, updated regularly by Gartner, is one of my favorites. It is not only a good test of seeing whether you are still reasonably up to date with the latest technology trends, it also shows you which technologies finally make it onto the plateau of productivity. A Mecca for any technology.

BY LUKAS DAALDER |

This graph shows the recognizable pattern of the various stages through which a technology passes. Take the dot-com bubble of 1997-2001, or even Bitcoin. At the beginning no one has heard of it and there is just a small group of dedicated insiders. Then the technology catches on, and more articles appear on the subject. The expectations for the future become rosier - more attractive, more extensive. Stories make the front page. By this time our imagination has run away with us and we have reached the peak of inflated expectations. The dismal trough of disillusionment inevitably follows. However, this does not necessarily mean that the technology suffers unduly - after all, the Internet is still going strong. But investors who stepped into the market when these technologies were at their peak will probably be disappointed.

54 |

OUTLOOK CHINA

– China admits the need to rebalance giant economy – Financial crisis unlikely due to stimulus measures – Authorities will act to prevent any hard landing – Country won’t defy gravity forever though

China is becoming middle aged, so it’s slowing down a bit In some ways, the rise of China has been too good to be true. Its economy has grown with breakneck speed for decades (an average of 9.1% a year since 1994), if we can believe the official accounts.

LÉON CORNELISSEN Chief Economist Robeco

‘Chinese growth up until now has still been slightly disappointing’

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The Chinese authorities have recently begun to preach the need for a gradual rebalancing, making China less dependent on export growth and increasing domestic consumption. The country also wants to develop greater social security for its 1.3 billion people. Nevertheless, the growth target remains a hefty 7.5%.

After the Lehman crisis the Chinese authorities successfully prevented a sharp downturn, at the cost of a sharp build-up of debt. In 2014 the economy was struggling once again and the authorities quietly stimulated the economy, fuelled once again by a strong growth of credit.

Estimates differ about the current level of debt as a percentage of GDP, but the trend is clear: the debt binge is far from over. You might well compare the country to someone in middle age who is still enjoying the good life, fuelled by credit, but has started to slow down a bit, and is looking for better balance in their life along with a social safety net.

And indeed, it has not done so: after a ministimulus earlier this year, Chinese growth up until now has still been slightly disappointing.

In 2014, China injected a massive USD 80 bln into the five largest banks, equivalent to a 50 basis point rate cut. Chinese leaders sought to assure everyone that they’re not preparing a massive stimulus package, while hinting that they could live with an undershooting of the Chinese growth target of 7.5%. Market participants have since lowered their forecasts of Chinese growth towards 7.0%. On the other hand, Chinese leaders won’t accept a sharp weakening momentum of the economy because of the risks to employment and social stability that this would imply. Their preferred course of action is what I would call ‘quiet stimulus’ of this kind.

Funding in China – bank loans still make up the bulk of lending

‘Quiet stimulus’ has been preferred Does this mean that China is on the brink of a financial crisis caused for example by a property crash, followed by a string of corporate defaults? I don’t think this is very likely, although these fears are widespread and to a certain extent understandable. The theme of a ‘hard landing’ has been around for years.

It has also been pointed out that the rise of the most successful capitalist economy of the 20th century, the United States, was interrupted by the Great Depression and then World War Two, so we should not expect China’s meteoric rise to go on smoothly forever.

250

200

150

100

50

0 2002 Total

2003

Bank loans

2004

2005

2006

2007

2008

2009

2010

Entrusted loans, trust loans, bank acceptances & net corporate bond financing

2011

2012

2013

2014

Non-financial enterprises, equity & other

China’s total social financing – As % of GDP. Sources: People’s Bank of China; National Bureau of Statistics

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continue lending, particularly through the shadow banking sector. Known officially as ‘non-bank intermediation’, this sector has more than tripled in size since 2008, albeit from a low base. As a consequence, shadow banking in China is relatively low both as a share of GDP and of financial intermediation. Central government debt is low, so it can absorb a lot of problems if it chooses to do so. A bond default – once unthinkable – has already been accepted. So the overall debt ratio is likely to continue to rise in the coming years as policymakers give priority to growth.

China is still behind western competitors on debt-to-GDP (in %) Indonesia India Taiwan Germany Australia South Korea China France Italy US Singapore UK Hong Kong

… but China can’t defy gravity forever

Spain Japan 0 End - 2008

100

200

300

400

End - 2013

Source: Standard Chartered

Easy to avoid a hard landing …

Meanwhile, the Chinese economy still has important structural advantages to avoid a hard landing. For instance, it has a low dependency on foreign debt (around 10% of GDP) combined with impressive foreign reserves amounting to around 40% of GDP, or USD 4 trillion. The external sector is therefore an unlikely trigger for a crisis. Furthermore, the domestic debt load is to a large extent a consequence of state-owned banks lending money to state-owned companies.

And so the Chinese government can easily prevent a credit crunch by forcing banks to

In the long run, the Chinese growth rate cannot defy gravity forever – it has to come down at some point. The economy is still heavily dependent on investment, which in 2013 was the largest contributor to growth.

Gross domestic investment was a staggering 47% of GDP. However, some of these huge investments will most likely be unprofitable and will have to be written off. The current rate of investment is unsustainable over the long term, and will likely give way to higher domestic consumption.

Of course, events could take a different course, in which the Chinese authorities willingly let things slide. They could decide to bite the bullet after futile warnings for years that the debt dependency inherent in the economy is unsustainable. They could decide to curb debt growth decisively and let things run out of hand after a series of policy mistakes. This isn’t very likely, but it’s also not unthinkable.

So what would be the likely consequences for the world economy if Chinese growth did plunge to zero? As China is the world’s secondlargest economy, amounting to around 10% of world GDP on a purchasing power parity basis, a severe slowdown would be felt worldwide. It would mean a negative global demand shock, initially shaving 0.75% from world GDP growth.

‘China could decide to curb debt growth decisively’ Four victims of a struggling China

As national savings accounted for a staggering 49% of GDP in 2014, probably mainly due to the lack of a social safety net, there is ample room for increasing consumption.

Compensating for the inevitable slowdown in investments with a comparable increase in consumption won’t be that easy to engineer and could easily trigger a recession.

There would be four main victims of this.

First, the largest trading partners of China (as observed from China’s import side) would see their exports decline. These partners are in order of magnitude: the EU, Japan, South Korea, Taiwan and the US, who between then account for 47% of Chinese imports. OPEC would also take a knock as it is a major exporter of oil and petroleum products to China.

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Second, as China is a major commodities importer, a collapse of Chinese growth would probably mean a collapse in commodity prices, exacerbating deflationary trends in the world economy. From an investor’s point of view this would increase the flight to safe haven bonds such as German Bunds and US Treasuries.

It would be bad news for emerging markets equities and probably equities in general.

Third, from a regional point of view, a massive slowdown would be especially bad news for the rest of the Asia Pacific region.

Problems could be exacerbated if the Chinese authorities try to counter the lack of growth with a sharp depreciation of the yuan. Military tensions could also rise markedly if the Chinese authorities were to attempt to deflect domestic public anger by using confrontational action against countries labelled as external ‘aggressors’, such as Japan, with whom it has a long-running dispute over island ownership in the South China Sea.

Fourth, a hard-up China could be tempted or forced to dump a significant part of its huge stock of US Treasuries, provoking a sharp rise in US long-term interest rates, damaging the world economy further. A sharp deceleration of Chinese growth could therefore turn into a major earthquake, hitting the world economy, eventually pushing it into a recession.

Other countries need to sort themselves out But don’t worry just yet. China’s main priority over the next five years is to rebalance its economy and improve the quality of its social safety net, and I think it will succeed in doing so nicely. The real problem will be faced by exporters to a country that has been insatiable up until now. A gradually slowing growth rate in China, which is far more likely, would clearly lower import demand and thus lower export volumes from other emerging markets to China, preventing a decent rise in their current accounts.

So I expect at least some countries to counter this by addressing the supply side problems in their economies, making them more competitive in the global market and preventing cost push inflation and social unrest.

Current account deficits in emerging markets are still significant from a historical perspective and a further adjustment process could require further depreciation of currencies in the medium term. The Chinese economic miracle – and its knock-on effects – ain’t over yet.

58 |

ESG INTEGRATION 2

How to monitor your external manager?

While ESG integration seems high on the agenda of many asset owners, implementation remains a challenge when selecting and monitoring external managers. Cécile Churet, Sustainability Investing Client Specialist at RobecoSAM, researched the industry trends and concluded that there is still a long way to go.

– While ESG integration seems high on the agenda, implementation remains a challenge – For much of the pension fund industry, there is still a long way to go on sustainable investment

Cécile Churet analyzed over 80 reports from PRI signatories on the implementation of sustainable investment approaches. Her analysis focused on manager selection, legal appointment and monitoring. The incorporation of sustainable investment criteria into manager searches is highly relevant because two-thirds of asset owners outsource at least 10% of their listed equity investments and a quarter use external asset managers for more than 50% of their listed equity. Churet discussed her preliminary findings with a group of 20 asset owners and investment consultants at a briefing event in London in June.

Preference for ESG integration When asked which sustainability investing approach asset owners want their external

asset managers to apply, 70% indicated ESG integration, compared with 50% for screening and 25% for thematic approaches. However, this preference implies two challenges, i.e. identifying asset managers that truly integrate ESG into their investment decisions, and ensuring these aspects are incorporated in mainstream asset manager searches - and are actually implemented as intended. Churet found that while a fair amount is being done at the manager selection stage, less is done in terms of monitoring and ongoing dialogue with asset managers once they are selected.

Formalization in mandates is lacking A major challenge appears to be the appointment stage, as few SI-related aspects investigated at the selection stage are translated into formal contractual agreements. Only 6% of asset owners include reporting on portfolios’ SI characteristics in the contract clauses with their asset managers. Feedback from asset owners has been that part of the challenge of formalizing these requirements into legally binding agreements comes from legal advisers who are not convinced about ESG integration.

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Is ESG integration truly evaluated?

Similarly, less than 40% use a sustainable investment criterion as a formal component of manager performance evaluation. Twothirds of asset owners assess managers’ ESG incorporation strategies, but less than half actually assess the quality and coverage of the ESG research used by the asset managers, or meet with their investment staff to review their SI competences.

As asset managers become more sophisticated and consider ESG issues as part of their fundamental analysis, using different sources of data and feeding them into their valuation models and investment decisions, it will become more difficult to isolate the ESG component of the investment process, says Churet.

A long way to go In conclusion, while ESG integration seems high on the agenda of PRI signatories, implementation remains a challenge. What’s more, these findings represent the practices of the most committed and most advanced asset owners. For much of the pension fund industry, there is still a long way to go on sustainable investment.

Similar findings were observed across the whole PRI signatories’ base. To read more, go to unpri.org.

60 |

OPINION

Apple gadgets ‘may not make much money’ Apple’s array of new gadgets may have attracted a blaze of publicity, but they may not make that much money, two Robeco fund managers warn.

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– Limited appeal and market is seen for new ‘smartwatch’ – Apple Pay more interesting for other payment players – Upgrade to iPhone won’t crack key emerging markets

Jack Neele, manager of the Robeco Global Consumer Trends Equities Fund, and Patrick Lemmens, who runs the Robeco New World Financials Fund, however cautioned fans of the world’s most valuable company not to get too carried away with the innovations.

Limited appeal for Apple Watch “The Apple Watch demonstrates Apple’s ability to invent new stuff, but it only has a limited appeal and market,” says Neele. “‘The lack of a killer app on the Apple Watch will limit its appeal and I think it will be difficult to sell.

There is no clear case for using one yet, though the market has been waiting for new products and at least it’s something.”

‘The lack of a killer app on the Apple Watch will limit its appeal’

Lemmens is positive about the impact of Apple Pay, the new iPhone wireless payment feature. He selects companies for the fund that anticipate the digitalization of finance.

“Technology-wise this is a boost to near-field communication,” he says. “Many American investors expected that increasingly payments would be done wireless, using ‘the cloud’. We were not convinced of this. The disadvantage of payment data being dispatched over large distances over a wireless system is that it is more open to fraud.”

Lemmens finds it more interesting that Apple is working with other companies. “All the major credit cards are on board; American Express, Mastercard and Visa,” he says. “Other companies such as Discover Financial Services and Alliance Data Systems are negotiating with Apple in electronic payments. Apple’s partners will need to pay a small fee, but in return they should get a lot more volume longer term.”

Years before we have fewer cards He does not believe that credit cards will become outdated in the short term. “We expect that it will still take years before we will have meaningfully fewer cards in our wallets and even longer before we will have no wallets at all,” he says. “As more and other mobile phone brands would become payment enabled, we might see at some stage the number of credit cards declining. But for now, even cash-based payments keeps on growing with credit card based payments, electronic payments and mobile payments showing fast, faster and fastest growth.”

‘It will take years before we will have meaningfully fewer cards in our wallet’ Lemmens is also positive about the general impact of Apple Pay on the use of electronic payments. “We think this will help to further increase the general trend from cash payments to card based payments and electronic payments,” he says. “And especially this should provide a boost to mobile payments. Robeco New World Financials is positioned to benefit from those trends.”

New iPhone should maintain market share The upgrade to the iPhone was a wise move to remain at the top of the tree, but it’s not a major means of getting into new markets, says Neele. The iPhone makes up 70% of Apple’s profits and the gap in their portfolio - the need for a bigger screen size phones - was filled yesterday,” he says. “This may enable them to increase their market share, which will come mainly from developed markets, where they are now better positioned than before. Margins may also improve as the iPhone 6 Plus will be at a premium to previous iterations. So it is important for Apple to maintain its position as king of smartphones, but will not help them crack emerging markets.”

62 |

INFOGRAPHIC

WHAT DROVE INVESTORS IN 2014?

2 Mario Draghi’s speech

1 The rise of

smart beta Smart beta is the talk of the town in professional investing.

Assets under management grew fast last year; they are set to grow explosively as investors look for alternatives to market cap-weighted indices. But investors beware: implementation is important.

During the annual central bank symposium in Jackson Hole, ECB President Mario Draghi reasoned for stimulus, reforms & quant easing. In his speech, Draghi announced that the ECB will do more to halt falling inflation, but that it needs assistance to succeed. “The destructive effects of austerity somehow need to be reversed,” he said.

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3 Interest rates declined further

5 Crashing oil price

Interest rates dropped to unprecedented lows as the bond market theme shifted towards secular stagnation, i.e. a future world of subdued growth and low inflation.

Oil prices dropped sharply in the second half of 2014, due to weak global demand and to rising US unconventional oil supply. For the first time since 2008, milk became more expensive than a gallon of gasoline in the US.

US UK JAP GER

4 Return of the dollar The end of easy money caused the US dollar to rise.

6 The internet of things

The ‘internet of things’ was this year’s biggest buzz phrase. The connected society requires new business models and this will lead to job losses.

Tell your child to become a dentist, not an accountant.

64 |

FACTOR INVESTING 4

The best of two worlds: alternating between mean variance and risk parity Choices relating to asset allocation have major effect on the risk/return characteristics of investment portfolios. New academic insights have led to important innovations in this area. One of these is implementing a market view in a risk-parity portfolio.

– Mean variance solutions too sensitive to expected returns – Risk parity does not use market views, however strong – Researchers create bridge between the two methods – Degree of confidence in views affects asset allocation

RODERICK MOLENAAR Robeco Portfolio Manager

In our present challenging investment environment, it is important for pension funds and other institutions to make use of the opportunities offered by innovations in asset allocation. In a knowledge-sharing session held in May, Robeco discussed three such new developments: ‘mean variance versus risk parity’, ‘global diversified carry’ and ‘strategic allocation to commodity factor premiums’.

These are innovations that - as the session showed - can all come up trumps by adding value to a portfolio. In this first of three articles we look at the implementation of a market view in a risk parity portfolio.

65

From mean variance to risk parity For a long time, portfolio managers based their asset allocation on ‘mean variance’ - the method linked to the modern portfolio theory of weighing (expected) risk against return.

Roderick Molenaar, portfolio strategist at Robeco, describes this method of portfolio optimization as ‘a mathematically satisfactory solution’, though one that has fallen in popularity, and not without good reason.

Starting in the late 1990s, investment professionals increasingly began to favor riskbased solutions in determining their strategic asset allocation. Mean variance solutions had become too sensitive to expected returns: small adjustments led to major portfolio changes. Risk parity solutions (in which expected returns do not play a role) gained in popularity. Triggered by the financial crisis of 2007-2009, this movement took on landslide proportions. Determining the right parameters for portfolio construction turned out to be more difficult than imagined in previous decades.

“Skepticism about relying fully on a market view increased,” says Molenaar. “Expectations were often uncertain, but they still had a huge impact. You have to be very sure of your view to be able to rely on it completely. Mean variance could also produce a concentrated risk profile in a portfolio. Investment professionals wanted to get away from this.”

‘You have to be very sure of your view to be able to rely on it completely’ This resulted in strategies that partly disregarded expected returns. Risk parity, or as Molenaar prefers, ‘equal risk contribution’, became popular as a method of setting up portfolios in such a way that the different investment categories held in a portfolio made up an equal risk budget. In practical terms, this often means that exposure to bonds will be much greater relative to equities when compared to a portfolio constructed on the basis of mean variance.

Confidence in information “Choosing a specific strategy is linked to the degree of confidence you have in your data on expected returns, volatility and correlations,” says Molenaar. The strategist cites examples of other methods of constructing portfolios, such as maximum diversification, minimum variance, volatility parity (1/ ), risk parity and equal weighting (1/N). The methods differ from each other as regards the extent to which they include data on volatility, correlations and investment expectations in the considerations. In the case of risk parity, for instance, investors will assume that while the available information on volatility and correlations is sufficiently reliable, they cannot forecast expected returns, or can only do so inadequately.

The ‘portfolio decision pyramid’ – from maximum to minimum confidence in information

Max Sharpe ratio:

investment professional can indicate practical differences between all inputs: risk premiums and (co)variants

min variance max diversification risk parity

investment professional can determine practical differences between all volatilities and correlations

inverse volatility 1/N

Source: Hallerbach (2013)

investment professional can determine practical differences between volatilities mean-variance investment professional cannot indicate practical differences between risk premiums, volatilities and correlations between investments

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Actually implementing strong views What if an investment professional has a strong view regarding market changes? Risk diversification, a key factor in risk parity, is important, but how can you put your view to use? Risk parity is popular and has been successful for a long time,” says Molenaar.

“However, in May 2013 [when the Fed first started talking about ‘tapering’, i.e. reducing its bond-buying program], the rise in interest rates had a heavy impact on this strategy.”

He expressed a further concern: “The success of risk parity is measured mainly in terms of returns. This seems strange in itself, as portfolio construction under this strategy in fact takes place without considering returns.

While with risk parity volatility is low, returns lag. And the Sharpe ratio is high, but you cannot live on that.” According to Molenaar, one way of boosting returns here is to use leverage. “But is that what we want? And will the regulator agree to this?”, he asks.

Molenaar thinks that since it seems that interest rates can hardly go any lower, the success of the risk parity method could be in doubt. According to various sources, the chances of rising bond yields in the coming years are considerable. “When confidence in a specific market view is strong, you would do well as an investment professional to implement it,” he says. “But the big question is how to proceed if you have constructed your portfolio on the basis of risk parity. In the strength of risk parity also lies its weakness: it does not use market views, however strong.”

‘In the strength of risk parity also lies its weakness’

The degree of confidence in a market view affects the weighting of the investment categories 75%

50%

25%

Black & Litterman model helps According to Molenaar, the Black & Litterman model (which provided a solution in the 1990s to the problems surrounding the assessment of expected returns on investment categories), can also introduce market views into risk parity portfolios. Based on Bayesian techniques, Molenaar and his fellow researchers show how optimized portfolios can be influenced, depending on the amount of confidence there is in such views. The amount of confidence in a view is central to the solution studied. If there is very little or none, the portfolio manager will construct the portfolio around risk parity. If there is substantial confidence, asset allocation will resemble that for a traditional mean variance portfolio. As a function of the degree of confidence, the weights of the investment categories will be determined by a mix of both extremes.

“Our starting point is a portfolio based on risk parity, and depending on the way confidence in a market view increases, the portfolio will start to resemble the mean-variance portfolio that goes with that projection,” says Molenaar.

“This way we can create a bridge between the two strategies. The best of both worlds comes together.”

0%

-25%

Low confidence in view Risk parity

Bonds

Stocks

High confidence in view Mean variance

Commodities

Source: Robeco

A practical problem that Molenaar highlights is the challenge posed by the quantification of the degree of confidence in a view. Hans de Ruiter, CIO at the TNO pension fund, picks up on this point in his response to Molenaar’s research. He points out, for instance, that the findings from the behavioral finance literature show that investment professionals are generally not particularly good at estimating risk parameters. De Ruiter believes that Robeco’s research could be supplemented by taking into account in the analysis the relative attractiveness of the different investment categories (e.g. equities performing better than bonds).

Molenaar responds in a takeaway for pension fund investment professionals that if funds work with risk parity, they would do well to look beyond just risk considerations: “If you have confidence in a view, then put it to use.”

5-YEAR OUTLOOK

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Equities are the top picks for the next five years Equities will deliver the best returns over the next five years, with emerging markets stocks at the top of the tree, says Robeco’s CIO of Investment Solutions.

– Stocks expected to return 5.5% a year – Emerging markets equities are top picks – AAA-bond returns seen as low as 0.25% – Three scenarios adopted for next 5 years

LUKAS DAALDER Chief Investment Officer Investment Solutions

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Robeco predicts that developed market stocks will return 5.5% a year from 2015-19 while emerging markets equities are set to deliver 6.75%. This is considerably above the expected returns from bonds, where a gradual normalization of economic growth means interest rates will eventually rise from their historic lows, raising bond yields but lowering their prices.

AAA-rated government bonds are seen returning as little as 0.25% a year, below the rate of inflation in most countries, though high yield bonds and emerging market debt should offer more at 2.0%. Of the other major asset classes, indirect investment in real estate (through financial investments rather than physical property) is seen as returning 4.0% a year from 2015-19, while commodity market returns are seen dropping substantially.

Economic growth favors stocks “Strengthening economic growth and low inflation create a more favorable environment for stocks compared to bonds,” says Daalder, Chief Investment Officer for Robeco Investment Solutions. “On an absolute basis, the returns for developed market stocks are forecasted to be lower than during the prior five-year period at 5.5% a year. But in

‘Stocks are expected to yield aboveaverage returns over government bonds’

relative terms, as an excess return over government bonds, stocks are still expected to yield above-average returns.”

However, while equities are the clear favorite, Daalder cautions that stock market returns are seen being lower than those forecast in the previous edition of Expected Returns covering the 2014-18 period. He argues that the long bull run for equities since the market bottomed out in 2009 has made some valuations inflated, and that stock prices will fall more into line with the actual earnings growth of companies. “The continued strong rally in equities in recent years has not been matched with earnings growth, leading to stretched valuations (overvaluation) for the asset class as a whole,” he says.

“But following a year of underperformance, emerging markets stocks look to be the most interesting option, as their valuation versus developed markets is now low. Investors should be mindful of course that volatility for this asset class is traditionally higher, though it has declined in recent years.” The table below shows the volatilities that can be expected from each asset class, with emerging markets clearly showing the highest levels for stocks over bonds.

Our predictions for the major asset classes for the next five years Difference

Volatility

Asset class

Expected returns for 2015-19

Expected returns for 2014-18

Equities emerging markets

6.75%

7.25%

-0.5%

25%

Equities developed markets

5.5%

6.75%

-1.25%

18%

High-quality government bonds

0.25%

0.5%

-0.25%

5%

Investment grade credit bonds

0.75%

1.5%

-0.75%

6%

High yield bonds

2.0%

3.5%

-1.5%

12%

Emerging market debt

2.0%

3.5%

-1.5%

10%

Commodities

1.5%

4.0%

-2.5%

25%

Indirect real estate

Source: Robeco

4.0%

5.25%

-1.25%

20%

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‘Policymakers will choose a gradual approach and won’t be aggressive’

erupted earlier than the Eurozone crisis (2010-2012), it is not surprising that the US will take the lead in this process.”

Three scenarios for recovery Daalder and his team use three scenarios for predicting returns. The preferred one is a ‘gradual normalization’, which he and his team believe has a 60% probability of occuring. There is a more pessimistic one of ‘secular stagnation’, which is given a 30% chance of happening; and a more optimistic one of ‘strong recovery’, which has a 10% likelihood of coming to pass. Daalder sees the US economy, which has been going from strength to strength, taking the global lead.

“The central idea with a gradual normalization scenario is that all hangovers eventually lift, even those from a financial crisis,” he says.

“Given the fact that the subprime mortgage crisis in the US (2007-2009)

“Interest rates will be raised, although policymakers are expected to choose a gradual approach, rather than being too aggressive. Growth will be supported by a recovery in labor markets and investments, but at the same time will be held back by demographics and (especially for Europe) the slow healing process of the recovery of the banking sector.

Inflation in this scenario will pick up, but is not likely to pose a threat for financial markets.”

In the ‘secular stagnation’ scenario, the world continues on the path which we have seen over the past five years, with modest growth for the world economy as a whole, and no growth or mild deflation in the Eurozone.

“In this scenario the weight of an aging population and the lack of meaningful technological change that helps the whole of the economy (rather than the lucky few) prevents growth from moving into a higher gear,” says Daalder. “It would mean that ‘Abenomics’ fails in Japan and China weakens. Bonds and real estate would be the relative winners in this scenario, as monetary authorities will continue to push yields lower in hope of reviving the ailing economies.”

Alternative scenarios Gradual Normalization odds: 60%

Secular Stagnation

Strong Recovery

30%

10%

Cash

0.75%

↓

↑↑

Government bonds

0.25%

↑↑

↓↓

Credits

0.75%

=

↓

High yield bonds

2.00%

↓↓

↓↓

Emerging market debt

2.00%

↓↓

↓

Equities developed markets

5.50%

↓↓

↓

Equities emerging markets

6.75%

↓↓

↓

Indirect real estate

4.00%

↓↓

↓

Source: Robeco. Arrows show differences versus the central scenario.

He says a far happier outcome for the world economy as a whole would be the ‘strong recovery’ scenario, where investments are thriving, productivity gains translate into higher earnings, and economic growth is gathering strength globally.

But don’t hold your breath – the chance of this happening is put at no higher than one in ten. “And this scenario is not without its own drawbacks,” says Daalder. “Inflation would at long last return to haunt central banks and investors alike. As such, with the exception of cash, most asset classes would end up with a lower return compared to our central scenario. Higher refinancing rates and higher wages would pressure earnings margins, while bonds would suffer from an across-theboard sell-off.”

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The past predicting the future Daalder says one of the reasons why the next five years are not expected to be as lucrative as the past five is because abnormally low interest rates since the financial crisis have artificially distorted returns since 2009.

“Five years out, returns have to be seen within the context of the current state of the world economy, and the developments we have seen over the past five years or so,” he says.

“From an investor perspective, the past five years have been pretty impressive – all of the major asset categories have yielded returns well in excess of their longer-term average, with listed real estate leading the pack, boasting a 16% annualized return,” he says (see adjacent chart).

From an economic perspective however, the developments have been a lot less impressive. “The world economy as a whole managed to keep up its average growth rate, but this was mainly thanks to the very strong growth performance of the developing countries: growth in the advanced economies has been lagging,” he says.

Annualized returns from September 2009 – September 2014

“There has been no strong rebound from the major blow that was dealt during the 2008-2009 recession, with especially Europe only showing lackluster growth. Recoveries following a financial crisis are usually weak and the current one is no exception. It has pushed central banks around the world to keep interest rates close to zero, while trying to revive their economies by embarking on various unconventional monetary measures, all aimed at flooding the system with ample liquidity.”

18% 16% 14% 12% 10% 8% 6% 4% 2% 0%

Emerging markets debt

Eurobonds

Credits

Equities emerging markets

High yield bonds

Equities developed markets

Real estate

Source: Bloomberg. 5-year annualized returns September 2009 – September 2014

“This has been the driving force for the returns we have seen in the various asset classes. Liquidity has pushed interest rates and bond yields to unprecedented lows, forcing investors to look for returns elsewhere. Valuations in various asset categories have been pushed to stretched levels, which have a clear impact on the expected returns for the years to come.”

This document is solely intended for professional investors

TIME2READ

Important information This statement is intended for professional investors. Robeco Institutional Asset Management B.V. (trade register number: 24123167) has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This document is intended to provide general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com.

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