Robeco Quarterly March 2018

Robeco

Intended for professional investors only

QUARTERLY QUANT investing SUSTAINABILITY investing

#7 / March 2018

THIS YEAR’S FIVE ENGAGEMENT THEMES – 40 WANTED: STRONG HANDS – 10 THE DIGITAL FUTURE OF FINANCE – 17 STEPHEN SCHAEFER ON THE ORIGIN OF FACTORS – 28 LONG READ: INDUSTRIAL INNOVATION – 36

‘Every company must not only deliver financial performance, but also show how it makes a positive contribution to society’ Larry Fink, CEO BlackRock

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Robeco QUARTERLY • #7 / MARCH 2018

Strong hands needed to unlock the potential of factor investing 10 The average investor is not good at timing. Adverse timing can completely wipe out the returns generated by factor investing strategies. Investors with ‘strong hands’ – patient long-term investors with persistent style exposures – are much more likely to make the most of factor investing.

SUSTAINABILITY investing

‘Trading is an opportunity to capture alpha’

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Twenty years of dynamic duration management

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No place for Liquidity in our set of relevant equity factors

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We need decarbonization, not divestment 22

And MORE

QUANT investing

CONTENTS OPINION The dividends of lower oil prices are reaped slowly

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OPINION A love letter to economic history

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RESEARCH Fintech: invest in the digital future of finance

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GREAT MINDS – STEPHEN SCHAEFER On the origins of factor investing

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RESEARCH Financials: six things to watch for

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LONG READ Industrial innovation: hype or investment opportunity?

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INTERVIEW The five engagement themes for 2018

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COLUMN The battle for Frankfurt

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Assessing climate risks in an investment portfolio can be a hell of a job. Investors who want to reduce this risk and also make an impact in speeding up energy transition are looking for ways to do this… but how?

Fact or fiction: sustainability means sacrificing performance

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An inconvenient truth about stranded assets

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Smart investing in smart materials

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The extent to which diversity is improving can be seen in new figures on incoming independent directors for companies in the S&P 500.

In 2017, half of the incoming directors on S&P 500 boards were women or from minorities, a survey from Spencer Stuart has shown. Female representation among new directors rose from 26% in 2012 to 36% in 2017, while 20% of new independent directors were from nonwhite groups. Gender diversity on boards has improved prominently in recent years, and government intervention in this area has increased. The gender and racial diversity discussion forms part of the wider campaign to improve corporate governance practices by increasing female and minority participation in corporate life.

Diversity becomes a crucial factor to promote success at the boardroom when

Size matters It’s one thing to get to the top, it’s a different thing to stay there.

End-2017 USA 51.3% Japan 8.6% UK 6.1% France 3.3% Germany 3.2% China 2.1%

End-1899 UK 25% USA 15% Germany 13% France 11.5% Russia 6.1% Austria 5.2% Sources: DMS Database, Elroy Dimson, Paul Marsh and Mike Staunton (2018) FTSE Analytics FTSE All-World Index Series, Dec 2017

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understood from a broader perspective, moving beyond solely gender equality and including diverse representation of tenures, ages, nationalities and professional backgrounds. Robeco has long engaged on the issue, believing that such diversity leads to better performance and returns.

“It’s simple – diversity at the boardroom reflects the real world in which the company operates,” says Carola van Lamoen, Head of Active Ownership at Robeco.

“Well-diversified boards add value to a company since people from different backgrounds are more likely to approach issues from various perspectives, leading to a more effective decision-making and efficient supervision. As part of Robeco’s Active Ownership approach, we have been addressing diversity at the boardroom of our investee companies through our engagement and voting activities.”

Sustainability in numbers Robeco's 2017

Sustainability

Board diversity is on the rise

EUR 240 billion

EUR 63 billion

Assets under engagement

Assets under voting

206

4,733

Number of engagement cases

Number of shareholders meetings voted

177

73

Number of companies engaged

Number of markets voted

45 (87%)

60%

Number of cases closed successfully

Meetings with votes against management

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52,242

Number of engagement themes

Number of proposals voted on

Robeco QUARTERLY • #7 / MARCH 2018

The third dimension of active ownership

The case for emerging versus developed markets is still compelling.

Emerging markets show a 25% discount to developed markets (based on forward PE) and are in a more recent stage of recovery particularly versus the US. That said, not all emerging markets are equal.

The outlook for Asia is healthy, even when including China, where we expect growth numbers to come down only gradually.

However, growth in Latin America has been disappointing. In Brazil, economic growth remains low and the fiscal deficit is still very large. Mexico is showing some strength, but the outlook remains uncertain due to NAFTA negotiations.

“We know that nothing ever moves in a straight line, and that we always need to

Editorial

Emerging markets

Not a straight line

Robeco was one of the first to sign the United Nations Principles for Responsible Investment. In so doing, its focus was primarily on the first principle: incorporating ESG issues in the investment process. But it shouldn’t end there.

As truly active shareholders, it goes without saying that you try to influence how a company is managed through voting and engagement processes, including when it comes to ESG issues. Voting is fine, but engagement is particularly important. In recent years, the active-passive debate has focused on the two Rs: risk and return. But the debate also has a third dimension: your ability to impact the world around you. Active investors are expected to make choices and be committed on all three of these fronts.

This is because they are inextricably linked. It is not as though you have a team that analyses a business in terms of risk and return (the financial analysis) and one that is responsible for the ESG side of things. These elements have become increasingly interrelated – ESG is now part of every financial analysis. Ultimately, the goal is to deliver added value to your clients on all three fronts. Risk and return are part of the virtual world of figures and numbers; engagement is the impact side that you, as a shareholder, discuss with companies: What impact do they have on the environment? What is their remuneration structure? How do they treat employees?

keep an eye on the risks,”, says Fabiana Fedeli, senior portfolio manager Emerging Markets. “We see two risks that developed and emerging markets have in common.

The first is political risk, the second is the pace of tapering.” None of these risks are part of our base case scenario at this moment, which supports our positive view on emerging equity markets. However, in this world where everything seems predictable – even the unpredictability of the risks – we need to look at what comes from left field.

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Too little attention is given to this third dimension in a world where risk and return are still very much the buzzwords. But I’m seeing a transformation from a 2D to 3D picture. It still isn’t a perfect cube, but as an industry we’re heading in the right direction. You see more and more large investors taking their role seriously and giving this third dimension more weight, which is a positive development for society at large. We’ve been steering this course at Robeco for some time now – and are mentioned several times as an example in A Practical Guide to Active Ownership in Listed Equity (UNPRI, 2018). It is one of the merits of an active investor – a merit that in recent years has too often been glossed over in the one-dimensional cost debate.

Peter Ferket, Head of Investments

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Expect the unexpected

The average unemployment rate in OECD countries has fallen to an historical low of 5.16%. Yet, inflation has failed to reach the levels targeted by central banks.

Doubts about the relevance of the Phillips curve, which indicates that inflation should rise as unemployment falls, seem legitimate. So what’s going on?

A recent research paper, ‘The Return Expectations of Institutional Investors’, looked at the long-term expectations of 230 US pension funds1.

One possible explanation is that the drop in unemployment is largely due to the increase in lower-wage part-time and

temporary jobs. While this was certainly the case in the years after the crisis, companies are now hiring more permanent workers. A second explanation is that it takes time for wages and, ultimately, inflation to register the effects of lower unemployment levels.

A third possibility is that this long period of low inflation is just an anomaly. Whatever it may be, I’m not convinced yet that the relationship between unemployment and inflation is broken.

Returns

Column

Inflation set to rise?

According to the study, their nominal average expected return is 7.6%, resulting in an expected real return of 4.8%. This is based on longrun average nominal returns on cash (3.2%), bonds (4.9%), real estate (7.7%), hedge funds (6.9%), publicly traded stocks (8.7%) and private equity funds (10.3%). ”This look pretty ambitious,” says Lukas Daalder, CIO Investment Solutions, ”given that historically these US pension providers over 2006-2016 achieved an annual return of 1.5% in nominal terms and -0.3% in real terms. And that was despite the average total return of the S&P 500 coming in at 6.9% during this timeframe.”

Given the continued decline in productivity seen in recent decades, as well as the popularity of the secular stagnation school of thought, it raises the question of how realistic the return expectations for the riskier parts of their portfolio really are,

Daalder says. “By way of comparison, our own long-term (steady state) expected nominal return on equities is 7%, while bonds are expected to yield 4.25%. As such, you still need a pretty optimistic view of the world to get to a 7.6% longer-term return envisaged by these pension funds.

Recent performance clearly does not support these kinds of return expectations.”

Daalder says another problem with future expected returns is that rising PE levels over many decades mean that stocks have structurally become more expensive over time. “You only need to look at the very low yields that we currently see in the bond market to make the point: these low future returns have come on the back of above-average returns as bond prices were bid up. You see the same process in real estate and equities: you get above-average returns on your investment as stocks and houses are being bid up, but this leads to a reduction in future dividend yield or rental returns.”

1 Andonov, Aleksandar and Rauh, Joshua D., The Return Expectations of Institutional Investors (September 29, 2017). Stanford University Graduate School of Business Research Paper No. 18-5.

Jeroen Blokland Senior Portfolio Manager

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Why the dividends of lower oil prices have been reaped slowly Lower oil prices don’t necessarily translate into higher economic growth instantly, says Robeco strategist Peter van der Welle. He says many investors have been surprised that GDP in western economies has not been boosted by consumers having extra money in their pockets thanks to cheaper energy and gasoline in 2014-2016, but there are good reasons why this hasn’t happened.

Opinion

producers, but does not exceed it.

The price of benchmark Brent crude first began to fall in the summer of 2014, moving from a high of USD 115 a barrel to a low of USD 28 in January 2016. “The US and global economy-at-large continued to struggle throughout this period, continually lagging consensus growth estimates, despite the supposed benefit of lower oil bills,” says Van der Welle.

“For the US, there were two reasons why the benefits of lower oil prices were probably lower than expected. Firstly, as a result of the shale revolution, the US oil & gas sector had by then gained more importance in overall economic activity. Subsequently, the cuts in capital expenditure that accompanied the fall in the oil price as oil producers laid off rigs weighed more heavily on overall GDP growth than had been included in the forecasts.”

“Secondly, the energy consumption per real dollar of US GDP – its ‘energy intensity’ – was already on a steady downtrend, lowering the sensitivity of the overall economy to an oil price shock compared to what a similar shock would have delivered in the past.”

A zero-sum game?

Van der Welle says the prevailing consensus in late 2014 was that savings differences between oil importing countries and oil exporting countries (with the former more prone to spend any additional dollars of income) should induce a net plus for the global economy as oil prices dropped. However, as negative growth surprises in advanced economies materialized, an alternative view emerged: that higher spending by consumers fully mitigates the negative impact of the revenue-losing oil

Robeco QUARTERLY • #7 / MARCH 2018

“In other words, it is a zero-sum game, and each opposing effect cancels the other out,” Van der Welle says. “Indeed, a research paper by the US Federal Reserve in 2016 concluded that ‘the boost to economic activity in advanced economies in conjunction with the drag on economic activity in emerging countries of equal size thus rationalizes the muted response of global activity to oil market developments’.”

“But this zero-sum game story does not fully convince, as it implies that differences in oil price sensitivity at a country level almost perfectly hedge each other on a global scale. Under this logic, say a USD 1 decline in the oil price causes an increase of 0.04% in GDP for oil importing countries as a result of cheaper oil imports, it should simultaneously imply a decrease of 0.04% in GDP for oil exporting countries.”

“But the perfect hedge assumption is quite unlikely when looking at the significant differences underlying countryspecific factors that determine oil price sensitivity, such as fossil fuel reserves, the import/export ratio of oil, its production/ consumption ratio and sectoral composition, all of which are relevant for the eventual global impact of an oil price shock.”

Zero lower bound a key factor Van der Welle says rather than suggesting a zero-sum game solution, the crux of the problem is assessing the aggregate impact of these cross-country differences as reflected in timevarying oil price elasticities – the degree to which oil influences a particular economy over time. Different studies already report

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Opinion

stimulate the global economy. In this situation, falling oil prices lower inflation and raise real interest rates, choking off economic activity.”

different oil price elasticities for the same group of countries, or even the same country, over time. For example, the IMF downgraded its 2017 GDP growth forecast for Venezuela to -12% from -7.4% in just three months, as the fallout from lower oil prices developed in a non-linear fashion.

Dividends are reaped slowly

“Despite incidences of the severe economic hardship as seen in Venezuela after the oil price slump, the absence of immediate evidence of a positive causal relationship between low oil prices in 2014-2016 and global economic activity does not mean that it is not there in some form,” Van der Welle surmises.

It is actually quite plausible that declining oil prices temporarily hindered the ability of real interest rates to fall low enough to rebalance supply and demand in the global economy and spur economic activity, says Van der Welle. Conversely, a recovery in oil prices would bring positive inflation surprises and the muchneeded fall in real interest rates, spurring growth.

“Events usually play out with variable and long lags, especially in economics. So, why wouldn’t the global cyclical upswing the world has been enjoying recently at least partly be due to the 2014-2016 oil price slump? In early 2016, the IMF said the ‘shot in the arm’ for the global economy accruing from low oil prices had yet to materialize, as paradoxically, the benefits would appear once oil prices had recovered somewhat.”

“The reason for the surmised delay was that the oil supply shock had occurred in a low-growth environment, where central banks had already run into the ‘zero lower bound’ problem – they were unable to further reduce nominal interest rates in order to

“With hindsight, events have played out fairly well along these lines; we have experienced some reflation, and industrial production for OECD countries has indeed recovered as oil prices have rebounded,” Van der Welle explains. “This in turn allowed the Fed to raise interest rates, moving away from the zero lowerbound problem. On the back of this, the decisive move away from the ‘bad equilibrium’ – the arrival of secular stagnation due to the zero lower-bound problem – has also fed optimism. This has become self-reinforcing, with producer confidence indices such as the German IFO indicator marking all-time highs in 2017.”

There are other reasons why the positive response of economic activity to lower oil prices has been muted. “In Europe, the progressively higher taxation of gasoline has limited the ability of lower global crude oil prices to be passed on to lower retail gasoline prices, limiting the windfall available for European consumers,” Van der Welle says.

“Meanwhile, the euro was depreciating against the dollar at that time, also partly offsetting the decline in the dollar price of Brent oil for European consumers.”

“This story has evolved as well, with what is now a stronger euro partly offsetting the rise in the dollar price of Brent oil, while the global cyclical upswing bodes well for European exporters. In the meantime, the drag on activity for oil exporters has faded, even as current prices are still below fiscal breakeven prices for some OPEC countries. It all suggests that the perceived wisdom does not always manifest itself immediately.”

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QUANTinvesting

Get a grip Extensive empirical evidence shows a significant and widespread gap between the returns achieved by investors and those of the underlying assets they invest in. The reason is simple: poor timing skills, often due to behavioral causes such as overconfidence or impatience. In the particular case of factor investing strategies, such poor timing skills can completely cancel out the benefits of being exposed to well-rewarded premiums. Patient long-term investors with persistent style exposures, in other words ‘strong hands’, are more likely to succeed in harvesting factor premiums.

The problem is that having such strong hands is difficult for the impatient. It usually takes years of practice to be able to keep a firm grip on one’s investments.

Robeco QUARTERLY • #7 / MARCH 2018

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Strong hands needed to unlock the potential of factor investing The average investor is not good at timing. Adverse timing can completely wipe out the returns generated by factor investing strategies. Investors with ‘strong hands’ – patient long-term investors with persistent style exposures – are much more likely to make the most of factor investing, says Pim van Vliet, portfolio manager and head of Conservative Equities.

Timing investments is tough and the average investor is unfortunately not good at it. When mutual fund investors start allocating massively to a certain style, their ‘buy’ signal is often more of a ‘sell’ signal, since on average they move in at the

underperformed a buy-and-hold strategy by a whopping 2.7%.

What’s more, these results were all gross of fees and transaction costs. So, in practice, the gap between investor returns and fund performance is actually even larger. It is an established fact that the average mutual fund investor underperforms the index after costs, but the significant performance drag caused by poor timing is less well-known.

wrong moment. The reverse is also true: when mutual fund investors start avoiding that style, this can be seen as a contrarian signal.

This collective bad timing explains most of the difference between investment returns and investor returns, sometimes referred to as the ‘behavior gap’. Investor returns take into account the timing effects and cash flows of investors. For example, when a large fund has a loss, or when a small fund has a gain, the difference between fund return and investor return can be considerable.

These findings are consistent with those reported by Ilia Dichev,2 back in 2007, who showed that overall, US stock investors lag the buy-and-hold equity return by 1.3% (period 1926-2002, table 3 in the study). For international investors this figure is 1.5% (period 1973-2004, table 4).

Figure 1 summarizes the findings from the literature.

In a 2016 research paper,1 Jason Hsu, Brett Myers and Ryan Whitby analyzed this interesting question using US mutual fund data, over the January 1991-June 2013 period. They found that the average mutual fund investor lagged a buy-and-hold strategy by 1.9%. This finding was persistent across different styles, varying from 1.3% for investors in value funds to 3.2% for investors in growth funds. Meanwhile, ‘passive’ investors, in market index funds,

Cancelling out the benefits of factor investing These empirical studies prove that adverse market timing is not just an anecdotal observation, but a widespread phenomenon, with serious consequences for investors. In the particular case of factor investing strategies, such poor timing skills, or ‘weak hands’, can completely cancel out the benefits of being exposed to well-rewarded premiums.

‘Collective bad timing explains most of the difference between investment returns and investor returns’ 10

Patient long-term investors with persistent style exposures, in other words ‘strong hands’, are more likely to be able to harvest the factor premiums.

The problem is that having such strong hands is difficult

Robeco QUARTERLY • #7 / MARCH 2018

QUANT INVESTING Figure 1 | Investor return minus investment return 0,0%

Finding the right partner might help to successfully reach long-term investment goals. In the case of factor-based investing, the first obstacle is to narrow the factors down to a limited set of the most robust and effective factor groups. This is needed since some factors will turn out to be fake.

-0,5% -1,0% -1,5% -2,0% -2,5% -3,0%

US stocks

International stocks

Mutual funds

Index funds

Source: Robeco Research; fund return gap from Hsu et al (2016) and stock return gap from Dichev (2007).

for the impatient. This usually requires years of practice.

Due to overconfidence, most investors think they have strong hands, which is by definition not possible. Everyone pays lip service to patience and a long-term vision.

But these are meaningless concepts if they are not specified. It is crucial to make the investment horizon very concrete and translate ‘a long period’ into a specific

number of years. The length of this horizon will depend on the risk or return objective.

Partnering is often a useful way to ensure you stick to your plans. For example, in sports, study, and work it helps if someone knows your plan and is willing to help you execute it. Many successful investors acknowledge that the biggest enemy is you. The best way to win this internal battle is to create a plan and seek allies in order to successfully execute it.

A disciplined approach pays off and might help to avoid the average 2% booby trap.

Education is key since teams change and investment horizons are often short. This continuing education fosters a successful investment culture, which leaves no room for harmful emotions or misaligned incentives. Deeper knowledge of weak hands and strong hands will help to increase humility and patience and limit harmful trading.

1 Hsu, B. Myers and R. Whitby, ‘Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies’, The Journal of Portfolio Management, 42(2), pp.

90-98.

2 Dichev, ‘What Are Stock Investors’ Actual Historical Returns?

Evidence from Dollar-Weighted Returns’, American Economic Review, vol. 97, no. 1, March 2007 (pp. 386-401)

‘Trading is an opportunity to capture alpha’ Trading is often considered a necessary, but tedious and costly step of the investment process.

However, it should also be seen as an opportunity to improve performance. Moreover, there are ways to make trading more efficient and better integrate it into the investment value chain, in particular for quantitative strategies, says Wouter Tilgenkamp, a member of our equity trading team in charge of R&D.

In your opinion, how does trading fit into the investment process and where can value be added?

“Trading is frequently associated with costs, but this is a somewhat negative perspective. I see trading more as an opportunity to capture alpha, rather

Robeco QUARTERLY • #7 / MARCH 2018

than a burden on performance. One way to put it is to compare investing with car racing. In order to perform, you need to have skillful drivers: the research and portfolio management teams. But they can only be as good as the quality of their vehicle. And that is where good trading comes in.”

“To win the race, you obviously need to be there on time and get off to a good start. In investing, that means responding as quickly as possible to signals and with trading orders. But your execution also needs to be excellent, and you have to take corners in the best possible way.

And a good trading team can make a difference in bringing everything together.

In recent years, our efforts have focused on leveraging technology but also on removing the boundaries between portfolio management, operational portfolio management, research and

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trading, to make the investment process integrated and more automated.”

How can that be achieved?

“As quantitative researchers, we always try to measure everything. Initially, we quantified investment strategies, but now we also want to quantify and optimize the implementation process, in particular the implications in terms of trading. The underlying idea is that with these insights, we might be able to generate orders in a smarter way, using different instructions, different order sizes and different algorithms.”

“We want to get the best stocks in the best possible quantities, which can be quite challenging. Let’s imagine that we want to have a certain position in the market.

Instinctively, we would rather trade as quickly as possible to avoid alpha fading

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‘We want to quantify and optimize the implementation process of a strategy’ away. In the process, however, we might disrupt the market and end up paying higher transaction costs.”

“So we would like to be fast, but we also have to be patient. We need orders to come in as quickly as possible, but we also need to trade them slowly in the markets.

This is the kind of balancing act we strive for on a daily basis.”

What do you mean by having the teams working together in a more integrated way?

“Here is an illustration. Most academic papers do not take transaction costs into

account and the ones that do usually use some general model or just assume fixed costs. At Robeco we go further; we have calibrated a custom Transaction Cost Model, based on our own historical trades. This model is used directly by different departments in the portfolio construction process and simulations.”

“This helps us get realistic results in the simulations and make smarter trading choices in the portfolio construction phase.

Additionally, it sets the standard for the trading department. This continuous feedback loop between the trading desk and the research teams has helped specify the portfolio construction process in the best possible way.”

Robeco QUARTERLY • #7 / MARCH 2018

QUANT INVESTING

These changes have been applied to some of our quantitative strategies.

But they could also help improve fundamental strategies, right?

“Absolutely. The liquidity driven approach is applicable to any strategy in an investment universe with unpredictable liquidity. The use of automation and customization of algorithms is also being rolled out to the fundamental trades.

Additionally, we shared insights into the usage of different order instructions and how they yielded different results in terms of trading costs with the fundamental investment teams. Based on this, fundamental portfolio managers made some enhancements. Sometimes a small change makes a big difference. Ultimately, the trading equity roadmap involves all capabilities. Coming back to the metaphor of investing and car racing, the secret lies in understanding the different requirements, and adapting the car to the needs of the driver.”

Twenty years of dynamic duration management January 2018 marked the 20th anniversary of the implementation of Robeco’s duration model as the sole instrument for systematically determining the duration positioning of our Dynamic Duration strategies. Although the main components of the model are the same as in the early days, some significant improvements have also been implemented over the years, says Olaf Penninga, Lead Portfolio Manager of our Dynamic Duration strategies.

Actively managing a portfolio’s sensitivity to interest rate moves is crucial for maximizing the returns on fixed income portfolios, which are predominantly driven by changes in government bond yields. Active duration management offers protection against rising yields and it allows investors to

Robeco QUARTERLY • #7 / MARCH 2018

generate strong returns when yields decline.

To forecast changes in yields, Robeco developed a quantitative model back in the 1990s: the duration model. This model has determined the duration positioning of our Dynamic Duration strategies since 1998. The model was built

and is maintained in close collaboration between researchers and portfolio managers. This ensures that decisions are based on rigorous quantitative backtesting, combined with deep fundamental knowledge and practical investment experience.

Implementing the model’s outcomes in a disciplined way avoids well-known human behavioral biases and can even benefit from them, when emotions have caused markets to drift away from fundamentals.

The ‘anchoring bias’, for instance, is often visible when investors state that ‘yields

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has been continuously monitored and many new ideas have been tested – and in some cases, implemented – to improve it further. The model’s implementation has been adapted to changes in financial markets, like the introduction of the euro, and to technological innovations.

In 1998, for example, some of the data series used in the model were only available with a one-day lag. As a result, we could not implement the model earlier than the second business day of the month. As data availability improved, we were able to switch to weekly implementation by 2004.

Figure 150% 1 | Changes in yields are main driver of bond market returns 125% 100% 75% 50% 25% 0% -25% -50% 2008

2009

2010

Rates

2011

2012

2013

2014

2015

2016

2017

Spread

Source: Bloomberg, Robeco

cannot fall further’ as they ‘are already so low’, even when fundamental factors like growth, inflation and monetary policy point to even lower yields.

Strong performance Over the years, the model has shown strong performance especially when risky assets, like stocks, were under pressure. In 2008, for example, when equities suffered and bonds rallied strongly, the fund benefited with its pronounced duration overweight. In fact, the model’s track record shows that it delivers the most value when yields move dramatically, whether upwards or downwards.

Stable team

sideways. That was the case, for example, when the strong reduction in bond market volatility engineered by the Fed’s massive bond-buying programs created a more difficult environment for our duration model.

Just as the fundamental elements of the model have remained unchanged over the past two decades, the people responsible for its implementation and maintenance have also been at it for a long time. Many researchers that have worked with the model almost since its inception, are still involved to this day in improving it. Both portfolio managers of Dynamic Duration strategies, Olaf Penninga and Johan Duyvesteyn, have participated in the research and execution of the duration model already since the late 1990s.

Symmetrical design The duration model’s design is symmetrical. As a result, it has no inherent bullish or bearish bias on the bond markets and it has proved capable of providing valuable signals across a wide variety of market circumstances. While yields have generally declined over the past 20 years, the model has also added value when yields have risen, by reducing the duration in most of these cases.

‘The model has proved capable of providing valuable signals across a wide variety of market circumstances.’

As a result, the model works best when you need it most, providing strong diversification benefits. The flipside, however, is that the model’s performance tends to be weaker when yields move

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The duration model bases its forecasts on the fundamental drivers of bond markets such as inflation and economic growth, combined with factors like trend and valuation. It derives its expectations from financial markets. These basic principles behind the model have not changed over the past two decades.

But, although the fundamentals of the model have not changed, its performance

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No place for Liquidity in our set of relevant equity factors Liquidity is an important aspect investors need to take into account when building investment portfolios. A large body of academic research suggests that illiquid stocks should outperform liquid stocks in order to compensate investors for their illiquidity risk. Yet empirical evidence supporting the existence of a significant and persistent liquidity premium in stock markets is weak. As a result, we don’t include Liquidity in our set of relevant factors for quantitative equity strategies, say David Blitz, Jean-Paul van Brakel and Milan Vidojevic.

Liquidity can be defined as the ease of executing a transaction without creating excessive costs. When executing a transaction, investors pay explicitly for the prevailing bid-ask spread, and implicitly for any adverse price swings due to the removal of liquidity from the market.

All else being equal, the more illiquid a stock, the more difficult and expensive it is to trade it, and this property makes illiquid stocks less attractive than liquid stocks.

For this reason, illiquid stocks should command a premium to be held, or conversely, liquid stocks should trade at a discount. This reasoning warrants the

Robeco QUARTERLY • #7 / MARCH 2018

existence of a liquidity factor premium in stock returns, and some academic studies indeed claim to observe such a premium in the data.

However, unlike other established factors, liquidity has never received much attention from institutional investors, at least not in equity markets.

liquidity constraints in their allocation decisions, that make an equity strategy that explicitly invests in illiquid stocks less appealing.

Another possible explanation is that the evidence for the existence of a liquidity premium is not very solid. While liquidity undoubtedly matters when it comes to portfolio construction and implementation, it is not clear whether stocks earn higher returns simply because they are illiquid. In other words: are equity investors compensated for taking on extra illiquidity risk?

A catalyst, not a factor One possible reason for this is that investment strategies based on the liquidity factor are difficult to implement in practice. While other established factors can be exploited in broad, diversified portfolios that are considered investable from an institutional investor’s standpoint, these investors often face

Over the past few decades, a number of academic studies1 have presented evidence in favor of existence of a relationship between liquidity and stock returns. However, the robustness of these findings has been called into question.

In particular, multiple studies2 have shown that the liquidity effect is not

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robust across different time periods, and can only be found during the in-sample period, if at all.

Moreover, the liquidity effect is largely driven by microcaps, which represent around 3% of total market cap of the US stock market, but account for around 60% of the total number of stocks. Once these elements are taken into account, the evidence vetting the existence of a wellrewarded liquidity factor simply cannot be found.

But while the existence of a standalone liquidity factor is questionable, interactions between liquidity and other established factors do exist. The relationship between size and liquidity is a good example of this, as small stocks also tend to be less liquid. More generally, it makes sense that some factors are stronger amongst illiquid stocks, since illiquid segments of the market are less efficient at determining the fair value of assets.

Small, illiquid stocks can therefore be seen as a catalyst for other factor premiums, as opposed to an independent source of return. Provided there are interaction effects between established factors and stock-level liquidity, it is the job of an active manager to identify and model these effects in the stock selection and portfolio construction phases. Given that these stocks, by definition, tend to be more difficult and expensive to trade, smart portfolio implementation can therefore add substantial value for investors.

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Business School, “There are crucial differences between transacting on paper and transacting in real markets”. This gap is better known as the ‘implementation shortfall’. When constructing investment portfolios, trading costs, which are a direct function of the liquidity level of a stock, erode the expected alpha.

Although expected alphas are driven by exposures to proven factor premiums

sophistication of order-placement strategies and the skill of the trader. In another study published in 2000, Russ Wermers determined that approximately 70% of the average difference between the gross (before costs) and net (after costs) outperformance of stocks held by mutual funds is due to implementation inefficiencies. Naturally, any sophisticated portfolio construction process should include liquidity estimates to minimize the ‘slippage’ between investment decisions and actual transactions.

If the usage of liquidity estimates within portfolio construction is successful, portfolio managers can take a prudent approach to investing in assets that take a long time to trade or that are expensive to buy or sell. Additionally, liquidity can be used to adjust position sizes of investments, to reduce the impact on after-cost investment performance.

‘Small, illiquid stocks can therefore be seen as a catalyst for other factor premiums, as opposed to an independent source of return’ and liquidity does not qualify as an independent alpha factor, it is nonetheless a key driver of transaction costs, and therefore net returns. As a result, a sophisticated portfolio construction process and smart portfolio implementation can add a lot of value to the investment process.

A crucial element for portfolio construction

Estimates of liquidity are needed to optimize portfolio turnover and ensure that the portfolio’s investments remain within liquidity risk boundaries. There is widespread evidence in the literature that the performance of mutual funds is highly dependent on their turnover and transaction costs. In 1997, for example, Mark Carhart showed that expenses and turnover are negatively related to fund performance and that changes in execution costs per transaction partly explain why certain funds perform consistently better than others.

Liquidity is a critical element to take into account when translating theoretical investment strategies to live portfolios. In the words of André Perold from Harvard

Shortly afterwards, in 1998, Donald Keim and Ananth Madhavan found that stock trading costs vary with the

In the portfolio implementation phase of the investment cycle, liquidity is also of utmost importance. After portfolio construction, the order is sent to traders.

The moment an order hits the trading desk, minimizing the implementation shortfall of that investment becomes the trader’s top priority. At this point, estimates of liquidity and knowledge about expected transaction costs help the trader to get the best price for the asset.

1.

See for example: Y. Amihud and H. Mendelson, ‘Asset pricing and the bid-ask spread’, Journal of Financial Economics, December 1986; V. Datara, Y. Naikb and R. Radcliffec, ‘Liquidity and stock returns: An alternative test’, Journal of Financial Markets, August 1998; T. Chordia, A. Subrahmanyam and V. Anshuman, ‘Trading activity and expected stock returns’, Journal of Financial Economics, January 2001; V. Acharya and L. Pedersen, ‘Asset pricing with liquidity risk’, Journal of Financial Economics, August 2005, L. Pastor and R. Stambaugh, Liquidity Risk and Expected Stock Returns, Journal of Political Economy, June 2003.

2.

See for example: J. Drienko, T. Smith and A. von Reibnitz, ‘A Review of the Return–Illiquidity Relationship’, Critical Finance Review, Forthcoming October 2018; K. Hou, C. Xue, and L. Zhang, ‘Replicating Anomalies’, NBER Working Paper, 2017; H. Li, R. Novy-Marx and M. Velikov, ‘Liquidity risk and asset pricing’, 2017.

Robeco QUARTERLY • #7 / MARCH 2018

A love letter to economic history The credit cycle is close to the end. Risky assets, including credits, are vulnerable. Central banks risk falling behind the curve. Sander Bus and Victor Verberk, co-heads of the Credit team, are becoming more careful. They prefer safety and stay up in quality to benefit from further decompression and higher risk premiums.

Speed read

Opinion

• Global, synchronized economic growth, with more upside • Central banks risk being caught behind the curve • Expect less technical support, decompression and more volatility

The global economy has delivered another good quarter in terms of growth. It even seems that capital investments are finally contributing to growth. This has been the main disappointing economic variable to date in this business cycle.

Moreover, it looks like the different economic blocs have synchronized their cycles. Except for China, all of them are showing an upturn. Chinese credit to GDP has reached levels we last saw in crisis situations in countries such as Korea, Japan and Thailand.

will massively reduce monetary stimulus during 2018. The only thing that would keep us from expecting increased market volatility, is a scenario in which other market participants, such as commercial and retail banks, take over the purchasing of fixed income assets. In our view, the numbers are too large to expect such a perfect scenario. All this holds for all risky asset classes.

Once in a while, we take a helicopter view. We try to think outside the box, outside this economic cycle with all daily noise influencing us. Guess what, that does not make us more relaxed. Ever since we abandoned the Bretton Woods system

Central banks falling behind?

This brings us to a topic that is in sharp contrast with the last two years: the risk

‘We believe inflation might be at a secular turning point’ of central banks falling behind the curve.

The biggest question mark in this cycle is why inflation is so low. Considering the reduction of the economic output gap, we could expect some inflation scare soon at central banks. We believe inflation might be at a secular turning point.

In any case, all central banks combined

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Opinion

in the 1970s, we actually created fiat money, leaving it fully in the hands of central banks and politicians. This has created an ever increasing amount of financial shocks. Central banks managed by academics, overestimating themselves and the control they have on an economy, solve economic problems with lower interest rates.

‘We live in an era of financial shocks with too much debt and overconfident central bankers’

Central banks have been right for the wrong reasons in their loose monetary policies. A massive labor supply shock of over one billion Chinese entering the labor force since the 1980s has been disinflationary. This created the debt super cycle we started writing about ten years ago. Solving debt issues with more debt will eventually create more rather than fewer financial shocks.

We live in an era in which we should expect a regular cycle of crisis, releveraging, boom, excesses and bust again.

Studying economic history

Just by studying economic history, we as a credit team have created a certain degree of understanding of the events around us. That is why we call this outlook a love letter to economic history. We keep informing our clients in an honest way about our views on the credit cycle, even when we think it is close to the end.

And now risky assets are vulnerable, maybe even more so than government bonds.

Credit positioning: careful beta, up in quality and minding tail risks There are several indicators that the cycle is maturing. It is hard to predict the exact turn of the cycle, but all segments of the market are close. Despite the fact that fundamentals are improving in economic terms, we are becoming more careful.

Asset price corrections do not always require a recession. There are some extreme things we worry about. When five FAANG stocks drive up the S&P 500 index by over 20%, when inflation is so low even though unemployment tells you different and when credit markets face a net selling system of central banks, beta positioning should be careful. Then we are well positioned to benefit from the volatility that is to come. The opportunity loss of not owning enough beta exposure is just too low.

It is darkest before dawn but all looks bright before darkness too. Remember 2007. Since then debt levels and dependence on low interest rates have increased ever more. We just need some kind of shock to reprice risky assets. It has happened so many times before, and it will again. This is the lesson history teaches us. We live in an era of financial shocks based on too much debt and overconfident central bankers.

Opportunities: stay up in quality We like companies that just relevered or changed their strategy into deleveraging. We also like credit that just offers good yield, such as short-dated high yield or the ATI paper of the good banks. Otherwise we prefer safety and stay up in quality to benefit from further decompression and higher risk premiums.

A correction is not the end of the world, it will not necessarily be like it was in 2008.

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Robeco QUARTERLY • #7 / MARCH 2018

Fintech: invest in the digital future of financials The traditional banking business is being radically transformed. Major trends, such as the revolution in financial technology, or fintech, are creating new investment opportunities in the financial industry.

Speed read

Research

• Fintech is moving from the start-up phase to the mainstream • Digitization of the financial sector will drive significant growth • Listed fintech opens up exciting investment opportunities

Imagine a world in which you can arrange all your financial affairs online. You don’t go to a bank but to a Google, Apple or Amazon app store to take care of a whole range of financial matters, including your bank account, financial planning and your mortgage. Behind the financial platform might be an innovative bank or insurer, or even a tech company.

State-of-the art financial technology will enable you to integrate all your data from various banks, pension statements from the government, etc. The technologies used will vary from artificial intelligence (AI), virtual reality (VR), to distributed ledger technology (blockchain). Welcome to the world of digital finance, brought to you by fintech.

technology companies, which have the technology and the flexibility to stay on top of developments. Not getting cybersecurity right, for example, simply means going out of business.

The benefits of listed fintech Although it’s still mostly venture capitalists and other private equity companies that currently invest in fintech companies, fintech is definitely investible from a listed perspective, with an average market capitalization of more than USD 10 billion. One of the benefits of listed fintech is its higher liquidity, as venture capital assets tend to be locked up for seven years or longer.

Moreover, listed fintech is less risky. Many start-ups don’t make it and when they do come to the stock exchange, their viability is reasonably proven.

To keep up with the rapid changes in their sector, such as digital payments, blockchain or robo-advice, financial institutions will need to make significant IT investments in the coming three to five years. In the not too distant future, online payment methods will become mainstream, and cash will be the exception. Fintech companies will benefit from this trend.

Apart from the technological improvements it enables, fintech will also have a major social impact, as it will open the way to 2 billion people who currently don’t manage their financial affairs. In order to survive, incumbent banks and insurers, with their large customer base, will have to cooperate with new

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Research

‘Financial institutions will need to invest heavily to keep up’

The lower risk doesn’t have to be at the expense of return. Some listed stocks have increased multiple times in value.

We do expect many fintech IPOs in the coming years, especially in software and Asia. Research by Citigroup shows that the annual spend on banking software and IT alone is ten times as large as what’s currently invested in global fintech and is expected to grow to EUR 255 billion in 2020.

China and India will dominate Asia, especially China and India, is set to become larger in listed fintech than the rest of the world combined. As countries in this region have skipped some steps the west has made, they have been much quicker in embracing digital finance. Also smartphone penetration is very high in this region and phones will be the remote control of digital finance platforms.

Western companies want to copy China’s successful model. This means banks, insurers, asset managers and tech companies are looking to create financial platforms which enable easy client access to a whole range of financial solutions. This will prompt

cooperation between large technology companies and financials. Larger tech companies have the IT capabilities and flexibility to stay on top of developments, but are often held back by the jungle of regulatory requirements. Smaller fintechs prefer cooperation as they lack a customer base.

Regtech: PSD2 and GDPR The new EU Payment Services Directive 2 (PSD2) can give a substantial impulse to fintech. One of the consequences of this directive, which has come into force in January 2018, is that clients can allow banks to make their data available to other parties (including other banks), which can then offer them additional products or services. As banks will gain more information about their clients, the shift towards financial platforms accelerates.

Of course, this new development is accompanied by the necessary regulation. Towards mid-2018, the General Data Protection Regulation (GDPR) will come into force in the EU, creating a tremendous administrative challenge. This is where specialized regtech companies come in. Using sophisticated algorithms, they make reporting and record-keeping easier and enable compliant client onboarding.

What about bitcoin and blockchain?

Where does bitcoin fit in all of this? For a listed fintech fund, it’s still impossible to invest in cryptocurrencies, as they are not listed. On top of that, they are extremely volatile, often have no economic basis and lack regulatory oversight. We do see the attraction of the distributed ledger technology behind it such as blockchain or ethereum.

Cryptocurrencies may become more interesting if they are backed by a central bank. Poland is already doing this with the billon, which is traded 1:1 against the zloty by the Central Bank.

If 1,000 billon is created, the Central Bank takes 1,000 zloty out of circulation. In our view, regulatory approval is essential for cryptocurrencies to become globally accepted.

Conclusion: fintech is moving into the mainstream Fintech is moving from the experimental, start-up phase to the mainstream. This opens up a lot of opportunities for investors.

Investing in fintech is especially interesting for investors who believe in the long-term strength of fintech and who want to benefit from the investment opportunities in new fintech, insurtech, regtech and other companies that profit from the digitization of the financial sector.

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Robeco QUARTERLY • #7 / MARCH 2018

SUSTAINABILITY investing

Carbon copies don’t work Divestment has become all the rage as investors take steps to decarbonize their portfolios by selling out of fossil fuels. As a quick fix, there’s no denying that removing environmentally unfriendly holdings from portfolios instantly reduces its carbon footprint. It is a useful first step, but the chances are that it doesn’t actually lead to a lower-carbon world, and has little impact on the real problem of combatting global warming. In our lead story this month, Robeco’s head of ESG integration and a sustainability specialist from Allianz Global Investors argue strongly that ‘we need decarbonization, not divestment’.

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SUSTAINABILITY INVESTING

We need decarbonization, not divestment Assessing climate risks in an investment portfolio can be a hell of a job. Investors who want to reduce this risk and also make an impact in speeding up energy transition are looking for ways to do this… but how?

and the energy used in these operations, you miss part of the risk. What about the use of the company’s products? A car maker might be less carbon intensive than another manufacturer, but its products have a high carbon footprint through emissions. And the risks lie in a change in market behavior and preferences too, for example, in the switch to electric cars.”

A common instrument used is decarbonization of the investment portfolio: this means measuring the carbon footprint of the fund and reducing it by selling the largest contributors. This is a good first start, but there are several other issues to be considered, says Masja Zandbergen, Head of ESG Integration at Robeco.

“Similarly, a food company has high exposure to agriculture, and thereby to generating large amounts of CO2 emissions in its supply chain. What about companies whose clients are all in the energy sector? It’s not as simple as it looks.”

‘By only measuring the footprint of the company’s operations, you miss part of the risk’ “The largest contributors are often only found in a few CO2 intensive sectors, meaning you will divest from those sectors completely, and therefore have no impact on the much-needed energy transition,” she says.

“The current footprint of a company does not necessarily say anything about its future footprint. If one were to take two identical companies with the same footprint, but one company is considering making an energy transition of strategic importance and is preparing for the future, it is clear which company you would want to invest in.”

“Meanwhile, by only measuring the footprint of the company’s operations,

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Divesting transfers a problem

These issues were illustrated by Isabel Reuss, Portfolio Manager for European SRI Equities at Allianz Global Investors, at a recent Sustainability Investing Forum that Allianz GI jointly hosted with Robeco. She says divestment simply transfers a problem, and an investor cannot sell out of an entire sector anyway if they want to make a long-term impact.

Creating a lower-carbon society effectively means investing in things such as more efficient buildings and renewables to keep global warming below two degrees Celsius – so it is therefore impossible to avoid the energy, materials and utilities sectors while doing so, she says. Instead, extensive engagement with the largest generators of greenhouse gas emissions is necessary.

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“Does divesting make an impact? No; at best it is neutral and at worse it may even be negative,” says Reuss. “Achieving a lower-carbon economy means you must use energy, materials and utilities.

Divesting an entire sector may lower the carbon footprint of a portfolio, but it makes absolutely no impact on the environment.”

Two-degree economy “We want to reach a two-degree economy, so how are we going to do that if we don’t use these three sectors? If you divest something, whoever is buying it is not interested in climate change – so they’re not sitting at the table. We cannot then discuss climate with divested companies, or engage with them.”

‘If you divest something, whoever is buying it is not interested in climate change’ Reuss cites the example of building insulation, which has a net beneficial effect on the environment. “For every kilogram of CO2 emitted in the production of insulation, 330 kg of emissions are avoided once it is installed,” she says.

“It is part of the materials sector, so if everybody divests that, then why would the sector invest in R&D to find better insulation materials? It’s not black and white.”

Reuss says that in terms of portfolio construction, there are three dimensions to choosing stocks: the companies that are the best performers in cutting carbon; those that are making the best efforts to reduce emissions; and those offering the best solutions for others.

“For us, the best solution is looking at something like washing detergent,” Reuss says. “What if a company makes an enzyme that means you can wash your whites at zero degrees, using less energy, and it still all comes out white. This is something that has a real impact. We need to find solutions; you have to look for them and find them.”

Fact or fiction: sustainability means sacrificing performance Sustainability investing is subject to more myths than any other style of investment. And perhaps the first and foremost is the idea that it means sacrificing performance – giving up returns in pursuit of some sort of perceived ideal.

So, where does this myth of poor performance come from? Part of the reason is that in some cases, adopting sustainability does require investment – it costs money to implement it. Energy companies retooling to focus more on renewables do indeed need to spend millions on new infrastructure. Sourcing products from suppliers that pay their employees properly means costs go up. Less tangibly, a company with poor diversity may need to pay third parties such as recruitment consultants, also raising costs and cutting short-term returns.

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This should, in theory, mean that companies that take sustainability seriously underperform. In fact, the reverse is usually true: the use of environmental, social and governance (ESG) principles by companies and investors can be shown to enhance performance. This is primarily due to the ability to reduce risks, particularly as standards are raised in all three domains to combat climate change or bad corporate behavior.

Financially materiality is key At the core of improving decisionmaking by including ESG information

in the process is taking an investment perspective and only analyzing issues that are financially material – they go to the core of a business. In other words, the focus should be on researching those ESG issues that have a direct financial outcome on company results in the longer term, and therefore feed through into investment returns. For a utility, these would be issues related to energy efficiency of its operations and its strategy towards the energy transition.

For a bank, this would be governance, risk management culture and product stewardship.

Further, adopting ESG can lead to opportunities, or reduce risks. For example, the trend towards the adoption of electric cars has generated investment

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opportunities in both the car makers and their suppliers, including the new smart materials being produced such as lithium for batteries. Meanwhile, the role of ESG in reducing risks can be seen in how it has exposed potential supply chain problems in industries that had been reliant on cheap labor such as fashion and retailing.

This in particular allows investors to pick the ‘wheat from the chaff’ when deciding which stocks or bonds to buy, in a ‘bestin-class’ approach.

Four studies prove outperformance Four studies looking at this ‘added value’ issue in the past three years are particularly noteworthy. The extent to which this can add and not subtract

value was first demonstrated in abstract in a 2015 study, ‘From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance’

by Oxford University and Arabesque Partners. This examined more than 200 sources including academic research, industry reports, newspaper articles and books, and concluded that “80% of the reviewed studies demonstrate that prudent sustainability practices have a positive influence on investment performance."

A separate survey later that year by Deutsche Bank’s asset and wealth management division in conjunction with the University of Hamburg went much further. The research examined

“Using both calendar-time portfolio stock return regressions and firm-level panel regressions we find that firms with good ratings on material sustainability issues significantly outperform firms with poor ratings on these issues,” the report says. “In contrast, firms with good ratings on immaterial sustainability issues do not significantly outperform firms with poor ratings on the same issues. These results are confirmed when we analyze future changes in accounting performance.

The results have implications for asset managers who have committed to the integration of sustainability factors in their capital allocation decisions.”

And sustainability investing is also about active ownership, partly achieved by engaging with companies to improve their ESG standards. This can also be shown to enhance returns. A 2017 research paper by three academics analyzed a dataset of 660 companies that had agreed to some form of engagement for a range of ESG issues, with 847 separate engagements in total. The research found that the engaged companies saw stock returns that were 2.7% higher than non-targeted firms in the six months after the engagement ended. The results for

‘At the core of the SI process is only analyzing issues that are financially material’ the entire universe of 2,250 academic studies published on this subject since 1970, using data spanning over four decades until 2014. It concluded that ESG made a positive contribution to corporate financial performance in 62.6% of meta-studies and had negative results in only 10% of cases (the remainder were neutral).2

Higher stock returns Better corporate results should in theory feed through into higher share prices. A 2016 study by Harvard Business School directly linked better performance and disclosure on material ESG issues to higher share prices for the first time. The paper entitled ‘Corporate Sustainability: First Evidence on Materiality’ made a clear case for the financial benefits feeding through into asset values.3

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1 Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance (March 5, 2015). Available at SSRN: https://ssrn.com/abstract=2508281 or http://dx.doi. org/10.2139/ssrn.2508281 2 Deutsche Asset and Wealth management, ‘ESG and corporate financial performance: mapping the global landscape’, December 2015 https://institutional.deutscheam.com/ content/_media/K15090_Academic_Insights_UK_EMEA_RZ_ Online_151201_Final_(2).pdf

Khan, Mozaffar and Serafeim, George and Yoon, Aaron S., Corporate Sustainability: First Evidence on Materiality (November 9, 2016). The Accounting Review, Vol. 91, No. 6, pp. 1697-1724. Available at SSRN: https://ssrn.com/ abstract=2575912 or http://dx.doi.org/10.2139/ssrn.2575912

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4 Tamas Barko, Martijn Cremers and Luc Renneboog, ‘Shareholder Engagement on Environmental, Social, and Governance Performance’, Working paper for the European Corporate Governance Institute, 2017 https://papers.ssrn.com/ sol3/papers.cfm?abstract_id=2977219

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SUSTAINABILITY INVESTING

companies which previously had had low ESG scores were even more marked, as their share prices outperformed nontargeted companies by 7.5% in one year after the end of the engagement.4

Changing business models Taken together, this growing body of evidence concludes that companies which are progressively more sustainable today will reap the rewards in the future – and it may even save their businesses.

Oil companies, for example, are slowly changing their business models to replace fossil fuels with renewables, while car makers are switching to electric vehicles, and retailers are sourcing only

from suppliers with verified human rights records.

Meanwhile, the greater efficiencies enjoyed today will cut costs and raise profits.

‘Firms with good ratings on material sustainability issues significantly outperform’ Should carbon limits ever be introduced, those companies that are cutting their carbon footprints now will be better placed to deal with new regulatory or governmental regimes in the future.

This is already an issue for real estate companies, and for virtually all utilities.

Put simply, taking sustainability issues into account leads to betterinformed investment decisions, and that leads to better returns in the long term. This is why Robeco remains convinced that it works, and has integrated ESG analysis in the investment process for fundamental and quantitative equities, and for fixed income.

An inconvenient truth about stranded assets The world needs to wake up to the problem of trillions of dollars’ worth of stranded fossil fuel assets, says climate change campaigner Al Gore. The former US Vice-President addressed investors at a screening of his new film, ‘An Inconvenient Sequel: Truth to Power’, that was co-sponsored by Robeco.

As its name suggests, the film is a sequel to Gore’s Oscar-winning 2007 movie ‘An Inconvenient Truth’, seen at the time as ground-breaking in challenging the ‘inconvenient’ nature of having to stop 150 years of fossil fuel use.

“The world now has USD 28 trillion of carbon assets marked to market on the books on multinationals and governments with a value that is based on the assumption that there will be put to their intended use and burnt – but they won’t,” Gore says.

“Numerous experts have calculated that

Robeco QUARTERLY • #7 / MARCH 2018

no more than one-third and probably less of those assets can ever be burnt.

So at what point does the realization set in that these are likely to become stranded assets?”

Changing business models “It set in at the end of 2017 for the Norwegian sovereign wealth fund – a very well-managed fund whose assets came after all from gas and oil – who said they’re taking their investments in fossil fuels down to zero.”

“It set in for the coal industry some time ago that they had lost 90% of their market capitalization in the

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last decade. What will the fast-growing markets for electric vehicles do to the markets for liquid petroleum products?

And what opportunities are opening up to fill these gaps and give returns because of the changing business models?”

Gore says the move away from using fossil fuels was already affecting major businesses not keeping up with events.

“Moody’s has announced it will downgrade municipalities or governments that are not adapting to the new climate issues,” he says. “General Electric just laid off a big percentage of its workforce because the boilers it makes for fossil fuel-generated electricity are not selling any more. Siemens made a similar decision beforehand. All of these straws in the wind are coming at us every day now.”

Integrated sustainability Gore is himself now a leading sustainability investor as the founder and chairman of Generation Investment

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Management, which has USD 17 billion under management. His fund fully integrates environmental, social and governance (ESG) factors into its investment decisions – as does Robeco for its fundamental equity, fixed income and quantitative strategies.

“The full integration of sustainability into the investment process has been the subject of widespread discussion for many years now,” he says. “As a risk management tool, the inclusion of ESG factors is extremely valuable, but what’s more important is a recognition of the opportunities that are now emerging.”

“The technological transition is sweeping and persuasive, and offers fantastic

opportunities in solar, wind, batteries, electric vehicles, energy efficiency – new business models that can see where a new sustainable approach is going to disrupt the old ways of doing things. So it’s extremely important for investors who are focused on the long term to take stock of how quickly our world is changing and how numerous these opportunities are.”

It’s your fiduciary duty Gore says sustainability has moved on to become so important in investing that to not use it has become a violation of an asset manager’s fiduciary duty to do what’s in the best interests of its clients, despite a myth that persists that it can hurt returns.

‘The technological transition is sweeping and persuasive, and offers fantastic opportunities’

“Once in the investment business it was common for men and women to say that ‘I would like to use sustainability, but I have a fiduciary duty to make returns

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for clients’. Now all that’s changed,” he says. “Best practice now is that if you do not take those ESG factors into account, then you are violating your fiduciary duty, because at a time when the world is changing so profoundly and the risks are growing, why wouldn’t you use sustainability?”

“Good investors have always considered sustainability in the investment process, but doing it systematically with every investment should be the way forward.”

Two major developments Gore says two major changes have occurred since his first film came out 10 years ago. “One is that unfortunately, extreme weather events are far more

destructive and more common. We’ve seen that with hurricanes and floods.

But the second-biggest change is that we have the solutions now, and they have come down in cost to the point where

that has the magnitude of the original industrial revolution but with the speed of the modern digital revolution. This revolution is being jump-started by developed and developing countries simultaneously all around the world, powered by new digital tools. We can make this transition much faster than some people think.”

‘If you do not take ESG factors into account, then you are violating your fiduciary duty’ in many regions of the world, electricity coming from renewables is now cheaper than from burning fossil fuels.”

“I believe that the world is in the early stages of a sustainability revolution, one

“But no matter what we do, there will still be a considerable amount of sea level rise this century. But we still have the ability to control the pace of that sea level rise, and the maximum extent of it. The next few decades are going to be challenging for humanity.”

Smart investing in smart materials Global megatrends make it more important to invest differently to benefit from opportunities in smart materials and technologies, says specialist Pieter Busscher.

He says the materials that are replacing increasingly scarce traditional resources represent the future of commodity demand, while the ingenious solutions being developed for products such as electric cars will create vast new markets for minerals such as lithium and cobalt.

“The British economist Dylan Grice said that going long on commodities is like going short on human ingenuity, and what we’re trying to do here is go long on human ingenuity,” says Busscher, portfolio manager of the RobecoSAM Smart Materials fund.

“If you look at business cycles for traditional resources, you are usually exposed to

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boom and bust, with limited upside, such as for oil, where we foresee a massive shift towards electric mobility. With smart materials, we’re exposed to the longer-term solutions to resource scarcity. We focus on materials that are competitive and can gain market share from traditional materials or less-efficient technologies."

Four main clusters So, what are the new breed of smart materials? Busscher focuses on four main clusters: Advanced Materials and Transformational Materials, and the efficiency gains that come from new Process Technologies and Automation/Robotics.

These include themes such as fiber-lasers, artificial intelligence and 3D printing,

plus the software needed to power new technologies and make new products.

Electric vehicles represent perhaps the biggest transformational change in modern industrial production, accounting for 70% of the 110 million new vehicles that are likely to be made in 2030.

This has created a whole new market for the minerals used in making electric car batteries, particularly lithium and cobalt. However, this does raise its own sustainability issues, since much of the world’s supply comes from emerging markets such as South America and the Democratic Republic of Congo. Problems include environmental damage from mining operations and the waste that it generates, combined with poor or even dangerous working conditions, requiring engagement with the operating companies.

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Stephen Schaefer

On the origins of factor investing Great Minds

Stephen Schaefer is Professor of Finance at the London Business School and a co-author of the influential 2009 report on the Norwegian Government Pension Fund and factor investing. In our Great Minds series – a set of interviews with renowned academics and investment experts – we spoke with him about how factor investing came about and went on to become a popular investment approach. We also talked about the major issues researchers should focus on going forward.

You have worked with some of the most prominent academics in the field of finance of the past few decades. Through your work for the Norwegian Oil Fund you have a significant impact on the adoption of the concept of factor investing. How did this concept emerge? What exactly were academics looking for at the time?

“The term factor investing may be relatively new, but the ideas that underpin it have been around in different forms for quite a while now. Firms such as Dimension Fund Advisors (DFA) have been making use of concepts such as the premium on small firms for several decades. Taken individually, this and other findings such as the value premium were initially seen as small steps in the academic field of finance, and we certainly did not imagine they would become so influential on investment practice. Actually, it is only over the last ten years or so, that these concepts have caught on in a substantial way.”

“Let me tell you an anecdote that will illustrate what the situation was like 30 or 40 years ago. One of the very first anomalies to emerge in the literature was the small-firm effect, which was first discovered by Rolf Banz back in the late 1970s. I happened to be visiting the University of Chicago at the time and attended the seminar where Rolf first presented his results.”

“There are two striking things in this story. The first is that, initially, Rolf was not looking for a potential small-size effect in returns at all. He was trying to do something quite different and happened to rank firms in a way that nobody had done before: by market capitalization. This is how he discovered the extraordinary

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fact that the returns of small-capitalization stocks in his data were on average much higher than those on large-capitalization stocks and by an amount that was easily as large as the equity market premium.”

“The second remarkable thing, which at the time seemed totally reasonable, was the reaction of the audience. It was a very distinguished group, but their initial response was that Rolf had made a programing error, that he should go away and correct this technical mistake. Of course, there was no error and people finally took his conclusions on board.”

What have been the major changes in the way factor investing is perceived over the past few years?

“What has changed over the past decade is that individual factors are now increasingly considered as part of a broader family.

Instead of being enthusiastic about, say, investing in small firms, or investing in value stocks, investors are getting used to the idea of somehow exploiting these investment strategies as a family and looking at the interaction between them. This is actually quite an important element and this is what is actually new.”

“In the early days it was natural to think about anomalies in the context of the Capital Asset Pricing Model (CAPM), in which many people at that time still had a lot of faith. Then, in an important paper, future Nobel prize winner Eugene Fama and co-author Ken French made things much clearer by showing that average returns on a stock were strongly related to its size (market capitalization) and its book-to-market ratio, in other words to its characteristics, and not just to beta.”

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Stephen Schaefer is a Professor of Finance at the London Business School and the author, together with Andrew Ang and William Goetzmann, of the 2009 report, ‘Evaluation of Active Management of the Norwegian Government Pension Fund – Global’ (the ‘Norwegian Oil Fund’), which represented a major breakthrough for factor investing.

Throughout his career, he has published extensively on a variety of topics such as fixed income markets, risk management, credit risk and financial regulation. In particular, Stephen Schaefer’s academic work includes a study on corporate debt default in the US over the past 150 years, which was awarded the first prize in the 2011 Fama/DFA Award for the Best Paper Published in the Journal of Financial Economics in the areas of capital markets and asset pricing. He was formerly a faculty member at the Graduate School of Business at Stanford University. He has also been a visiting professor at the Universities of British Columbia, California (Berkeley), Cape Town, Chicago and Venice, where he was recently awarded an Honorary Fellowship. Today, he is the lead Academic Director for the AQR Asset Management Institute at LBS. Outside academia, Stephen Schaefer has consulted for a variety of financial institutions.

He has also been an independent board member of the Securities and Futures Authority; a senior research advisor to Moody’s KMV; a trustee-director of Smith Breeden Mutual Funds and a member of Moody’s Academic Research and Advisory Committee.

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Great Minds

‘The initial objective was to say something about the CAPM and expected returns’

“Then, in a slightly later paper, they showed that average stock returns were also related to their sensitivity to portfolios constructed on the basis of size and book-to-market. This was a decisive step from the perspective of asset pricing theory and gave a much richer description of the pattern of return premia across stocks. And this second step was also extremely useful from an investment point of view.”

You mean, before it eventually turned into a popular investment approach, all the theory around factors had more to do with uncovering which elements affected expected returns, right?

“Correct. The initial objective was to say something about the CAPM and expected returns. And these findings were extremely important because they showed that the CAPM failed quite badly.

It turned out that the value minus growth portfolio generates a big positive premium. So, value stocks achieve better returns than growth stocks but, at the same time, have a lower beta. This is a robust finding and goes against the most important prediction of the CAPM which is that expected returns are positively related to beta.”

“From then on, and for a variety of (often practical) reasons, academics started to acknowledge the need to adjust the expected returns they were measuring for their exposure to factors such as size, book-to-market and, more recently, momentum.

Otherwise, standard statistical methods in finance such as event studies, simply didn’t give the right answer. However, even if this adjustment in expected returns is correct, it doesn’t have direct investment implications.”

“Take, for example, the 3-factor model which was introduced by Eugene Fama and Kenneth French, back in the early 1990s. As I’ve mentioned, this model shows that expected returns do not simply depend on the sensitivity to market moves (beta), but also their sensitivity to portfolios chosen on the basis of size and book to market. However, as a pricing model this has no more 1

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C. Harvey, Y. Liu and H. Zhu, ‘…and the Cross-Section of Expected Returns’

direct implications for investment than the CAPM does. The CAPM just predicts that the higher the beta, the higher the expected return. The portfolio you choose to hold then boils down to how much beta risk you wish to take. And, as a pricing model, the implications of the three-factor model are essentially the same. ” “To me, the fork in the road occurred when some people started to regard factor returns as anomalies – inefficiencies that you might want to exploit – while others just saw them as part of a broader asset pricing model. The former is consistent with the way that most investors see factor investing: regarding the factors as potential sources of return that, in principle, everybody should exploit.”

“Alternatively, factor premiums could be market compensation for types of risk that the CAPM does not address. That is both perfectly logical and theoretically plausible. A number of alternative models that try to capture some of these additional risks have been proposed. Up to now, however, nobody has been able to translate the factors that have emerged from research on anomalies into the kind of risks that, for example, Robert Merton was talking about when he introduced an extension of the CAPM

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that gave rise to multiple factors. In his framework some investors, depending on their own preferences, would be willing to bear these factor risks and others would wish to take the other side of the trade in order to hedge.”

How do you see the success of factor investing after your report on the Norwegian pension fund was published in 2009? How has this report changed the way people perceive investment, in your view?

“Well, I am not sure you want to put this in the interview, but let me tell you another anecdote. Approximately five years after the publication of our report on the Norwegian pension fund, a major US investment bank invited me to talk about factor investing at one of their events. I thought: ‘Sure!’ And then they showed me some kind of booklet they had been using to pitch factor investing to potential clients. Well, on page two of this document was an extensive summary of our work on the Norwegian Oil Fund. So it does appear that, somehow, our work has been genuinely influential, although I did not know exactly to what extent for several years.”

“One crucial conclusion we came to was that a significant fraction of the Oil Fund’s outperformance, most of it really, was simply due to exposure to the very standard factors we have been talking about. But since these exposures were not built into the benchmark that the fund was using, it was viewed as ‘outperformance’. Divergence in factor exposure between the portfolio and the benchmark has important consequences for the way investors should view the performance of their asset managers nowadays.”

“Before the crisis and before the large negative returns relative to their benchmark in 2008, I think people viewed the Oil fund as an actively managed fund that was producing small excess returns relative to the benchmark with relatively low risk. Indeed, I think that’s the impression you get from reading the Fund’s own reports prior to the global financial crisis. The recommendation in our report – which they did not actually follow at the time – was: ‘if you want exposure to a given factor, that’s something you should decide: it should be in the benchmark.’ In other words, these exposures should not happen by accident, they should be the result of explicit decision by the fund sponsor.”

“There are two reasons for this. The first is that different factor exposures are accompanied by different types of risk, and the fund sponsor should decide whether or not these risks are acceptable.

The second reason is that, if the fund decides to take on such risks,

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nowadays there are relatively cheap ways to get different types of factor exposure. Therefore, a fund should only pay an active management fee to someone who can actually outperform a benchmark that actually takes into account exposure to these factors.”

“This is crucial because we now know that portfolios with different characteristics – for example a portfolio of value stocks versus growth stocks, or a portfolio of large-capitalization stocks versus small capitalization stocks – will often have quite different factor exposures and will, therefore, often behave quite differently over time. Since we can measure these sensitivities fairly accurately it would be a mistake to use benchmarks that do not reflect these differences.”

More specifically, what is your view on the current frenzy of research around factors and smart beta product launches?

“Well, there is obviously a danger about it. We all work on the same data, and the time period we look at increases very slowly, so it is difficult to get new data very quickly. There is a paper1 you may be familiar with, written by Campbell Harvey, Yan Liu and Heqing Zhu, in which they count the number of factors that academics have identified; there are about 300 of them. They also point out that, because results are typically both identified as ‘interesting’ and published on the basis of statistical significance, at least some of these results – perhaps many – are likely to be ‘false positives’.”

“This ‘p-hacking’ risk is a widespread problem in many areas of scientific research; it is not restricted to finance. Here is an illustration. Let’s imagine two completely independent series of returns data, i.e., with a true correlation of zero. If we generate 500 such pairs of data then, even though the true correlation is zero in each case, we would expect to find that, on average, 25 of them (5%) will appear to be significant at a confidence level of 5%. And if, from that finding, I deduce that I have found an interesting and meaningful pattern in 5% of the data, I am making an obvious mistake. In this case the mistake is obvious because I can see the 95% of the data that produces no significant correlation alongside the 5% that appears to be significant.”

“So, in this case, I can easily see that it’s just luck. But now imagine that 500 different researchers do exactly the same thing with each researcher analyzing just one pair of series. The (on average) 5% of researchers who find a result that is significant at the 5% level are likely to be convinced they’re on to something!

And, because they appear to have found something, these are the

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Great Minds

results that are more likely to get published. We’ll never see the 95% of analyses that resulted in nothing at all because analyses that find nothing don’t get published. This is simplified version of the point being made by Campbell Harvey and his co-authors.”

“You may remember this famous phrase by the 20th century physicist, Sir Arthur Eddington, who is famous for carrying out observations of a solar eclipse in 1919 that confirmed Albert Einstein’s predictions about the effect of gravitation on light.

He once said: ‘it is a good rule not to put overmuch confidence in a theory until it has been confirmed by observation.’ But then he went on: ‘it is also a good rule not to put overmuch confidence in the observational results that are put forward until they are confirmed by theory.’ In other words: if all you have got are some observations and you lack the theoretical framework to understand them, you really need to be cautious.”

“But let me make another comment on the current explosion in research and product launches. I think that one of the reasons behind it is linked to some kind of widespread sentiment that future returns may be lower than they have been in the past.

And added to this is the fact that you need a huge amount of evidence to be lucky enough to identify an active manager that will outperform in the future and not charge you a fee that will basically wipe out all that outperformance. You’ll be fortunate if you find a manager like that.”

“There is a growing skepticism among some asset owners, correctly so in my view, about the benefits of active management and about the fees that usually go with it. In a way, factor investing falls somewhere in between conventional active and purely passive management. It differs from passive investing in the sense that it is not purely holding the market. But, at the same time, it is not classic active management, in the sense that the strategies are quite transparent.”

“So, for investors who are tempted to give up active management and go for purely passive strategies, factor investing is a very natural thing to look at, because it features many of the elements that can be found in active management.”

Are there any other kind of warnings or recommendations you could give to researchers and investors?

“Yes. As I already mentioned, I think we all need to realize that while it is true there is a lot of evidence on the widespread nature of factors, and the historical premiums attached to them, there

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is not, so far, any fully convincing explanation of why this is the case. That is not to say that these premiums don’t really exist, or that a good explanation isn’t possible. It’s just that, so far, we haven’t got it. In any case, as researchers we should definitely keep looking for an answer to this question. And, as investors, we should always keep in mind the fact that, to this point, we don’t have a clear answer to the question.”

“In the case of market risk premium it’s not at all difficult to explain why there should be a premium on equities as a whole relative to government bonds. Equities bear much of the business risk in the economy and if we could be confident that government bonds would achieve average returns similar those of the equity market we would all hold government bonds. So, the logic for a market risk premium in equities is quite clear. Determining the size of the premium is another issue, but the reason it exists is clear.”

“But when it comes to focusing on a specific premium that reflects just one aspect of the equity market, say the premium on value stocks over growth stocks, things become much less obvious. It is not that we can’t think of possible reasons for this kind of premium, but there is currently no consensus on what those reasons actually are. And I think investors should definitely be aware of that.”

What are the most important aspects or questions academics should focus their research on?

“Let me point out two important areas where I think further research is much needed. As we have already discussed, there is now a very long list of factors in the academic literature; a sort of ‘zoo’ with a lot of different species in it. I suspect that many these species are related in some way, and if we were able to get a better grasp on the relationship between them, that would help quite a lot.”

“For example, momentum and value are generally negatively correlated, and this is in itself very surprising, because both factors apparently have a positive risk premium. Finding an uncontroversial explanation for this phenomenon would be very useful in helping to understand the interrelationships between the different factors.”

“The second area of research I would mention is the quest for a genuinely convincing theory of why these factor premiums exist.

Until we find some satisfactory explanation for what is going on, I think there will always be a concern that factors may not be permanent and could, therefore, disappear at some point.” This is a possible scenario if everybody were to suddenly start investing using factors, right?

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‘Until we find some satisfactory explanation, there will be a concern that factors may not be permanent’ “Up to a point, because collectively we do hold the sum of whatever is out these in terms of assets – let’s call it the market.

So factor investing is about people deviating from this average position and we can’t all deviate from the average position in the same direction. But I do think factor investing will remain successful and will very likely grow. This framework has been around for over 30 years now and it is a fact that the risk characteristics of different categories of stocks are predictably different. So I think that as investors become increasingly conscious of the fact that there are different risk-return characteristics within the overall market, they will take these into account and then make well-informed choices.”

“Yes, definitely. There are already concerns about the amount of money that is currently being invested in strategies of this kind, and the consequences this may have on expected returns. And some of these strategies are very puzzling. Think, for example, about momentum. This factor is among the most perplexing, because it leads to an investment strategy that your five-year old nephew might come up with. Why on earth should we invest in things that have gone up and sell things that have come down? I mean, it sounds so naïve...”

“So, in this case, it is quite difficult to come up with a rational risk-related explanation. Why has the momentum effect not just disappeared? People have had long enough to arbitrage it away. As a consequence, we cannot simply rule out a risk-related explanation. If a factor is related to fundamental risk, it may well never disappear. And this is why, from my perspective, it is so important to get a better theoretical grasp on what these factors exactly are. And that should be a concern not just for academics but also for practitioners.”

Where do you see factor investing going forward? Do you foresee a similar success to that of passive strategies? What would limit the development of factor investing?

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“Some investors may consciously decide not to explicitly target any factor premium and simply go for conventional indexation.

But other asset owners, who previously allowed their active managers to determine the portfolio’s factor exposures, will increasingly make these choices themselves. Some will do so based on their own risk preferences, some will target the premiums attached to the different factors and others will pay attention to both the risk characteristics and the premiums.”

“So even though there is still an ongoing debate on the actual size of the different premiums, I think factor-based approaches are likely to become an increasingly important part of the investment landscape going forward, just because they enable investors to make more deliberate choices about the kind of risks that they are prepared to take. As we understand more about these risks it will make it easier for asset owners to decide whether they are prepared to be exposed to certain risks and the level of exposure they feel to be acceptable.”

“As for the potential limits to the development of factor investing, well, as I have mentioned, most of these strategies imply longshort positions and not all investors can implement the same long-short position. This could limit the expansion of factor investing unless there are enough investors happy to take the other side of these bets. But for now, at least, I think we are still quite a long way from this limit.”

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Financials: six things to watch for If there’s one sector that is being transformed completely, it’s the financial sector. Blockchain, fintech, and all sorts of other developments will continue to change the financial world as we know it. We have distilled six themes investors need to watch in 2018. footprint, other (regulated) crypto-currencies which require no mining become more popular.

Speed read

Research

• Valuations in many asset classes are quite rich • Economic conditions around the world are solid • Within financials we see many undervalued opportunities

At the start of 2018, we are in a market with increasing volatility from very low levels and with a very flat yield curve. Interest rates are historically low and credit spreads have also narrowed substantially. US banks and many European banks are expensive.

Financials with a high dividend yield or the fantasy of higher dividends or buybacks have seen valuations climb, as investors are searching for yield. However, there are still quite a few attractively priced financials, says Patrick Lemmens, senior portfolio manager.

“These often have lower dividend yields, are more growth-oriented, or investors do not believe in their cash-flow generating and future dividend-paying capacity.

Financial tech stocks are mostly valued at higher levels but also have the earnings growth to justify these valuations. Digital finance stocks have solid long-term (earnings) growth potential but need to beat expectations in order to deliver further stock performance.”

Apart from these macro- and microeconomic considerations, Lemmens expects 2018 to be marked by six major developments in the financial equity sector: 1. Blockchain Blockchain or distributed ledger technology will finds its first real and recognized user cases, but at the same time bitcoin will become ever more volatile. With increasing regulation and growing critique of its very poor carbon

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2. Volatility As (long-term) interest rates increase with growing inflation, volatility will also rise. This will lead to much more interest in life insurers, exchanges and investment banks, but whether overall markets will end higher in 2018 depends on how measured these increases will be.

3. Consolidation Consolidation in payments continues with high activity in the US, Europe, cross Atlantic and increasingly the Far East. Tech platforms will become more important globally, in terms of direct influence with more and more partnerships but also as a model for the future financial services landscape in the rest of the world.

4. Geopolitics The places to be in 2018 are China and India. These two 1 billion+ population countries are obviously growing in importance, but the US and Europe remain very important for market sentiment. How will the changes in tax law affect the US and the rest of the world?

What will president Trump and his administration do in 2018?

5. Tech investments After years of underinvestment and the need to make investments on the regulatory side and in KYC (know your client), banks, insurers and asset managers will devote substantial resources to getting their core technology platforms up to speed. Some companies will try to hide this for their shareholders by capitalizing these investments on the balance sheet, but no matter how the investments are made, they are necessary!

6. Regulation As the regulatory pendulum swings back from more and more regulation and rules to less regulatory pressure, one should not be surprised by the occasional unexpected new and tougher regulation, as there are still enough politicians and regulators out there with little love for the financial sector. On top of that China is doing some regulatory maintenance after years of laissez-faire.

Finally, around the world there is a need for better rules on Initial Coin Offerings, crypto-currencies and more generally fintech innovation.

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LAST BUT NOT LEAST

Nothing ever stays the same Everything is changing and the same goes for our industries. In no time, self-driving cars will be populating the streets, artificial intelligence will make production faster and smarter, sun and wind will fuel local production and cybersecurity will be there to keep us safe. Investors cannot afford to be daunted by this prospect, as the investment opportunities are huge. Hyped even? Trend investors Marco van Lent and Henk Grootveld don’t think so. Robotics are already past the hype and investors are now underestimating their potential.

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Industrial innovation: hype or investment opportunity?

Marco van Lent and Henk Grootveld – Robeco Trends Investing

The world is on the eve of the fourth industrial revolution. New developments in robotics and exponential growth in digitization will make factories smart, flexible and very efficient. Renewable energy will take over as the world’s main energy source and cyber insecurity will unlock massive investments to protect companies.

How can investors capitalize on these rapid transformations?

While the first industrial revolution was marked by the shift from manual to mechanical production, the second one by mass production and the third one by automation, the fourth industrial revolution is about robotics and digitization. In this landscape, we discern four disruptive trends: robotics, digital manufacturing, energy transition and cybersecurity.

Robots and digitization make production smart Robots will replace most heavy-duty work still done by humans.

Nowadays, robots and machines have sensors, machine vision and other features that allow them to work together in an intelligent and highly efficient way. Not only will they enable a new wave of productivity increases, they will also improve quality, shorten lead times for new products and require less energy to produce them.

What’s interesting at this stage is that robots are being combined with new technologies, such as self-learning software, allowing the robot to collect and analyze data and give feedback autonomously.

In the late 1970s, automation merely related to standalone products: machines in the factories were controlled by a computer, but there was no cooperation nor connection.

A sector that is being completely overhauled by these developments, is the logistics sector. Many tasks that used to be done by humans are now being carried out by robots in all shapes and forms, such as automated guided vehicles (AGVs). Demand for robotic systems in warehouses is expected to surge from 40,000 in 2016 to a mind-boggling 620,000 in 2021, says 13D Research. A 2013 Oxford University study already estimated that up to 98% of US packaging

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and filling machine operators and tenders, shipping, receiving and traffic clerks’ jobs would be robotized by 2030.

At UK online grocer Ocado, a leader in logistics automation, robots can retrieve goods, pick groceries and help pack items into boxes. Ocado’s warehouse robots can complete a 50-item order within a few minutes, while this still took two hours in Ocado’s first-generation warehouses. In 2012, Amazon bought robotics company Kiva and currently has 100,000 Kiva robots, which can find the pod containing the product, lift it and send it to the picker. The picking is still done by a human, but Amazon has organized a yearly Picking Challenge, called the Amazon Robotics Challenge since last year, awarding a prize for the university or company that is able to design a robot that can do the picking fully automatically. Up until now, however, humans still beat robots in picking.

As 95% of warehouses worldwide still don’t use this type of advanced automation, this development presents a huge opportunity for investors. We invest in companies that make robotic equipment but also design and set up the warehouses.

Another form of robotics is the self-driving car, which could be seen as a collaborative robot. Self-driving cars will change the car industry and society as a whole. They are expected to reduce accidents by roughly 90% and remove most traffic jams.

China is leading the way The use of robotics technology is propelled by aging countries such as China and Japan. In China and Japan, the working population is shrinking. The resulting shortage in staff is solved by using robots instead. Another reason why China is installing more robots than any other nation is that its vast manufacturing industry is moving up the value chain. The country added about 90,000 robots last

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year, a third of the global total, and this will increase to 160,000 in 2019, according to the International Federation of Robotics. The current 5-year plan is to increase from 49 robots per 10,000 manufacturing workers to over 150 per 10,000 by 2020. Given China’s track record, the country will probably reach this target much sooner.

‘The fourth Industrial Revolution is transforming global production’

Bringing production back home An unintended but interesting effect is that production capacity is moving back from low-wage countries to developed countries, as it no longer pays off to have the product made by cheap labor in Asia.

Production by robots at home, without transport costs, is cheaper. It is thanks to robots, for example, that VDL NedCar in the Netherlands is up and running again after having been on the verge of bankruptcy in the past. Since July 2014, the company is producing MINI cars and the BMW X1 for BMW. The MINIs are heavily customized and customers can choose from a stunning 15,000 versions. Due to large-scale automation, the company can deliver within three weeks after the order has been made. In August 2017, the number of permanently employed people at VDL NedCar had risen by 2,000 to 6,000, working alongside 1,300 robots. Robots actually created jobs!

available in Germany. Similarly to what Inditex is doing with its fast-fashion concept for Zara, Adidas wants to be able to supply high-end, customized sports shoes within a week. This reduces both the fashion risk and the operating capital required. By using 3D printer technology to design the shoes and measure customers’ feet, the shoes can both be customized and delivered quickly. In this set-up, the standard products will continue to be manufactured in low-wage countries, while the high-end segment will be produced in Europe.

Changing power dynamics in the car industry The first industries that have been robotized are low-margin industries such as cars and electronics. The production of the iPhone, for example, is becoming more robotized with each new model.

Of the first model, which was introduced ten years ago, 10% was manufactured with robots, against 70% for the latest iPhone X.

The other side of the coin is that if, say, Donald Trump wants to bring back car manufacturing from Mexico to the US, this can only happen if the Mexicans are replaced by robots; otherwise cars would be too expensive. Also, although Foxconn and Samsung will be opening factory outlets in the US, people generally underestimate that this will mainly create jobs for robots.

Robots and digital manufacturing have even more far-reaching consequences for the auto industry. Car manufacturers used to have an edge because of their specialization in electric harnessing and motors. It took seven years to design a new Golf, which still looked very much the same as the previous one. This is changing with the advent of electric cars, which can be produced in two to three years as their production can be unbundled. In essence, an electric vehicle is nothing more than a huge plate of batteries with one, two or four electrical engines, a steering wheel and a large tablet with software.

This modular build-up increases the speed to market substantially and lowers the barriers to entry for new entrants.

Digital manufacturing also allows for differentiation. Adidas, for example, has opened a speed factory in Germany. This additional local factory will be able to benefit from the cheap renewable energy

Currently, electric cars still look the same as a fuel-driven cars, but this will change. New technologies will optimize the design for electric cars. Before long, we will have electric cars without a hood, because

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Figure 1 | Portfolio construction in line with the hype cycle

illustrated in Figure 1. In the first two stages of the hype cycle (technology trigger and peak of inflated expectations) it is often not yet clear who the winners will be. As the investment community gets excited about a trend and the media picks it up, momentum increases and the tide raises all boats: every company that can be associated with the trend increases in value. Expectations are very positive and overreaction can result in bubble-like valuations.

Source: Gartner; Robeco Trends Investing

they simply don’t need it anymore. And the wheels, which are now optimally placed for transmission, will move more towards the outer parts of the car, to create more room inside.

As competition is rapidly increasing, it is hard at this point to pick the winners. We therefore invest in suppliers of lithium ion batteries, sensors, software and manufacturers of harnessing for electric cars.

From hype to disillusionment and long-term underreaction With all that is being written about robotics nowadays, people often ask us if it isn’t it a hype, which has already been discounted in stock prices. The answer is that we are already past the hype and investors are actually underestimating robotics’ potential. To explain why we believe this, we have to explain how our investment process works.

In our portfolio construction process, we use the concept of the Gartner hype cycle as a tool in determining our strategy. This is

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In this stage, there are no clear winners yet, and we believe it is best to construct broad baskets of companies with good (preferably pure) exposure to the technology in question. Another approach is to invest in companies that facilitate the new technology. This is the ‘picks and shovels’ approach. Instead of trying to invest in a (presumed) star gold miner during the gold rush, our approach is to invest in the shop in town that is supplying the picks and shovels.

After the hype has peaked, the next phase is difficult from an investment perspective. During the ‘trough of disillusionment’ and part of the ‘slope of enlightenment’, sentiment is still very negative and some companies cease to exist. During this shake-out, winners will emerge, but it is hard to invest during this period, which we have dubbed the ‘investment chasm’.

The second stage of investment opportunity takes place halfway up the ‘slope of enlightenment’ and continues onto the ‘plateau of productivity’. This is where we find the companies that have survived the shake-out period and are able to continue developing the technology. The big difference with the hype period is that this time

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‘Investors underestimate the investment potential of robotics’

companies actually implement and use the new technology and are able to monetize this development with a sound underlying business model. The best investment opportunities occur during the ‘slope of enlightenment’ phase, when sentiment is still negative because many investors also witnessed the crash period. The portfolio approach during this phase is to identify long-term winners and concentrate portfolio holdings into these names as opposed to the basket approach in phase one.

Industrial robots are in this slope of enlightenment phase. We are past the hype and investors are underestimating the potential of robotics companies. We have concentrated our holdings in a small number of companies which we believe will be the long-term winners, including component suppliers. Electric vehicles, on the other hand, are in the hype phase, which means we invest in the picks and shovels, which in this case are sensors, battery producers and lithium miners.

Renewable energy to become the cheapest source Besides robotics and digital manufacturing, energy transition and cybersecurity are two other trends that drive global industrial innovation.

Renewable energy is rapidly becoming cheaper. 2016 marked a breakthrough in solar and wind energy, as Chile and the United Arab Emirates auctioned solar projects below 50 USD/MW while Morocco and Mexico auctioned onshore wind projects below 40 USD/MW. Bloomberg New Energy Finance expects wind and solar energy to be cheaper than natural gas by 2020 and cheaper than coal by 2024.

The increased penetration of renewable sources in overall electricity generation requires heavy investments in ‘smart grids’, as renewable generation is inherently unpredictable. A smart grid is an electrical grid which uses digital information and controls technology, such

Robeco QUARTERLY • #7 / MARCH 2018

as smart meters and renewable energy, to improve the reliability of the grid.

Just like cheap shale gas, which caused the US to move production of, for example, plastics back from Asia to its own soil, solar and wind energy can promote local production in other parts of the world. Solar and wind energy prices have already come down a lot and on windy and sunny days, they can even be negative. This has already happened in Germany, as there is as yet no good solution to store energy. As storage and transport of renewable energy are still expensive and troublesome, this stimulates local production.

Cybersecurity keeps the world safe The fourth trend is cybersecurity. Cyber insecurity can be a game stopper for companies that can only be warded off by the best possible defense. Hacks upsetting the functioning of hospitals, telecommunications companies, railways and airlines have exposed our vulnerability to cyber-attacks. This vulnerability has increased rapidly with the advance of cloud computing and the Internet of Things. Cybersecurity has become a necessity and not surprisingly, IT spending on security has grown substantially over the past ten years.

Now is the time As the way in which global production is organized is changing quickly, now is the time to benefit from the investment opportunities that arise. The average age of US production facilities has never been as high as today, as most investments were postponed due to the global financial crisis. Demographic pressure, Trump’s America First policy and China’s Made in China 2025 plan, which aims to boost manufacturing innovation, are all accelerating the adoption of new production technologies, which are making production more efficient, cheaper and quicker.

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Carola van Lamoen

The five engagement themes for 2018 Interview

Robeco’s Active Ownership team has selected five new engagement themes for 2018. Team head Carola van Lamoen explains why they were chosen, and what the challenges are in trying to get companies to improve themselves.

What are Robeco’s engagement themes for 2018? Why did you pick these ones… is it based on where we have the most investments?

“We select engagement themes in a very structured way. We ask input from our portfolio managers and analysts, and from the SI research teams at RobecoSAM, and match them with the ideas of the engagement specialists within my team. We ask clients what they consider to be most relevant to focus on, and with all that input we come up with a balanced set of financially material themes. We also aim to align engagement themes where possible with the UN Sustainable Development Goals (SDGs). Through that process, we came up with five themes.”

“The first focusses on challenges relating to climate change where we will target the world’s biggest carbon emitters. The second topic is discussing food security with agrochemical, seeds and fertilizer companies. The third is cyber security, where we will focus our efforts on companies in the ICT and consumer sectors that are vulnerable to these issues. The fourth one is good governance, amongst others looking at Brazilian and Chinese companies. And the fifth topic is waste management, specifically within the tech and solar power industries.”

Is targeting climate change linked to Robeco’s new climate change policy, or the commitments to adhering to the SDGs? “Our climate change policy aims to reduce investment exposure to climate risk, and we do that in many different ways. We are part of a global collaboration of 225 investors who have joined forces to get into dialogue with the top 100 carbon emitters in the world. In this ‘Climate Action 100+ initiative’ we’ll be taking a leading role in engaging with some of these companies. We

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will also co-file shareholder proposals with regard to two-degree scenario planning and methane emission reduction targets at some companies.”

Why are you targeting technology and solar companies in the drive to reduce waste? Why not target the plastics companies or polluters?

“We’ll focus specifically on a transition to circular business models, so that no waste will be produced. In the production process of solar energy, toxic waste is still an issue. Currently, the product cycle of solar panels is linear: at the end of their life they are disposed of, instead of recycled. Actually, they were never designed to be recycled to begin with. They are not biodegradable, so how do you decompose them – we don’t want them to end up on an Indian beach. If companies have an adequate approach to manage the end-game through the initial manufacturing process, it can alleviate this problem. This is also aligned towards the SDG on responsible consumption and production.”

Do you think cyber security is getting worse? Which companies are particularly threatened by cyber crime?

“More data is stored now in systems around the world due to cloud computing and social media – 90% of the data in the world today has been created in the last two years. There have been many more attempts to steal this data through hacking attacks. The level of security needed is getting more advanced, but the skills of the hackers and their incentives to steal more valuable data are growing more quickly than the abilities of companies to respond to the threats. We will focus on the ICT and consumer sectors for this engagement. Retail companies now operate much more online, while banks face an obvious security threat.”

Robeco QUARTERLY • #7 / MARCH 2018

‘We don't want solar panels to end up on an Indian beach’

Why are you targeting Brazilian and Chinese companies for governance improvements?

“There isn’t a common denominator as such, but a lot of the suggestions we received from clients and the investment teams related to trying to achieve governance improvements in emerging markets. We see a lot of upside potential there. There’s a difference in the quality of corporate governance in developed markets compared with emerging markets, including structures needed to improve disclosure, shareholder rights and these kinds of issues. Our engagement specialist in Asia specifically focusses on governance issues. Corporate governance standards have been improving in several countries following pressure from investors, governments and other stakeholders, but there are still a lot of challenges.”

Robeco QUARTERLY • #7 / MARCH 2018

Is food security a big issue again? Hasn’t a lot of progress been made?

“It’s still on the agenda; we’ve made a lot of progress but like, it remains a large global challenge. Weather patterns will negatively affect farmers in emerging countries due to droughts or flooding, along with urbanization in low-income countries. A global population growing to 10 billion by 2050 is a big driver of demand for food systems. So there is a lot of room for improvement. We engage with agrochemical, seeds and fertilizer companies on the role they can play in developing yield-enhancing solutions for famers, with a specific objective to support smallholder farmers. Similar to with waste management, there was a strong desire from a client to do this. And the whole topic is aligned with the SDG relating to food.”

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Column

The battle for Frankfurt Spain is back. It has not had a seat on the ECB's six-person executive board since 2012 despite being the Eurozone's fourth-largest economy. Now Mr. De Guindos has been nominated by the Eurogroup. He has been Spain's economy minister since 2011 and can be considered the architect of the impressive supply side reform driving Spain’s remarkable recovery.

Before that, Mr. De Guindos headed the Iberian unit of Lehman Brothers before it collapsed. With Spain’s return, the informal understanding that the four largest economies of the Eurozone are always represented on the six-person board has been restored.

There are more vacancies to be filled. Eastern Europe will claim a post for the first time. De Guindos’ nomination opens the way for a northern European to be appointed successor to ECB-president Mario Draghi in order to keep a regional power balance in the board’s composition. Draghi will retire at the end of October 2019. The frontrunner is generally thought to be the current head of the German central bank, Jens Weidmann.

This sounds reasonable as the Eurozone’s largest economy has never had an ECB president, unlike the second- (France: Jean-Claude Trichet) and third-largest (Italy: Draghi). OK, Frankfurt is home to the Seat of the

ECB. Though the German-speaking Francois Villeroy de Galhau (from Alsace) of the Bank of France is also in the running, I guess that a second French turn at the helm would generally be considered too much.

Weary of giving too much power to Germany, there is some speculation that European leaders will opt for a representative of a smaller Northern European country (Finland, the Netherlands?). Given that the first ECB president was a Dutchman (Duisenberg) I would not, in any case, put my money on Klaas Knot.

However, Weidmann’s appointment would not be without problems. It would mean that Sabine Lautenschläger, the only female board member, whose term ends in January 2022, would have to resign early, as having two Germans on the board would be a bit much. The ECB executive could therefore easily end up with an increasingly embarrassing all-male team.

A second problem is that Weidmann has consistently opposed the more radical measures taken by the ECB in the aftermath of the crisis. His past hawkishness could lead to resistance to his nomination as he could be considered a threat to the euro’s long-term survival. On the other hand, despite his minority views, he hasn’t resigned, unlike the former Chief Economist Jürgen Stark. So he is probably a pragmatist. Currently 49, he is also young.

But perhaps we shouldn’t exaggerate the importance of the chair in terms of practical policy, as the ECB is the only important European institution that takes decisions by simple majority. It isn’t only the chair’s view that is decisive. Moreover, the strong upswing in the Eurozone economy will put a gradual end to the extraordinary monetary measures and usher in a return to normality.

It could also be argued that the overreliance on monetary policy has been unhealthy and has given politicians too much room to avoid making tough decisions. All in all, Weidmann seems like an easy, perhaps even inevitable, choice.

Léon Cornelissen, Chief Economist

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Robeco QUARTERLY • #7 / MARCH 2018

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wholesale investors within the meaning of clause 3(2) of Schedule 1 of the Financial Markets Conduct Act 2013 (‘FMCA’). This document is not for public distribution in Australia and New Zealand.

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Version 11/17

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CONTACT Robeco P.O. Box 973 3000 AZ Rotterdam The Netherlands T +31 10 224 1 224 I www.robeco.com