Investment opportunity conservative equities november 2014

INVESTMENT OPPORTUNITY November 2014 For professional investors

INTERVIEW WITH PORTFOLIO MANAGER PIM VAN VLIET

Conservative Equities • Volatility is not constant, trying to time it is a difficult task • Low-volatility investing has gained broader acceptance • An enhanced approach leads to higher risk-adjusted returns

Headline-grabbing stocks may attract attention, but it is less known that everyday stocks have lower risk, more stable returns and unexpected upside potential.

Conservative Equities benefits from Robeco's long-lasting expertise in global equities investments and pioneering work in low-volatility investing.

The Conservative strategy is based on a solid academic foundation.

Robeco was a forerunner in the academic debate on low-volatility investing with many publications on this topic including the awardwinning research in 2007 ‘The Volatility Effect’. For example, its researchers were some of the first to prove that the volatility effect exists in Europe, Japan and the emerging markets.

Robeco is one of the world’s leading active low-volatility managers with over EUR 9.1 billion (end of September 2014) in assets under management and we offer strategies for Emerging, European, Global and US Conservative.

Robeco also manages EUR 3 billion (end of September 2014) in Conservative credits.

Investment Opportunity | 1

volatility of Emerging Conservative was lower, while the difference in volatility between it and the index was especially significant at the beginning of 2012, which was a period of high market volatility.

Portfolio Manager Pim van Vliet, answers questions on Robeco’s Conservative Strategies.

Volatility in equity markets has rapidly increased this year.

Does this influence your stock selection?

Our Conservative stock-selection model is designed to work in different market circumstances.

Investors should always realize that volatility is not constant, but changes over time and can suddenly increase as it is doing now. Trying to time market volatility is a difficult task, but predicting relative volatility through stock selection is easier.

The chart below shows just how effective the Conservative Equity Strategy can be in reducing volatility through time. It gives the rolling 260-day volatility of Emerging Conservative (blue) compared with that of the MSCI Emerging Markets Index (red).

During this entire period the

Aren’t low-volatility stocks becoming expensive?

The current valuation of lowvolatility stocks is above market average. However, our portfolios have a more attractive valuation than the average low-volatility strategy. The explanation for this is that our conservative stockselection model does not just consider low volatility but also takes a stock’s valuation into account.

This prevents us from overpaying for low-volatility stocks. Take for example the MSCI World. It has an average PE ratio of 17.3, while the MSCI World MinVol Index has a ratio of 18.3. The PE of Robeco Global Conservative Equities is 15.2, thus less expensive compared to both indices (end of September 2014).

Now that low-volatility stocks have higher valuations on average, it is even more important to make a sound selection. No two lowvolatility stocks are the same. In periods like we witness today this can make a big difference in terms

of the returns generated. Research, with data going back 82 years, shows that an enhanced approach works most effectively compared to a generic low-volatility strategy when low-volatility stocks have higher valuations. This is in line with the performance of our strategies since 2006: lower average valuation and higher return.

Have perceptions of lowvolatility investing changed?

Today low-volatility investing has gained broader acceptance within academic circles and especially among investors. Much empirical evidence supporting the lowvolatility anomaly has been produced and nowadays investors are more focused on reducing absolute risk.

Low-volatility investing is attracting more interest from institutional investors, especially in the wake of the series of financial crises that started in 2008. Since then, investors have become more open to alternative ways of capital preservation and diversification.

The graph on the next page shows the effectiveness of the Conservative strategy in reducing losses during bear markets (left side).

These are markets with negative returns on an annual basis.

Real performance data shows that Conservative stocks perform in line or better during periods of moderate equity returns (middle).

Our portfolios tend to lag in strong thematic bull markets (right side).

In these markets absolute returns tend to be good.

Source: Robeco Quantitative Research

Investment Opportunity | 2

Source: Robeco Quantitative Research

The average return series is based on the net asset values of three funds from inception up to December 2013: Global, European and Emerging Conservative are gross of fees.

How has low-volatility investing been embraced by the asset management industry?

Investors have more choice nowadays than in 2006 when we started. Of course we are happy that the general level of interest and knowledge is increasing.

Initially, besides Robeco, a small number of specialized boutiques were at the forefront of lowvolatility investing and developed strategies in this field. Later on, many large asset managers also created mutual funds which tried to benefit from the volatility effect.

Following the success of active managers, passive managers have now also jumped on the lowvolatility bandwagon by introducing ETPs based on low-volatility indices.

We estimate the market to be around 200 billion USD as of Q4 2014, of which 2/3 in active strategies and 1/3 tracking lowvolatility indices.

Is your organization able to cope with the growth in Conservative strategies?

Robeco is committed to lowvolatility investing and the Conservative Equity team consists

of four experienced senior portfolio managers. I have 14 years of experience in this industry, Arlette van Ditshuizen 17, Jan Sytze Mosselaar 10 and Maarten Polfliet 15. We are all highly qualified investment professionals. The size of the team allows us to cope with the growth in assets under management over the past years.

In total, Robeco has 9 quantitative portfolio managers and 17 quantitative researchers.

What is your opinion of lowvolatility indices?

We think it is good that these indices exist nowadays. They solve the issue of how to benchmark a low-volatility strategy, which was for many of our clients a problem during the first years. Furthermore they increase choice for investors if these indices are tracked with an ETF or mutual fund. However, these indices can be suboptimal in my opinion. Although the ETFs based on those indices are often perceived as passive investment strategies, in reality they are not because the underlying index requires various subjective assumptions and choices tilting the portfolio away from the market cap weighted index.

Take for example, determining when to rebalance the portfolio and determining the rules for constructing it. Assumptions and choices in these two areas can have a large impact on performance, something investors are often not aware of.

If low-volatility investing is not implemented efficiently, investors may miss out on a large part of the potential added value. The lowvolatility indices are not specifically designed to harvest factor premiums in the most efficient manner, but primarily for simplicity and focus on 1 factor only. Finally,

the rebalancing rules are public information, which makes them vulnerable to predatory traders around rebalancing dates. Thus, the capacity of low-volatility indices is limited, maybe even more limited than proprietary active low-volatility strategies.

Can you name two drawbacks of low-volatility indices compared to the Conservative approach?

First, generic low-volatility indices tend to ignore other factor premiums. Not all low-volatility stocks are equally attractive. Some stocks are attractive from a volatility perspective, but can be very expensive.

We consider it to be risky to ignore the price you actually pay for a stock. It is also risky to go against momentum, because this factor not only predicts return, but also risk.

Research shows that expensive lowvolatility stocks with weak momentum tend to have belowaverage expected risk-adjusted returns.

In order to enhance the risk-return profile, Robeco Conservative Equities has always incorporated value and momentum factors into its stock-selection model. Thorough empirical research shows the benefits of this approach in generating higher risk-adjusted returns. Adding price momentum helps to improve up-capture (the percentage of market gains captured by a manager when markets are up), while adding valuation factors mitigates valuation risk. Incorporating value and momentum factors into a lowvolatility strategy enables us to realize our objective of maximizing the Sharpe ratio, which is the return per unit of risk.

Investment Opportunity | 3

Second, an optimized minimum volatility or minimum variance indices are quite sensitive to correlation estimates and concentration risks. This occurs, for example, in MSCI Minimum Volatility Indices which rely on these estimates, while the S&P Low Volatility Indices have no concentration limits. However, we do not use these correlation estimates to construct the portfolio and we mitigate concentration risk by having strict concentration limits for region, country, (sub) sector, size and single stock weights.

Our balanced approach distinguishes us from other managers or indices that focus on low volatility alone. For this reason we believe that Conservative Equities will continue to perform better in the long term than average low-volatility stocks.

Is the Conservative strategy a high dividend strategy?

Our funds give around 4% to 5% annual dividend, while the primary focus is on risk reduction. The Conservative strategy is more defensive than an average high dividend strategy. Many of our clients invest in our funds as part of a multi-asset income portfolio. The stocks that the Robeco Conservative Equity strategies have on its radar are not only expected to have lower risk, but usually also deliver a relatively high dividend. This is a result of our investment strategy.

We do not focus on selecting the highest dividend stocks, in the same way as a simple high dividend strategy does. Our starting point is to select the most attractive low risk stocks. Companies that pay out consistently high dividends are often profitable businesses that are active in stable, mature sectors, leading to low volatility in their stock price. This results in a

selection of low-risk stocks with a relatively high dividend returns.

How are stocks selected using the Conservative approach?

We select stocks on the basis of volatility, beta, low default risk and value- and momentum-driven factors. So we consider not only historical volatility, but also include other factors to enhance returns and avoid unnecessary risks and costs. We use the term 'Conservative' instead of ‘low volatility’ because this is not a generic low-volatility or minimum variance investment strategy.

Our Conservative stock-selection model determines the selection of stocks in our portfolios. This model categorizes all stocks from attractive (most conservative) to less attractive (least conservative).

We construct the portfolio with the aid of this categorization. We do not to adjust the portfolio too much, as switches incur costs that reduce net returns. There are clear and simple rules formulated in order to avoid unnecessary transactions. Of course, extensive tests have been run to obtain the optimal set of portfolio construction rules. Our expected average annual turnover ratio of 25% can be considered low. This means that stocks usually remain in our portfolio for around four years.

The product range consists of a global variant and several regional options. Which is the best one?

We offer our investors a selection of flavors to choose from. The best option depends on investor preference and the regional exposure of the existing portfolio.

These are a few considerations for investors to take into account:

Emerging Conservative Risk reduction and capital preservation are especially important in emerging markets. We notice that client interest in these markets has increased this year. Equity valuations have come down and emerging-market stocks are currently less expensive than stocks in the developed markets.

European Conservative The longterm economic outlook for Europe for the next 5-10 years is less favorable than for other regions and its population is shrinking.

Therefore, a more defensive equity strategy instead of one based on growth might be prudent. Our portfolio is overweight in sectors with a relatively high dividend yield, such as the utilities and telecom sectors. Over the longer term, dividend reinvestment contributes significantly to total returns.

Global Conservative The global strategy provides most diversification and broad exposure to the growth of the world economy, including emerging markets. The Conservative strategy does not have a top down country approach but selects individual stocks. The strategy can be combined very well with other global equity strategies due to the different pattern of returns it generates.

US Conservative The US economy has recovered strongly this year, but investors have become more worried about the valuation of equities. Our Conservative approach takes valuation into account when selecting lowvolatility stocks.

Investment Opportunity | 4

The charts below illustrate the performance of European and Emerging Conservative compared to the MSCI reference indexes. As you can see the strategies are effective in reducing downside risk.

Could you give examples of stocks you invest in?

In Emerging Conservative we have an above-average allocation to Malaysian stocks, as Malaysian stocks score high on our low risk factors.

An example is Malayan Banking, which is the country's largest bank in terms of assets and has significant banking operations in Singapore, Indonesia and the Philippines. The stock has a low correlation with the market as a whole, which makes it an effective diversifier. Malayan Banking offers a dividend yield of almost 6% and has relatively low bankruptcy risk.

In European Conservative, we are overweight in telecom stocks.

Within the telecom sector, we search for companies that have low-risk characteristics in combination with an attractive valuation and positive momentum.

Belgacom, the partly state-owned Belgian telecommunications company is such an example of a highly-ranked stock: it combines its low-volatility characteristics with a high dividend yield of around 7% in combination with positive earnings revisions, average valuation and low market beta.

All in all, our country and sector distributions deviate quite substantially from the indexes. At the same time, we seek to ensure diversification across countries and sectors.

Investment Opportunity | 5

Emerging and European regional and sector spread Emerging Conservative

European Conservative

Source: Robeco 30/09/2014

Conservative strategy range

Important Information Robeco Institutional Asset Management B.V. (trade register number: 24123167), hereafter Robeco, has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. Without further explanation this publication cannot be considered complete. It is intended to provide the professional investor with 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. All rights relating to the information in this presentation are and will remain the property of Robeco.

No part of this publication may be reproduced, saved in an automated data file or published in any form or by any means, either electronically, mechanically, by photocopy, recording or in any other way, without Robeco's prior written permission. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco's services are not available. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com.

Investment Opportunity | 6