Robeco Quarterly

Robeco

Intended for professional investors only

QUARTERLY

WE BELIEVE IN TEAM BUILDING, NOT IN HIRE & FIRE – 36

FIVE-YEAR EXPECTED RETURNS: DARKEST JUST BEFORE DAWN – 7 A NEW AGE FOR DISRUPTIVE BUSINESSES – 26 LOOKING AT THE FUTURE OF ASSET MANAGEMENT – 32

#1 / September 2016

QUANT investing SUSTAINABILITY investing

'It's always darkest just before dawn.

And if the mood of investors is anything to go by, it is already pretty dark out there.'

Lukas Daalder, CIO Investment Solutions

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SUSTAINABILITY investing

Defining the Quality factor

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Quality is a relative newcomer to the factor investing arena. It joins more commonly used factors – Value, Momentum and Low Volatility. But the Quality factor is rather different as there is no unanimous, unambiguous definition.

The profitability of low volatility

11

Factor investing with smart beta indices

13

Taking smart beta to the Asian market

15

Integrating sustainability into factor credit strategies 25

And more…

QUANT investing

CONTENTS Expected Returns It’s always darkest just before dawn

7

Macro economy America, a melting pot of opportunity mixed with stalemate

17

Trends Digitization and connectivity drive ground-shifting new business models

19

Research Lower liquidity, collective responsibility

28

Research Are low-vol stocks now too expensive?

30

Long read The future of asset management

32

Interview ‘Investing is like running a marathon, not a sprint’

36

Column The cult of the central banker

38

The objective of Robeco’s factor credit strategies is to maximize factor exposure at low cost while limiting risks. Sustainability is an im portant risk dimension, which is why we integrate it into our investment process.

Tackling the increasing threat of cyber crime

22

Engagement with Olam mutually beneficial

23

Investors explain how they want utilities to tackle COP21

27

Robeco QUARTERLY • #1 / SEPTEMBER 2016

3

Factor credits

Celebrating a flying start “Putting your research to the test is always exciting, and if it works out well, it’s very satisfying.” Patrick Houweling on the first anniversary of the Global MultiFactor Credits fund.

Textbooks College tuition Childcare Medical care Food & Beverages Housing CPI all items New cars Household furnishings Clothing Wireless service Software Toys TVs

Source: BLS

4

Performance:

One

Q3

Q4

Q1

Q2

EUR IH Share class

year

2015

2015

2016

2016

6.73%

0.66%

0.20%

3.26%

2.48%

6.10%

0.33%

0.11%

3.03%

2.75%

Robeco Global Multi-Factor Credits, gross of fees

The fund uses the Low-Risk, Value, Momentum and Size factors to find outperforming bonds in the global investment grade corporate bond market.

In its first year it has lived through the start of negative interest rates in the Eurozone, a US rate rise, a collapse in the oil price, and finally the shock Brexit vote.

But the result was ending the first year with outperformance of 63 basis points, returning 6.73% for investors. “It was a very volatile year, but nonetheless we stood our ground,” says Houweling.

“For the Brexit we had some good positions along with the bad, and it all balanced out in the end, with hardly any performance impact despite everything that happened. We were underweight

Inflation vs Deflation 1996-2016 1 2 3 4 5 6 7 8 9 10 11 12 13 14

A first year of outperformance for Robeco Global Multi-Factor Credits

+207% +197% +122% +105% +64% +61% +55% +2.1% -2.4% -4.8% -45% -66% -67% -96%

Barclays Global Aggregate Corporates Index (hedged into EUR)

The performance figures presented above correspond to the EUR IH share class of the Robeco Global Multi-Factor Credits fund launched in June 2016. Performance for other share classes may vary. The value of your investments may fluctuate.

Past results are no guarantee of future performance. All data to 30 June 2016.

Source: Robeco

UK banks but overweight in sterlingdenominated bonds, and the fund is hedged, so there’s no currency exposure.”

“The portfolio has been pretty stable, with a lower volatility than the market.”

Houweling says the main reason for launching the fund was client demand for this style of investing which has been so successful in equity markets. The fund focuses on low risk, value, momentum and size to find the winners in corporate bonds.

But these don’t always come into play at the same time, and often one factor can be in vogue at the expense of others, depending on market conditions. That’s why it’s important to adopt a multi-factor approach, he says.

Keeping pace with constantly changing markets in a year that saw a collection of differing macroeconomic shocks is another innovation. “We’re constantly doing research and trying to improve use of the factors,” Houweling says.

The portfolio of all investments worldwide has a value of USD 100,950 billion* and is allocated as follows: Government bonds

Equities

Corporate bonds

Real estate

Emerging market debt

26,390

39,990

17,580

6,120

2,630

billion Private equity

Inflationlinked bonds

4,160

2,360 High yield bonds

1,720

*Asset weights taken from Doeswijk, R., Lam, T., and Swinkels, L., 2013 and Erasmus page of Swinkels, L., (http://people.few.eur.nl/lswinkels/).

Robeco QUARTERLY • #1 / SEPTEMBER 2016

Enhancing knowledge, sharing ideas

Over the last six years we have witnessed a lot of negativism towards emerging markets. Fears of a Chinese economic hard landing, Brazilian political and corporate corruption scandals, Russian geopolitical issues and an African collapse at the end of the commodity boom era are just a few of the events that have created negative sentiment.

All these have led to a disappointing performance in emerging equity markets and a lot of investors have withdrawn from the asset class.

After the Brexit referendum, however, emerging equity markets have proven to be resilient. Also important, since most emerging currencies are far more correlated to the US dollar than

the euro, emerging currencies should remain relatively immune to potential turmoil in Europe. The main cause of the underperformance of emerging equities from late 2010 to late 2015 was that earnings were weak compared with developed markets. We expect better earnings ahead on the back of more favorable monetary policies and less pressure on emerging currencies. We think current rock bottom valuations offer interesting buying opportunities.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

Editorial

Emerging markets

Guess who’s back?

Welcome to the first edition of Robeco Quarterly. And it’s not your regular quarterly macroeconomic publication. We already have a yearly outlook and the five-year Expected Returns to look ahead at what’s going on in the world and to let investors know how we think they should position themselves.

Plenty of our competitors have quarterly macroeconomic outlooks, but we have deliberately chosen to deviate from that well-trodden path. This brand new magazine is all about innovation. And research. Two things that have been part of Robeco’s DNA right from the start. Almost a century ago, our first Chief Executive, Lodewijk Rauwenhoff, said that “every investment strategy should be research-driven”. Since then, our mission has been to use a researchbased, quality-driven process to produce the best possible long-term results for our clients. And that hasn’t changed at all.

But sticking to our guns does not mean we can’t change. Continuity and innovation can go hand in hand. This magazine focuses on those areas where we think we excel: quant investing, sustainability investing and research. We firmly believe in adding value for our clients. And two of the most important ways we do this are by using our factor investing approach, a rules-based, systematic way of generating alpha, and by adopting a true active investment style, based on our own fundamental research, which fully integrates sustainability information into the process. We believe including ESG data will improve the risk-return profile of our investments. Quant investing, sustainability investing and in-depth research are the main building blocks for the Robeco Quarterly.

To stay ahead of the pack in these three areas, we continue to increase our knowledge and improve our investment models. Our curiosity and ambition ensure that we continue to pioneer unchartered territories.

It’s a journey of discovery and we’d like to share it with you.

This new magazine replaces the sustainability magazine Advance and our holiday-reading booklet Time2Read. Robeco Quarterly enables us to do what we like doing most: sharing knowledge with our clients.

Peter Ferket, CIO Equities

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Sustainability investing – that’s us

When central banks talk about inflation, which number should we look at? Is it core inflation – inflation excluding the volatile components of food and energy?

If so, then the US doesn’t seem to have a problem. Since last December, US core inflation has continuously topped the 2% mark, the holy grail when it comes to inflation targets. In the Eurozone, however, it lies far below that threshold.

Robeco has retained the highest possible A+ score for sustainability investing on the United Nations Principles for Responsible Investment (UNPRI).

In fact, wasn’t it because headline inflation (including food and energy) fell below zero that the ECB started its quantitative easing program? However, even this may cause less of a headache going forward as simple mathematics shows that if the price of oil stays

anywhere near USD 50, headline inflation will shoot up due to base effects. That is provided no big surprises occur, of course.

But, to my knowledge, Frankfurt doesn’t possess a crystal ball either.

Jeroen Blokland Senior Portfolio Manager

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Sustainability

Column

Clarifying the inflation confusion

It is the third year in a row that Robeco has achieved the best possible score for all the modules assessed by the UNPRI. The A+ score was awarded because of the way Robeco uses environmental, social

and governance (ESG) metrics and integrates sustainability principles across the entire range of funds. The firm’s sustainability specialist, Zurichbased RobecoSAM, also received the A+ grading. RobecoSAM offers sustainability products and supplies the group’s ESG data using its Corporate Sustainability Assessment and Country Sustainability Risk surveys.

“We are delighted to have retained the best possible rating from the PRI as it honors everything that we hold

dear,” says Edith Siermann, Chief Investment Officer for Fixed Income and coordinator of Sustainability Investing at Robeco.

“Obtaining the highest possible score for all UNPRI modules seems to be becoming a tradition at Robeco. We have worked very hard to integrate sustainability across most of our products and it’s great to receive recognition for this for the third

year in a row. We firmly believe that integrating sustainability in the investment process leads to betterinformed investment decisions, while indirectly making a contribution to a more sustainable world by raising the bar for companies in the way they deal with sustainability issues that are relevant for society.”

The UNPRI is an international network of more than 1,500 investors working together to further the growth of sustainability investing.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

It’s always darkest just before dawn Every year Robeco Investment Solutions, the team led by Lukas Daalder, takes a fresh look at the outlook for the global economy over the next five years. Their analysis gives a prognosis for the major asset classes and three potential scenarios. to follow in the footsteps of the ECB and Bank of Japan and start quantitative easing. So unless we now regard QE as the new normal, it is clear that 2016 is not set to become the year of monetary normalization.

Speed read

Expected returns

• Slim hopes of monetary policy returning to normal in 2016 • Extremely weak sentiment among professional investors • Gradual normalization most likely scenario

Is this just another temporary setback, or should we succumb to one of the numerous credible doom scenarios: disintegration of the European economy (Brexit, the rise of populist parties, Italian banks), Chinese hard landing (unsuccessful rebalancing of the Chinese economy, high debt), rise in protectionism (the Trump factor), loss of central-bank credibility (Japan), and the bursting of the debt bubble. After all, we’re spoilt for choice.

In December 2015, when we first set out to discuss this year’s edition of our annual Expected Returns publication, we were in good spirits. The European economy had surprised everybody by growing above trend, the global economy was picking up and the Fed’s first interest-rate hike had not derailed markets as many had feared. The process of monetary normalization was all set to begin.

Sure, there were issues; there always are.

The ongoing decline in the oil price; positive for consumers, perhaps, but worrying for financial markets.

A growing consensus among economists that increasingly high debt levels could lead to an adverse debt cycle. And the meltdown in emerging markets with the Brazilian and Russian economies shrinking significantly (by 3.8% and 3.7% respectively in 2015), plus a Chinese growth path that was looking increasingly unsustainable.

But it was nothing we couldn’t handle.

It’s always darkest just before dawn But are things really so bad? You could be forgiven for thinking they are. Our impression is that sentiment among professional investors has probably never been as weak as it is right now. This is corroborated by what the financial markets have priced in: average inflation expectations in the European market for the period 2021-2026 are as low as 1.25%. Looking at the West-German track record (renowned for its tough inflationary stance), such a five-year average is pretty rare. Possible? Sure. But likely? Well, only if you really are very pessimistic about the future. And this is exactly the point we want to make.

‘Stock markets normally hit bottom when things are at their bleakest’

Black clouds Eight months on and our spirits are not in such good shape. The hoped for normalization evaporated after a solitary rate hike by the Fed. Falling oil prices have hit the positive impetus driving the US economy and the outlook has become more uncertain.

External factors have also curbed the Fed’s desire to hike rates: uncertainty about China, financial market volatility and a major negative blow in the form of the Brexit vote. This shattered any hopes of monetary policy returning to normal, causing the UK

Robeco QUARTERLY • #1 / SEPTEMBER 2016

Pessimism is a risk in itself. There is plenty of self-reinforcing momentum in the way economies work, so a move in one direction is not easily reversed. Once growth weakens, producers and consumers become more cautious, investment, employment and consumption levels all contract, reinforcing the downward trend.

Stock markets normally hit bottom when things are at their

7

Expected returns

bleakest. If earnings evaporate, companies collapse, people get fired and there is talk of ‘the end of capitalism as we know it’, that’s when the tide turns. The bad news may still continue, but the market has by then already discounted it. The bleaker the expectations, the better the odds that the surprise will be a positive one. It’s always darkest just before dawn. And if the mood of investors is anything to go by, it is already pretty dark out there.

based on the German ten-year benchmark, which has almost the lowest yield out there. Our projections for the US indicate a -0.25% negative return (local currency), while peripheral European bonds also offer better value. We have increased our five-year target for developed market equities to 6.5% (2015: 5.5%), reflecting lower equity valuations worldwide.

Stagnation scenario Baseline scenario Despite just how tempting it is to succumb to this general feeling of pessimism, we continue to believe that a gradual normalization is the most likely scenario. Call us optimists if you like. One fact Expected annual returns 2017-2021

Government bonds (German 10Y)

-3.5%

Cash or money markets (European)

0.75%

Investment grade bonds (worldwide)

-1.25%

High yield bonds (worldwide)

1%

Equities (global developed markets)

6.5%

Source: Robeco

We have become more cautious and this is reflected in the increased likelihood we have given our stagnation scenario (from 20% to 30%). Here, we expect global economic growth to decline to 1.6%, half the level seen over the past five years. Some areas will be hit by recession, China will hit zero growth and then see a subdued recovery. Inflation will drop to an average of 1%, but would reach deflationary average levels without the contribution of emerging markets. The Western world will sink into a Japanlike scenario. Unlike the baseline, in this adverse growth scenario bonds remain the place to be, offering the only value for money.

High growth scenario In our optimistic high growth scenario (10%), the US and the Eurozone economies expand rapidly, initially boosted by consumption and later by investment too. The global economy enters a virtuous circle and debt ratios fall. China successfully rebalances its economy and growth in Japan accelerates. Average real global economic growth will reach 3.5%. Perhaps not high compared to the 3.25% of the past five years, but if we take aging and the lower Chinese growth rate into account (6% compared to 8.5% in 2010-2015), it means growth will rise above its underlying potential. Inflation poses the main risk causing bonds to suffer and depressing stock performance somewhat, as wage and financing costs hurt margins.

overlooked by many is that – despite low growth – labor markets have strengthened and unemployment rates in the leading economies are below their longer term averages. In this scenario, consumers with a disposable income boosted by oil price falls should play a central role. Mind you, given the underlying growth and inflation assumptions, we are not predicting anything spectacular: the global economy will grow by roughly 3%, inflation will reach an average of 2.5% for the world as a whole and 2% for the developed countries. But EXPECTED RETURNS we are well aware of the risks in the current environment and the 60% likelihood we attach to our baseline scenario reflects this.

IT’S ALWAYS DARKEST JUST BEFORE DAWN

Robeco

P.O. Box 973 3000 AZ Rotterdam The Netherlands

T +31 10 224 1 224 I www.robeco.com

8

Expected Returns 2017-2021

The table summarizes our forecast for the broader asset classes. We are not particularly positive on government bonds and have lowered our five-year expected return on AAA European government bonds toContact -3.5% (2015: -3.0%). Yields have dropped to even lower levels than last year, giving less of a buffer when adverse price movements occur. This -3.5% is, however,

2017 2021

For a more detailed outline of what Robeco thinks the financial markets will bring from 2017-2021 and to read up on this year’s special topics: debt supercycle, emerging markets and global warming, visit Robeco.com and download our ‘Expected Returns 2017-2021 – It’s always darkest just before dawn’.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

QUANTinvesting

It’s all about quality Quality is the fourth musketeer, now riding alongside three more commonly used factors – Value, Momentum and Low Volatility – that Robeco applies when constructing its factor investing portfolios for equities.

How does this new factor correlate with the other factors? And does it work in all regions and in all markets?

But first of all, how can we ‘quantify’ quality? The quality effect is basically the tendency of high-quality companies to outperform lower-quality ones. As a rule, high-quality companies are typically more profitable and more conservatively managed, with stable and predictable earnings. Other characteristics such as safety and growth potential are also included in the quality premium, but can also fall under the low-risk premium, so there is some overlap between the different factors.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

9

QUANT INVESTING

Defining the Quality factor Quality is a relative newcomer to the factor investing arena. It joins the three more commonly used factors – Value, Momentum and Low Volatility – that Robeco applies when constructing its factor investing portfolios for equities. But the Quality factor is rather different as there is no unanimous, unambiguous definition. So how to go about defining the Quality factor? How can we ‘quantify’ quality?

Four Robeco quant experts, Georgi Kyosev, Matthias X. Hanauer, Joop Huij and Simon Lansdorp have tackled this subject in a recent white paper* in which they provide an overview of the common definitions and the differences between them.

As quality is a relatively unexplored factor, three main aspects have to be thoroughly tested – is the premium robust, sizeable enough and distinct enough for it to be a factor in its own right?

There is broad divergence between definitions of the quality factor in academia and those applied by many in the asset management industry. And although different definitions are also used to measure the value factor, for example, the dispersion in definitions is much greater for quality. This lack of consensus may lead to confusion among investors and deter them from incorporating the quality factor into their investment strategy. It also has important implications for the design of investment vehicles that give investors exposure to the quality factor.

The quality effect is basically the tendency of high-quality companies to outperform lower-quality ones. As a rule, high-quality companies are typically more profitable and more conservatively managed, with stable and predictable earnings. Other characteristics such as safety and growth potential are also included in the quality premium, but can also fall under the low-risk premium, so there is some overlap between the different factors.

10

Figure 1 shows that the industry definition of quality is relatively highly correlated with low volatility, due its focus on stability. Both quality definitions show similar correlations with the other factors demonstrating that they capture the same effect, but the academic quality is correlated to a more limited extent making it a more independent factor.

Sifting through the variables that proxy

for the quality definition is a huge and complex task but these can be broadly categorized into three groups – profitability, stability and growth.

The Robeco team’s research shows that there are significant performance differences between the different quality definitions, with the ‘academic’ definitions having significant predictive power for stock returns above and beyond common

Figure 1. Rank correlation between Quality and other factors 0.30 0.25 0.20 0.15 0.10 0.05 0.00 -0.05 -0.10 -0.15 -0.20 -0.25 -0.30 -0.35

Book to Price

Market cap

Industry

Academic

Momentum 12-1

Volatility 3Y

Market capitalization in USD, past 12 minus 1 month return (Momentum 12-1), and the past 3 years’ monthly volatility (Volatility 3Y).

Each month the rank correlation is calculated and then averaged over the full sample. Results are estimated based on our global universe (sample period = 1/1986 – 12/2014).

Source: Robeco

‘Research shows that there are significant performance differences between the different quality definitions’

factors, which contrasts with the predictive power of the individual ‘industry’ definitions. Their results also document regional differences in the predictive power of the alternative quality definitions.

“We show that there is a large dispersion in the definitions that are used for the quality factor with ‘industry’ definitions ranging from return-on-equity and

Robeco QUARTERLY • #1 / SEPTEMBER 2016

QUANT INVESTING

profit margins to leverage and earnings variability, and ‘academic’ definitions such as operating accruals, net stock issues, and gross profitability,” say the report’s authors.

They also note that there seems to be much more of a similarity between the measures used in academic studies and in the industry for the small cap, value, momentum and low-volatility factors. But that when these factors were ‘new’ such discrepancies were also more prevalent for them too and that these tended to converge to the ones most successful at predicting returns. That this is “the result of a learning effect in financial markets”. * 'Quality Investing – Industry versus Academic Definitions'.

Figure 2. International performance of different quality characteristics 10 8 6 4 2 0 -2 -4

United States

Europe

Japan

Global markets Emerging markets

Net stock issues

Accruals

Gross profitability

Earnings variability

Leverage

ROE growth

Margins

ROE

Market capitalization in USD, past 12 minus 1 month return (Momentum 12-1), and the past 3 years’ monthly volatility (Volatility 3Y).

Each month the rank correlation is calculated and then averaged over the full sample. Results are estimated based on our global universe (sample period = 1/1986 – 12/2014).

Source: Robeco

The profitability of Low Volatility Some people argue that the low-risk anomaly can be explained by Profitability, an example of a Quality factor. In a new paper 'The profitability of Low Volatility', David Blitz and Milan Vidojevic challenge this hypothesis and conclude that the low-risk anomaly is a distinct phenomenon, which cannot be attributed to profitability alone.

Since the mid-2000s, low-risk investing has become a widely accepted phenomenon.

Its increased acceptance, however, has also led to heightened criticism. Initially, the most frequent objection was that the low-risk anomaly is simply a different manifestation of the well-known value anomaly, i.e. low-risk was accused of merely being value in disguise.

In the paper titled 'The Value of Low Volatility' (published in the Spring 2016 issue of the Journal of Portfolio Management) we showed that a distinct

Robeco QUARTERLY • #1 / SEPTEMBER 2016

low-volatility effect exists which cannot be explained by the value effect. On the whole, the evidence even appears to support low-volatility more than value.

Can the low-risk anomaly be explained by the profitability (quality) factor?

More recently, the low-risk anomaly has been attacked from another angle.

Some now argue that it can be explained by another factor, namely profitability (an example of what is known in the industry as a ‘quality’ factor). Novy-Marx (2014) takes the standard Fama-French three-factor model, which consists of the

market, size and value factors, but adds profitability factor. This factor reflects the observation that highly profitable stocks tend to yield higher returns than stocks with poor profitability. He proceeds to show that low-beta and low-volatility stocks benefit from that phenomenon because they also tend to have a strong profitability, and that the model which includes a profitability factor can resolve their apparently anomalous returns.

Fama and French (2016) also found that with their (2015) five-factor model, which adds profitability and investment factors

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QUANT INVESTING to their original three-factor model, they could explain the returns on beta-sorted portfolios.

But what do the authors of these latest studies mean when they claim to have ‘explained’ the low-risk anomaly? Both studies reach these conclusions using an approach based on time-series regressions.

This means that every month they sort stocks into portfolios based on their risk (e.g. by using beta or volatility), then calculate the returns of these portfolios over the subsequent month, and next regress the return series obtained in this way on the returns of portfolios in which stocks are sorted on other factors, such as

size, value, and profitability. They then find that the implicit exposures to these factor portfolios largely explain the superior performance of the low-risk strategies.

Based on these results, they conclude that their proposed factors resolve the low-risk anomaly.

‘The low-risk anomaly exists beyond Value and Profitability’ In our new paper “The Profitability of Low Volatility” we do not question these results. We acknowledge that high- quality stocks do share certain traits with lowrisk stocks, and therefore that low-risk portfolios have an embedded quality tilt. However, we do not believe that profitability can fully explain the returns on low-risk stocks.

The anomaly is still much alive Suppose we sort stocks such that the resulting portfolios have neutral exposures to size, value, profitability, and investments, and only differ in terms of market beta or volatility. If the asset pricing models of Fama and French (2015) and Novy-Marx (2014) hold true, high-risk portfolios that are neutral in terms of other factors should yield higher average returns than their low-risk counterparts.

Unfortunately, as the number of factors increases, the sorting approach becomes practically infeasible. With five factors, you would need to construct 3125 (5x5x5x5x5) portfolios. In the early years of our sample, the number of portfolios was larger than the number of stocks in the universe, so we have to find another way to achieve this goal.

In our paper we describe an approach that can be used to calculate the return on portfolios with pure exposure to

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one factor (such as market beta), while neutralizing interaction with all other factors (such as value and profitability).

We find that as a portfolio’s exposure to factors such as size, value, momentum, profitability and investment increases, so do average returns, while, notably, they do not as market beta increases. Instead, we find that the relationship between market risk and return is flat, regardless of whether we control for new factors, such as profitability.

So what is the key difference between our approach and the timeseries approach applied in the previously mentioned studies? For one thing, the time-series regressions reveal that low-risk portfolios have some similarities to high profitability and value portfolios, and that, on average, these two factors can replicate returns on low-risk portfolios rather well.

However, our analysis, which is conducted at the single-stock level, reveals that simple averages don’t tell the entire story.

The low-risk anomaly exists beyond value and profitability.

We acknowledge that our research represents just one attempt to obtain a positive risk-return relationship by controlling for the factors that allegedly explain the low-risk anomaly. The fact that we were not successful does not necessarily mean that portfolios constructed differently cannot exhibit a clear positive risk-return relationship consistent with the predictions of the Fama and French (2015) and Novy-Marx (2014) models. But as long as the data indicates that portfolios with higher risk do not generate higher returns, it is premature to claim that the low-risk anomaly has been resolved.

This is a summary of the paper ‘The Profitability of Low Volatility’, which can be found at: http://ssrn.com/ abstract=2811144

Robeco QUARTERLY • #1 / SEPTEMBER 2016

QUANT INVESTING

Factor investing with smart beta indices Smart beta indices are a popular tool for investors to gain factor exposure, offering them a simple way of implementing a factor investing strategy. However, research suggests that they may not necessarily be the best way. The true factor exposure provided by smart beta strategies varies significantly, is not always easy to measure, says David Blitz.

In order to enhance performance, asset allocators increasingly take factor premiums into account in addition to traditional asset class risk premiums.

This factor investing approach focuses on the premiums that can be generated by allocating to factors that have been extensively documented in the literature, such as value, momentum and low volatility. In his research paper ‘Factor Investing with Smart Beta Indices’, Robeco’s Head of Quantitative Equity Research, David Blitz aims to provide an in-depth analysis of some of the key smart beta indices available to investors.

Using smart beta indices to implement a factor strategy A popular way of obtaining exposure to factor premiums is to replicate the performance of smart beta indices. Blitz and his team investigate how these indices can be used to implement a factor investing strategy. As a starting point they allocate strategically to value, momentum and low-volatility equity factor portfolios and, in addition, to two new factors in the Fama and French five-factor model, profitability and investment.

For this analysis, they take the value, momentum, profitability and investment portfolios directly from the online data library of Kenneth French. As he has no low-volatility strategy, the Robeco team has constructed one themselves, following a similar methodology.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

They look at the portfolios in two ways: on a capitalization-weighted and on an equally-weighted basis. A simple, equally-weighted combination of value, momentum and low-volatility factor portfolios results in a Sharpe ratio of 0.49, versus 0.32 for the market capweighted portfolio. But the Sharpe ratio can be improved further to 0.58 by using equally-weighted instead of cap-weighted factor portfolios. Adding profitability and investment factor portfolios to the mix does not push up the Sharpe ratios still further, but does boost the information ratios, i.e. market-relative performance improves.

available that specifically target the new profitability and investment factors so instead they use two indices that are quite popular in practice: the MSCI Quality Index and the MSCI High Dividend Index. For the market portfolio they use the standard MSCI Index. For each smart beta index the maximum available history is used.

Results: smart beta indices appear to offer limited factor exposure Table 1 shows how cap-weighted factor portfolios are able to explain the return of smart beta indices, taking into account the maximum available data history for each index through December 2015.

Not surprisingly, most of the performance of the Russell 1000 Value Index is attributable to the value factor portfolio, but its exposure to this factor is only 36%. The remaining exposure is attributed to the market portfolio (23%), the investment factor (21%) and the low volatility factor (20%). This implies that the Russell 1000 Value index is not very suitable for investors seeking pure and significant exposure to the value factor. Although the MSCI Value Weighted Index, which uses fundamental weightings, provides more pure value exposure (its exposure to other factors is much lower), this is still very low, given that 60% of its exposure is attributed to the market portfolio, giving it a relatively low active share.

'Using equally-weighted factor portfolios can further improve the Sharpe ratio' The research paper focuses on some of the most popular smart beta indices covering the US equity market. It should be noted that, unlike academic factor portfolios, the smart beta indices are not defined in a consistent manner and each use a different index construction methodology.

They have chosen the Russell 1000 Value Index and the MSCI Value Weighted Index for the value factor. For the momentum factor, they take the MSCI Momentum Index and for low-volatility the S&P Low Volatility Index. There are no indices

The table also shows that a substantial part (73%) of the performance of the MSCI Momentum Index is attributable

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QUANT INVESTING Table 1. Results using cap-weighted factor portfolios Market

Value

Russell 1000 Value

23%

MSCI Value Weighted

60%

MSCI Momentum

25%

S&P Low Volatility

MSCI Quality

Momentum

Low Vol

Profitability

Investment

Total

Outp (ann)

T-stat

36%

20%

1%

21%

102%

-0.62%

-1.49

29%

8%

6%

103%

-0.08%

-0.24

1%

99%

0.08%

0.10

71%

83%

2.28%

2.36

99%

0.14%

0.29

103%

1.08%

73%

12%

23%

MSCI High Dividend

76%

20%

83%

1.03

Source:Â MSCI, S&P, Russell, Kenneth French & Robeco

to the momentum factor portfolio. The remaining weight goes to the market portfolio. The S&P Low Volatility Index loads heavily on the low volatility factor portfolio (71%), combined with a little value exposure. These figures suggest that although both these indices are quite suitable for obtaining some momentum and low-volatility factor exposure, they do not offer maximum exposure to these factors.

The MSCI Quality Index is heavily tilted towards the profitability factor portfolio (76%). However, it does not provide exposure to the other new Fama-French factor, investment, which could be seen as another dimension of the quality factor.

None of the smart beta indices considered here appear to be very useful for investors specifically seeking exposure to the investment factor.

Interestingly, the MSCI High Dividend Index provides a huge (83%) exposure to the low volatility factor portfolio in addition to some value exposure. Although this index outperforms its replicating portfolio of factor strategies by over 1% per annum, the outperformance is statistically insignificant, which implies that there is insufficient evidence for added value

14

'The amount of exposure smart beta indices offer can differ significantly' beyond classic low-volatility and value factor exposure. The performance of the other smart beta indices is also in line with their factor replication portfolios. The one exception being the S&P Low Volatility Index, which shows an economically large (over 2% per annum) and statistically significant outperformance.

However, that outperformance disappears entirely if equally-weighted factor portfolios are also included in the analysis, as shown in Table 2. In this case, for the S&P Low Volatility Index they find an 84% exposure to the equally-weighted low volatility factor portfolio, plus another 8% exposure to the cap-weighted low volatility factor portfolio, and a performance difference which is close to zero.

From this table, it can also be concluded that most of the performance of the other smart beta indices is not attributable to equally-weighted factor portfolios, since most of the weight still goes to the cap-weighted factor portfolios. As equally-weighted factor portfolios show a

better performance than capweighted ones, this suggests that smart beta indices may not capture the full potential of factor premiums.

Conclusion: smart beta strategies may not be optimal The main findings of this research paper demonstrate that factor investing using popular smart beta indices is not as straightforward as it might seem. These strategies typically seem to target one particular academically-defined factor, but in reality the amount of exposure they provide to that factor can differ significantly. Many smart beta strategies not only fail to offer maximum factor exposure, but also contain either a significant amount of market index exposure or unexpected exposure to other factors.

Another reason why smart beta indices may not fully take advantage of factor premiums is because in most cases they seem to be exposed to cap-weighted factor strategies, while equally-weighted factor strategies are known to generate higher returns. These results imply that smart beta indices may be used to harvest generic factor premiums, but that it is

Robeco QUARTERLY • #1 / SEPTEMBER 2016

QUANT INVESTING Table 2. Results using cap-weighted and equally-weighted factor portfolios Market

Value

Momentum

CW

EW

CW

EW

Low Vol CW

EW 13%

Russell 1000 Value

24%

27%

5%

12%

MSCI Value Weighted

54%

20%

6%

13%

MSCI Momentum

25%

S&P Low Volatility MSCI Quality

Investment

CW

EW

CW

3%

17%

1% 12%

8%

23%

MSCI High Dividend

Profitability

84% 76%

12%

8%

83%

Total

Outp

T-stat

EW

(ann)

T-stat

1%

103% -0.99% -2.52%

9%

102% -0.31% -0.96% 99%

0.08%

0.10%

92%

-0.03% -0.05%

99%

0.14%

0.29%

103%

0.84%

0.80%

Source: MSCI, S&P, Russell, Kenneth French & Robeco

also crucial to properly understand the characteristics of these indices in order to obtain the desired amount of exposure to each particular factor, and the intended

portfolio risk-return profile. Although smart beta indices exhibit a performance that is in line with the amount of factor exposure they provide, they do not appear

to unlock the full potential offered by factor premiums.

Taking smart beta to the Asian market Jason Hsu is one of the best-known names in smart beta investing. After more than a decade at Research Affiliates, where he helped develop a pioneering fundamental indexing approach back in 2005, he recently founded a new company, Rayliant Global Advisors, offering smart beta and quantamental products to the Asian market.

How do you see factor investing today?

“Ten years ago factor investing was seen as something very quanty, very niche, and very hard to market. But the advent of the smart beta label – in what was essentially a rebranding exercise – has propelled factor investing into the mainstream.”

Does its increased popularity mean smart beta is in danger of getting crowded?

“Yes – too much inflow will always have an impact on forward-looking returns.

But smart beta encompasses different factors and a vast number of products that provide access to them and these tend to wax and wane in terms of popularity.”

“It has become much more accessible and, more importantly, much cheaper.

Awareness of factor investing has increased, but the greater availability of products, lower costs and the resulting better investment results have had the greatest positive effect.”

“Recently, low-volatility and qualityoriented strategies have attracted most attention and performancechasing inflows and now look more expensive from a valuation perspective, both historically and relative to value strategies.”

Robeco QUARTERLY • #1 / SEPTEMBER 2016

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QUANT INVESTING

What’s the background of your move into the Asian market?

“Bill Sharpe, one of the originators of the capital asset pricing model, has often asked me: If fundamental indexing or value investing really works, who’s the dummy on the other side of the trade?

That’s a good question. Studies show

Is there a risk that factor premiums could be arbitraged away in the future?

“An interesting question and something I researched with two other professors.

We first looked at value, because it’s one of the oldest and best-known factors. We tested how much arbitrage profit has been generated and the extent to which potential profit has been arbitraged away.”

“Arbitrage should cause the premium to shrink. But what we found, somewhat surprisingly, was that we were not really seeing arbitrage, but something cyclical.

The premium would fall for a while, sometimes turn negative, but then become positive again and then the cycle would begin all over again. The flows in and out of factors appeared to be driving this. So it’s more to do with trend-chasing than arbitrage.”

“Evidence suggests that people who try to play factors by trend-chasing in a naïve way generally lose money. This also means the premium is fairly safe from arbitrage if there’s enough naive capital affecting prices and thus premiums.”

Does this cyclicality mean sophisticated investors can successfully time factors?

“Flows are quite hard to see, so if you want to time factors you’ll need to look at recent price performance and essentially bet on factor mean reversion. But it’s a bit like playing blackjack: If you count cards well, you may have a slight edge, but you shouldn’t bet a lot on any single hand. To maximize your chance of success you need to play many hands, at a lot of tables, throughout a very long night.”

“But you can’t do this with factors because there aren’t that many to choose from.

What’s more, the mean-reversion period we see is probably over a three- to fiveyear cycle, so either way you’re limited.

While using predictive regressions to time factors might give you a slight edge,

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‘Evidence suggests that people who try to play factors in a naive way generally lose money’ that it’s generally a result of persistent behavioral biases and mistakes made by more naïve investors.” timing factors aggressively is a dangerous business.”

What do you think about Fama and French’s new five-factor model?

“In the past, the quality factor has been confusing. There have been many different definitions, often without a sound theoretical basis.”

“The new model looks at profitability and investment together, which can give a very different view It’s a good test of corporate prudence. You can avoid companies that overinvest because their managers are overconfident or simply like to empire-build (low ROE and very high investment), and find firms with solid profitability resulting from high-ROE projects and relatively conservative levels of investment.”

“So it makes sense to go to markets where there is very high retail speculation rather than those where assets are mainly handled by professional managers. Retail participation can be as high as 80-90% in Asia. There are also relatively few institutional-quality managers in the region, so it’s a great opportunity for someone with the potential to disrupt the ecosystem.”

And are you seeing lots of interest from regional investors?

“It’s still early days, but we are seeing very strong interest. There’s definitely a craving for high-quality institutional managers, and a fascination with our model-based, systematic, research-oriented approach.

We expect the solutions we offer to strongly appeal to investors in the Asian market.”

“Financial literature demonstrates that both these characteristics are undervalued by investors, so there’s strong potential for them to be successful.”

Robeco QUARTERLY • #1 / SEPTEMBER 2016

America – a melting pot of opportunity mixed with stalemate America is a melting pot of opportunity mixed in with political stalemate that will give its new president a difficult path to steer, says Chief Economist Léon Cornelissen.

Speed read

Opinion

• Inflation and interest rates will determine future US economic policy • Presidential and Congressional elections in November are key • Oil price is important as the shale energy revolution continues

Cornelissen cites four factors that will determine America’s future over the coming years: its interest and inflation rates; the ability of the US to use fiscal as well as monetary policy to avert a recession; the shale oil revolution and associated oil price; and the outcome of the presidential and congressional elections on 8 November.

And much depends on who will become the new US president, in an outcome that would be historic either way, with Democratic candidate Hillary Clinton becoming the first woman commanderin-chief, or her Republican rival Donald Trump becoming the first businessman outside of mainstream politics to take the job, Cornelissen says.

“Economically, the US had a very weak first half in 2016, but it’s now improving, with labor and wage growth picking up,” he says. “There are two worrisome points economically – one is that the post-Lehman recovery has been very timid, and that labor productivity is collapsing, which some say is a structural feature, though I have my doubts.”

“The second is that investments are lacking and one can debate whether sluggish growth is the cause of this, but it’s true that sentiment is still weak, and companies remain cautious. Part of the reason for this is government policy has been paralyzed because of a Democratic president and a Republican Congress causing a stalemate throughout the Obama years, so this weak investment and lower productivity is a worry.”

Meanwhile, the US base interest rate range of 0.25%-0.5% – following a hike for the first time in almost a decade last December – remains below the most recent inflation rate of 0.8%, meaning real rates are slightly negative. “If you have lower real rates of interest due to structurally lower growth potential, it means monetary policy should be looser than it was in the past, to get the business cycle going again,” Cornelissen says. “But the Fed is hugely divided on the ‘true’ level of real interest rates and the growth potential of the US economy, and has been very cautious, which has to be welcomed.”

‘Government policy has been paralyzed because of a Democratic president and a Republican Congress’

Robeco QUARTERLY • #1 / SEPTEMBER 2016

Fiscal vs. monetary stimulus So, is the US slowly sleepwalking into a recession after seven years of growth?

Usually the American economy retracts every five or six years according to the prevailing business cycle, though the financial crisis of 2008 ushered in a world of unprecedented low interest rates that

17

Opinion has turned economic forecasting onto its head.

“In terms of historical averages it’s about time that the US drifts into recession, but then a cyclical upturn doesn’t die of old age,” says Cornelissen. “At the moment we are seeing increasing leverage in US companies, but we’re not seeing the kind of excesses that are normally associated with the end of an economic upturn. So we’re not really in the full bull market phase, and this gives some comfort. However, the recovery since the financial crisis has been timid, and some kind of external shock could still push the US into recession.”

“And if the US does drift into recession, then of course the monetary arsenal available is mostly empty. It would be much more sensible to switch to fiscal stimulus by raising expenditure on public projects, or by increasing employment, for example.

The question is whether the next president would be able to get this sort of fiscal stimulus through; it goes back to the political stalemate being the real problem.”

“Oil is an important factor, but it’s difficult to make a call on the future oil price because the behavior of OPEC countries is so unpredictable,” says Cornelissen. “If the oil price comes down then inflation comes down, and so the pressure on the Fed to raise rates will diminish. The market is quite relaxed about Fed policy: the consensus is for a 50% chance of a rate hike in December, though I think it’s a bit more likely. If this happens then it would be a good sign, as it would mean the Fed is confident about the strength of the US economy, allowing a moderate rate hike.”

US elections are key The future course of America will be determined on 8 November, when elections take place for the next president, the entire House of Representatives and one-third of the Senate. “For economic policy, it would be a good thing if the president and Congress are of the same political color, be that either Democratic or Republican,” says Cornelissen. “What’s important is not to have the continued kind of stalemate that has bedeviled the US, with a Republican Congress vetoing any initiatives by a Democratic president, or vice versa.”

Low oil price is a mixed blessing Cornelissen says much depends on the future of the oil price, a double-edged sword for the US which for decades has been a net importer of energy. On the one hand a low oil price benefits gas-guzzling consumers and keeps inflation low, but it also means lower revenue for those small producers that have driven the shale oil revolution in the US.

“So the outcome of the US elections is important to see how much room for maneuver the next president will have on this front. Continuing political stalemate means the US economy would be vulnerable if it drifts into recession through some external shock, and it can’t use the recipe of fiscal policy due to the stalemate. The job of being the next US president isn’t necessarily something you should strive for.”

‘If the US does drift into recession, then the monetary arsenal available is mostly empty’

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Robeco QUARTERLY • #1 / SEPTEMBER 2016

Digitization and connectivity drive ground-shifting new business models New technologies are often seen as disruptive forces. But more often than not it’s the new business models enabled by new technologies that are the true source of disruption. So investors should focus on business model innovators, says trend-specialist Steef Bergakker.

Speed read

Trends

• Digitization coupled with connectivity is the common denominator • Network-based business models are potentially more disruptive • Business model innovators outperform traditional innovators

While new technologies often play a very important role in changing the dynamics of competition, more often than not, it’s changes in business models that play a decisive role in determining which companies will succeed or fail. Why did Google succeed where AltaVista failed? Certainly Google’s superior PageRank search algorithm played an important part in its early success, but it was the introduction of the clever clutter-free family of advertising programs Adwords, Adsense and Doubleclick, a business model innovation, that was the key to the company’s success and subsequent market domination.

In a similar vein, Facebook outgrew first mover MySpace. Not through its superior technology, but because it provided a superior user experience by listening and quickly responding to evolving user demands. Again, an example of business model innovation. It’s a popular notion that the replacement of film-

based photography with the digital camera was what sunk Kodak.

But, in fact, it was Kodak that invented the digital camera. Clearly, it wasn’t the new digital technology itself that lay at the root of Kodak’s demise, but its failure to design an appropriate business model.

The recent meteoric rise of disruptive business model innovators like Uber and Airbnb in hitherto slow-moving industries like personal transportation and accommodation lends anecdotal support to the notion that business model innovation can be an incredibly potent force for change. It pays for investors to keep tabs on business model innovation. According to a Boston Consulting Group analysis1, business model innovators clearly outperform traditional innovators over time. And the dominance of business model innovation over technological innovation as captured in process and product innovation is reflected in superior investment performance.

Potentially disruptive new business models We foresee five categories of new business models that should gain ground over the coming decade. For this we expand on an influential management strategy paper by Stabell and Fjeldstadt2 who proposed a framework of three generic business configurations to understand and analyze value creation logic at company level. We combine their ideas with the cost, experience

Five categories of new business models and their likely impact Five categories of business

Sustaining /

model innovations

Disruptive change / activities

activities

Personalization

Sustaining

Traditional discretionary consumer goods /

Everything as a Service

Sustaining

(XaaS)

Opportunity-rich industries / commercial areas Challenged industries / commercial areas / Personalized medicine; high profile discretionary consumer goods

medicine manufacturing

Industrial Internet of Things; infrastructure

Traditional capital goods manufacturing / after

services (e.g. light, cloud or flying hours)

market business models

Peer-to-peer networks

Disruptive

Crowd-based financial services (funding,

Traditional financial services / telecommunications

Online market places

Disruptive

Online retailing/wholesaling; online auctions;

Brick-and-mortar retailing / wholesaling; traditional

social media

auctions

Personal transportation; lodging, office space

Lodging; transpo­rtation / power generating utilities

lending, trading); P2P communication

‘Sharing economy’

Disruptive

Robeco QUARTERLY • #1 / SEPTEMBER 2016

19

products and services. Provided incumbents keep their eyes on the ball, they should be well-positioned to successfully make the transition to these new business models.

‘The ‘networkization’ of many industries is the most disruptive force’

and platform value implications of increasing digitization and connectivity as the principal underlying drivers of technological change in our time. The table lists the five categories and summarizes our views on their likely impact.

Of the five categories, we deem peer-to-peer networks, online market places and ‘sharing economy’ business models (these offer increased access to physical assets), to be potentially disruptive in nature, whereas personalization and ‘everything as a service’ business models are more likely to prove to be sustaining innovations benefiting incumbent firms. Disruptive business models are concentrated in network-like business configurations.

The principal reason for this is that peer-to-peer networks, online market places and sharing economy business models display network characteristics and, once a critical size threshold is surpassed, can potentially profit from non-linear network effects. Over time, the platforms this creates tend to become very dominant as they represent a kind of higher-order customer benefit that has inherent value-amplifying characteristics. As a result, incumbents find it very hard to compete as the traditional advantages of scale and scope tend to become irrelevant.

Conversely, we feel that incumbents’ advantages of scale and scope will remain very relevant if personalization and ‘everything as a service’ business model innovation occurs too. From the incumbents’ point of view, competition in these traditional value chain configurations tends to evolve along familiar dimensions of cost and experience value. In addition, there usually is an installed base that can serve as a semi-captive launching pad for new

20

Not only are network-based business models potentially more disruptive, they also spring up much faster and more frequently than business models based on a value chain or value shop configuration as they are perfectly suited to aggregating, retrieving and accessing distributed information, knowledge and resources.

Digitization and connectivity form the root of most disruptive technologies There are 12 disruptive technologies, according to McKinsey Global Institute3, that have the potential to transform the we way we live and work, enable new business models, and provide an opening for new players to upset the established order. Mobile internet, cloud technology, advanced robotics and renewable energy are a few of them. The common denominator and underlying force of almost all new technologies is digitization coupled with connectivity. Digitization spurs higher performance at a fraction of the cost and facilitates the development of new business models.

Changing value propositions based on digitization can be grouped into three categories: cost value, experience value, and platform value. Platform value is the most disruptive competitive force.

The dramatically increased possibilities to connect and interact with other people and even inanimate objects are defined as platform value. We expect to see a proliferation of virtual market places, peer-to-peer networks and the ‘sharing economy‘. Given the disruptive potential of platform value we see this as the most significant trend for investors.

Takeaways for investors are twofold, in our view. First, networks that have critical mass and exhibit positive network externalities are extraordinarily valuable as they usually grow to dominate their industry and, once established, are extremely difficult to dislodge.

Second, industries with physical assets that can either be digitized, digitally knitted together into a network or both, are vulnerable to disruption. Investors must realize that business model innovation is an important source of disruption, more so than the introduction of new technologies.

1. Zhenya Lindgardt, Martin Reeves, George Stalk, Michael S. Deimler; Business Model Innovation; The Boston Consulting Group, December 2009 2. Stabell and Fjeldstadt; ‘ Configuring Value for Competitive Advantage: on Chains, Shops and Networks” ; Strategic Management Journal, Vol.19 (1998) 3. McKinsey Global Institute; Richard Dobbs et al.; May 2013; “Disruptive technologies: Advances that will transform life, business and the global economy”.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

SUSTAINABILITY investing

Limiting risks by integrating ESG In our factor-credit strategies, we aim to harmonize two objectives: ensuring maximum factor exposure while limiting the exposure to unsustainable companies. At times these two objectives might contradict; financially attractive bonds are not necessarily attractive from a sustainability perspective (or vice versa). Maximizing the sustainability of a portfolio may lead to a deterioration in the factor exposures, thereby lowering expected returns. To avoid these unintended effects, we evaluate a bond’s attractiveness and the company’s sustainability at the same time. Companies with higher sustainability ratings have a higher chance of ending up in the portfolio.

Our primary objective is still to have optimal factor exposure, and we do so while controlling the sustainability of the portfolio. Rather than applying negative screening, our sustainability integration follows a symmetric approach where we not only dislike sustainability laggards but also prefer sustainability leaders. Moreover, imposing restrictions at portfolio level avoids potential adverse effects that might lower expected returns.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

21

SUSTAINABILITY INVESTING

Tackling the increasing threat of cyber crime Cyber risk should be addressed at board level as it poses an increasing threat to companies and investors, says Robeco’s head of Governance and Active Ownership.

Corporate risk oversight Many companies view cyber security risks as simply a hacking threat that can be combatted with anti-virus software, while others don’t train staff in how to deal with a problem, warns Carola van Lamoen. And for some companies, the very software they use to conduct business may be exposing them to serious risk, she says.

“One of the main takeaways was that cyber risk is now so serious it is something for boards to directly address as part of their corporate risk oversight,” says Van Lamoen. “In the past, cyber risk was an issue that was dealt with by some department on the 4th floor, but that’s no longer acceptable.”

The issue was hotly debated at the annual conference of the International Corporate Governance Network (ICGN), whose Corporate Risk Oversight Committee is co-chaired by Van Lamoen. The committee launched a Viewpoint outlining its aims on cyber risk which was widely circulated among ICGN members.

“It has become an issue of how cyber risk oversight is arranged, and whether boards are aware of their need to act and

‘You only really know if it's not enough when something goes wrong‘

communicate. There is significant room for improvement here because cyber risk has increased, in two main areas: the risk of being hacked as the cyber criminals become more professional, and the risk of the wrong implementation of software.

Even without a hacker, substantial risks can be faced if you don’t have your IT department in order.”

High profile hacks Some recent high profile cases include USD 81 million that was stolen from Asian financial institutions using a malware link; ‘denial of service’ attacks that brought down websites; and hacking that led to sensitive credit card details being stolen from online retailers.

An example of the major impact of wrong implementation of software was Knight Capital, which deployed untested software to a production environment containing a bug. When the firm released the software into production, their trading activities caused a major disruption in the prices of 148 companies listed on the New York Stock Exchange; Knight Capital’s stock price collapsed by 70%.

Van Lamoen says there is a danger that companies which are hacked will hush it up to avoid any embarrassment, leaving investors in the dark. “It differs between companies. Obviously as an investor it’s good to know first of all how a company is dealing with it. They need to be transparent on who is ultimately responsible, how cyber risks are mapped and what systems are maintained to

22

Robeco QUARTERLY • #1 / SEPTEMBER 2016

SUSTAINABILITY INVESTING

prevent incidents, and if any incidents do happen, how this will be addressed,” she says.

Company culture vital Some viruses get into a company when an employee clicks on a link in their email while using a corporate computer without realizing that it contains malware that is sophisticated enough to bypass firewalls. “So you should create a culture where people are not worried about reporting a problem if something goes wrong, because otherwise it can be harmful to the company,” Van Lamoen says.

“This starts at the top, through boardlevel oversight. Board members should provide adequate resources to deal with these kinds of issues. Non-executive

directors should build awareness of cyber risks, and investors should be prepared to engage with both directors and executive management to ensure that these risks are given appropriate attention and oversight.”

“That is a big topic of debate: what resources do you actually need for this, and what is enough? It’s difficult to say – you only really know if it’s not enough when something goes wrong. But we accept that there are limits to what companies can do.”

The Viewpoint includes a three-point plan for investors to consider. It advises that companies should have: 1. Strategy process and plan oversight,

2.

3.

with an assessment of what business operations are most vulnerable to cyber attack; Risk program management oversight: led by how the company is improving alignment between its business and IT strategies; Risk response readiness: particularly how does a company’s cyber risk response plan fully address the ‘what ifs?’ and warning signs.

“Taken together, these illustrate the need for board members to ensure an approach is used that is designed for complex, dynamic environments,” says Van Lamoen.

“It is important that cyber risk oversight is integrated with the strategy and risk management of the company.”

Engagement with Olam mutually beneficial We are convinced that engaging with companies on the most material sustainability issues enhances their competitiveness and profitability. It also generates measurable benefits for investors and society.

Our engagement with Olam is a case in point.

Olam International is one of the most diversified companies supplying raw and processed agricultural commodities to large food manufacturers and retailers.

In March 2014, Temasek, a Singapore based sovereign wealth fund, acquired an 80% stake in the company. Our portfolio managers supported this. In 2016 Temasek reduced its stake to 51.4% in another deal with Mitshubishi, which bought 20% of the shares. Since we started our engagement theme ‘Social issues in the food and agri supply chain’ in 2014, we have had multiple meetings with Olam’s Global Head of Corporate Social Responsibility & Sustainability to

Robeco QUARTERLY • #1 / SEPTEMBER 2016

discuss social risks in palm oil, cocoa, and cotton cultivation.

Cocoa plantations Cocoa is one of the most important parts of Olam’s business. Cultivating this crop is mainly in the hands of smallholders and is characterized by low yield and involvement of child labor. We visited Olam in London in June 2014, to discuss its strategy towards managing cocoa more sustainably in its supply chain. The company appeared to be aware of the cocoa challenges and one of their initiatives in this area is their ‘Cocoa program’, which focuses on improving yield and thus on improving the economic outlook for the smallholders.

The company has also identified a clear business case for collaboration within the cocoa sector to further the building of smallholder capacity. Olam is involved in a large number of industry initiatives that are combatting child labor on a large scale.

With 3% annual global growth in cocoa demand, and falling production levels in key countries such as Ivory Coast and Ghana, where Olam operates, the cocoa price on the global market is likely to rise.

This will make it increasingly attractive for smallholders to produce cocoa and for Olam to buy it and trade it on the global market.

23

SUSTAINABILITY INVESTING

Palm oil Olam was also one of the companies for engagement within the sustainable palm oil working group of PRI and we joined the group as a lead investor for dialogues.

Olam’s Global Head of Corporate Social Responsibility & Sustainability visited our office in October 2014. We used this opportunity to get insights into Olam’s approach towards managing its palm oil plantations in Gabon. We also communicated investors’ expectations in terms of RSPO (Roundtable on Sustainable Palm Oil) certification and smallholder capacity building. With the help of a consultant, the company identified the parts of their land that should be classified as high conservation value forest (HCVF) and protected wetlands which are not developed, but rather managed as conservation areas. On smallholder capacity building, the company committed

24

‘Another area of importance to us was Olam’s cotton purchasing in Uzbekistan’ to an ambitious plan to develop 30,000 hectares for smallholder palm oil production. This will have a major impact on the agricultural sector in Gabon, which represents just 5% of GDP – small compared with other African countries.

This model makes Olam International a sector leader when it comes to smallholder capacity building.

Later in June 2015, the company renewed its palm oil policy which also covers suppliers. By doing this, Olam is part of a growing group of companies that have developed a policy stipulating strict sustainability requirements on plantations,

traceability of trade and transparency on the status of the objectives outlined in the policy.

Cotton from Uzbekistan

Another area of importance to us was Olam’s cotton purchasing in Uzbekistan. This country is known for widespread practices of child and forced labor. This was also confirmed by a Human Rights Watch report. To take our dialogue forward, we visited the company in London in September 2015.

The company mentioned that it reduced its activities in Uzbekistan by 90% and moved to other neighboring countries.

However, they faced another challenge.

Trade with neighboring countries must be exported via a port in Uzbekistan and the government only issues a permit if the company continues to buy in the country

Robeco QUARTERLY • #1 / SEPTEMBER 2016

SUSTAINABILITY INVESTING

itself. Meanwhile, the child labor schemes organized by the government have largely been resolved by deploying military personnel and teachers during the three weeks of the harvesting season.

Increased understanding Olam has joined the Association for Cotton Merchants (ACME) to work closely with International Labor Organization (ILO), the UN Global Compact Labour Working Group, as well as international governments, to influence Uzbekistan government to enforce recognized labor standards. Olam noted that progress by the Uzbek government has been slower than desired. However, it firmly believes

‘The regular meetings with Olam gave us the desired confidence in the company’s commitment’ that a withdrawal from Uzbekistan at this stage would be ineffective, and would instead inadvertently undermine the advances that have been made, particularly as the Uzbek government has not been short of other international buyers. Having voluntarily reduced its purchases since 2012, Olam is still able to retain a level of access (through ACME) to apply pressure on the government.

We expressed our appreciation for the proactive approach by Olam. The regular meetings with Olam gave us the desired confidence in the company’s commitment and willingness to manage the inherent risks in the cocoa, cotton, and palm oil business. Olam’s openness and readiness to engage with us turned out to be mutually beneficial as the company has used our guidance to fine-tune its strategy. In turn Olam has increased our understanding of the company and its effective program to increase smallholder capacity building.

Integrating sustainability into factor credit strategies The objective of Robeco’s factor credit strategies is to maximize factor exposure at low cost while limiting risks.

Sustainability is an important risk dimension, which is why we integrate it into our investment process.

Sustainability is incorporated into two steps of the investment process. First, our fundamental credit analysts identify any unacceptable Environmental, Social and Governance (ESG) risks in our quantitative bond ranking. And second, when constructing or rebalancing a portfolio we ensure that the portfolio scores at least as strongly on sustainability as the reference index does.

Our primary objective is still to have optimal factor exposure, and we do so while controlling the sustainability of the portfolio. Rather than applying negative screening, our sustainability integration follows a symmetric approach where we not only dislike sustainability

Robeco QUARTERLY • #1 / SEPTEMBER 2016

laggards but also prefer sustainability leaders. Moreover, imposing restrictions at portfolio level avoids potential adverse effects that might lower expected returns.

Factor exposure and sustainability While a portfolio holding in one or two mediocre companies would not be a reason for immediate alarm to most investors, a strong portfolio exposure to unsustainable companies poses a serious risk, as sustainability risks could materialize in the future.

Our goal is to harmonize two objectives: ensuring maximum factor exposure while limiting the exposure to unsustainable companies. At times these two objectives might contradict; financially attractive

bonds are not necessarily attractive from a sustainability perspective (or vice versa).

Maximizing the sustainability of a portfolio may lead to a deterioration in the factor exposures, thereby lowering expected returns. To avoid these unintended effects, we evaluate a bond’s attractiveness and the company’s sustainability at the same time. Companies with higher sustainability ratings have a higher chance of ending up in the portfolio. Implicitly we want to be rewarded with a financial premium when we invest in bonds of less sustainable companies. This enables us to gain optimal factor exposure in a sustainable way.

Portfolio sustainability score We integrate sustainability into two

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SUSTAINABILITY INVESTING

‘A strong portfolio exposure to unsustainable companies poses a serious risk’ steps of our investment process. First, after we have ranked bonds using our quantitative multi-factor ranking model, our fundamental credit analysts check whether the top-ranked bonds have any additional risks that are not captured by the model. In this step, unacceptable ESG risks are identified, in which case the bond rankings are overruled. Second, when constructing or rebalancing the portfolio we require it to have a (weighted) average sustainability score that is at least equal to that of the reference index. This implies that bonds from companies with a favorable sustainability score have a higher chance of being bought.

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We rank companies from most sustainable to least sustainable. We systematically prefer companies with high sustainability scores to companies with lower scores.

Negative screening on the other hand (i.e. excluding the least sustainable companies from the investment universe) only focuses on the worst ESG-rated companies.

Moreover, it might lead to unexpected results. As no limit is set on the overall portfolio sustainability, the portfolio might even score below the reference index. In our approach we prevent this by directly controlling the portfolio sustainability score.

RobecoSAM sustainability scores Our sustainability scores are provided

by RobecoSAM, which has one of the

largest proprietary corporate sustainability databases with nearly 4,000 companies.

Every year since 1999, dedicated sustainability researchers obtain financially material information from a range of public sources and directly from companies by inviting them to the annual Corporate Sustainability Assessment survey.

RobecoSAM follows a best-in-class approach. Companies receive a score between 0 (low) and 100 (high) on environmental, social and corporate governance factors and are ranked against other companies in their industry. To fairly compare companies of different sizes with a range of potential resources, we control the RobecoSAM scores for company size.

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SUSTAINABILITY INVESTING

Higher sustainability without sacrificing returns Before explicitly targeting the portfolio’s sustainability, in 80% of the months the strategy already had a score that was on average higher than that of the reference index. This shows that our preference for low-risk credits in the strategy implicitly leads to a preference for low ESG-risk credits as well.

Maximum factor exposure at higher sustainability The impact of our sustainability integration can be seen in the difference between the portfolios with and without the minimum sustainability score (restricted versus

‘We can have optimal factor exposure in a sustainable way’ unrestricted portfolio). When we require the portfolio to have a sustainability score that is equal to or above that of the reference index, the sustainability scores of the portfolios further increase, while the excess return and volatility stay virtually unchanged. Because we invest in a large investment universe with a high number of attractively ranked bonds, it is possible to be more selective in the bonds we buy and still keep the desired factor exposure.

Our approach leads to a further improvement in the portfolio’s sustainability score without negatively impacting its performance. We require the portfolio to have an average sustainability score that is at least equal to that of the reference index, systematically preferring companies with high sustainability scores to companies with lower scores. By making a tradeoff between factor exposures and ESG risks, we can achieve both objectives: having maximum factor exposure and simultaneously limit the exposure to unsustainable companies.

Investors explain how they want utilities to tackle COP21 Over 270 institutional investors representing more than EUR 20 trillion in assets have published a guide for electric utilities, explaining how they expect them to deal with the low-carbon economy. Engagement Specialist Matthias Narr is the lead author.

‘Investor Expectations of Electric Utilities Companies - looking down the line at carbon asset risk’, was published by the Institutional Investors Group on Climate Change. The authors outline the threats and opportunities for utilities, and explain how they expect them to adapt their business strategies. With over 170 countries committed to the Paris Agreement, institutional investors are concerned that some electric utility companies may not be prepared for the transition to a lower-carbon economy.

The authors want to shape a constructive dialogue between investors and electric utilities. Business strategy and capital allocation decisions made in the coming

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years will determine the sustainability and profitability of electric utilities for decades to come and should give due weight to the low-carbon transition.

During the 2016 voting season, investors clearly showed, for example in resolutions at the Annual General Meetings of shareholders of AES and Entergy, that they expect electric power companies to address carbon asset risk. Asset owners and fund managers need to know how power companies see the future impact of climate change on energy demand and pricing, and how they plan to align their business models with the required greenhouse gas reductions.

The guide also encourages investors to ask electric utility companies about the management of legacy assets, such as power generation plants that are no longer economical to run, either due to a shift away from thermal coal or because of increased water scarcity.

Climate change is already driving structural transformation in the energy sector. It is essential for utility companies to undertake comprehensive 2°C stress testing of their business activities and to disclose to investors how their business model will fare in the face of climate change.

The guide can be downloaded from www.iigcc.org.

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Lower liquidity, collective responsibility The financial industry needs to collectively deal with lower liquidity in bond markets, says Robeco’s head of risk analysis, Robbert Vonk in a recent whitepaper. A look into the liquidity issue.

Speed read

Research

• Structural changes have made it harder to quickly trade bonds • An industry-wide solution is needed on top of internal risk controls • Taking a long-term investment perspective is essential

at once, the market faces a massive problem, Vonk says. “It is in the industry’s and clients’ interest to come up with measures to avoid a disaster scenario like massive fund closures in certain asset classes,” he warns.

The pros and cons of daily liquidity

The liquidity issue

The problem is exacerbated because most asset managers allow clients the freedom to trade in funds on a daily basis. This gives investors the confidence that they can always get their money back – or quickly top up investments should they wish. But it leaves asset managers vulnerable to a sudden exodus if a market turns unexpectedly, as was recently seen with the closure of several UK real estate funds following the Brexit vote.

“The client perception of liquidity can be even more misled by the wide offering of exchange traded funds, which can be traded on an intraday basis, investing in markets which are essentially illiquid,” says Vonk. “This can draw the wrong type of client to certain asset classes.”

Liquidity in the fixed income markets globally has been negatively affected since the financial crisis of 2008. Before the Lehman collapse, banks could hold substantial amounts of bonds purely for trading purposes, and their balance sheets functioned as a buffer.

Following the crisis, regulation enshrined in Basel III forced banks to abandon this function in order to reduce risk. At the same time, mutual funds grew in size, following increased client interest for higher-yielding assets. The lack of a buffer and more concentrated holdings in mutual funds created substantial volatility, leading to bigger shocks in markets potentially exacerbating client reactions (for instance, by selling in bear markets).

Robeco has its own measures to ensure the stability of its extensive range of funds. “There are several safeguards: firstly, through proper risk measurement and secondly, through risk mitigation,” Vonk assures investors. “Robeco has a comprehensive liquidity risk framework incorporating the dynamic that exists between liquidity risks related to assets on the one hand and funding on the other. Asset liquidity risk arises when transactions cannot be conducted at quoted market prices due to the size of the required trade, or, worse, when they cannot be conducted at all.”

Structural changes in the market are making it more difficult to quickly trade bonds, particularly under stressed conditions, Robbert Vonk warns. Robeco has taken internal measures to protect clients and is also working with regulators and other asset managers to discuss industry-wide solutions. In addition, clients are advised to have a long-term investment perspective and to act counter-cyclically.

A second problem resulted from the 2008 introduction of quantitative easing, whereby central banks printed new money and used it to purchase government bonds. Eight years later, some central banks own up to one-third of their domestic bond markets, thus taking these securities offline. The European Central Bank is now also buying non-bank corporate bonds, which may make the situation worse.

Meanwhile, persistently falling interest rates have led many investors to believe that bond yields cannot fall any further.

If yields start to rise then prices will start to fall, potentially starting a stampede to sell them. And if everyone tries to sell

“This type of risk tends to be compounded by other risks: when markets are falling or are very volatile, or when the creditworthiness of counterparties deteriorates; at these times, liquidity tends to dry up. Funding liquidity risk relates to the ability to redeem fund clients without significantly impacting the value of the portfolio. This kind of risk will only arise if there is limited asset liquidity, so the latter is dependent on the former.”

‘If everyone tries to sell at once, the market faces a massive problem’

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Robeco’s risk policy focusses on verifying whether the current portfolio is liquid enough to meet substantial future redemptions, Vonk adds. “If not, the

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portfolio will explicitly be discussed in the Risk Management Committee and measures will be taken.”

“Additionally, exposure to illiquid instruments is restricted at portfolio level. And Robeco maintains a detailed contingency plan which outlines the course of action in the event of severe liquidity crises, either as a consequence of severe cash outflows or unusual market distress. We also have strict rules to make sure we have sufficient cash buffers,” says Vonk. "For instance, the Robeco High Yield Bonds fund holds a minimum of 5% of the fund in cash equivalents. In more stressed situations this can go up to 7-10% of the fund held in cash.” Robeco has also ensured that the funds have the ability to temporarily run a deficit if necessary.

Collective response That said, the industry still needs to formulate more structural measures for some asset classes, says Vonk. “We strongly believe that the industry can benefit from further harmonization across different jurisdictions with respect to the risk management tools available to fund managers,” he says.

“This includes tools such as notice periods, and the availability of anti-dilution practices, like swing pricing, which will ultimately benefit the fund’s investors. Moreover, in order to reduce the likelihood of material mismatches in offered versus available liquidity, authorities should have a clear stance on what trading frequencies are considered acceptable for certain asset classes.”

“This needs coordination though. Nobody is willing, for example, to unilaterally move away from daily liquidity to say, 10-day liquidity or monthly liquidity. If your neighbor isn’t doing it, and you start doing it, you can be sure that everyone will exit the fund.”

Robeco is actively collaborating with regulators and other interest groups to consider implementing a crossindustry response. The firm is also working closely with industry associations such as the International Capital Markets Association (ICMA), contributing to a paper entitled ‘Managing fund liquidity risk in Europe’, which was presented to the European Fund and Asset Management Association for discussion in April 2016.

‘Slowly we have been turning towards the same vision’

He says a sign that the industry is moving in the right direction is the recent consultation paper by the Financial Stability Board (FSB) entitled ‘Proposed Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities’.

“This paper outlines very sensible proposals to harmonize and make the industry and markets more resilient to this low liquidity environment,” he says.

Long-term perspective and acting contrarian “We have frequent discussions on this with our fellow asset managers,” says Vonk. “Slowly we have been turning towards the same vision that something needs to be done. And we don’t want regulation to be counter-productive in that by mitigating a certain risk it creates a new one. So we need good interaction with the regulators so we can have a discussion on the proper way of dealing with it.”

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Investors can also help by adopting a long-term approach to investing and not panicking during market shocks such as the recent Brexit crisis, Vonk concludes. “We advise clients to have a long-term perspective when investing in certain asset classes and, in line with Robeco’s own investment philosophy, we advise people to invest in a counter-cyclical manner, so to stay ahead of the curve,” he says.

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Are low-vol stocks now too expensive?

Investors are worried about the high valuations of stocks in general and low-volatility stocks in particular. And so are we!

In relative terms, low-volatility stocks have become more expensive during the last two years, but it’s not the first time.

It happened first in 2008 and again in 2011. is currently priced at a 5% discount to the market, while the MSCI Minimum Volatility Index is priced at a 15% premium.

A valuation gap of 20%. This offers our active low-volatility portfolio a substantial margin of safety compared to a generic low-volatility portfolio.

Speed read • Low-volatility stocks have become more expensive • Robeco Conservative Equities is priced at a discount • We have been able to deliver equity-like returns with less risk

Research

Conclusion

Low-volatility stocks have been trading at higher valuation multiples than the global equity market for years. The MSCI World Minimum Volatility Index, for example, has been more expensive than the broader market since 2009. During such periods, which can stretch into decades, there are large performance differences between generic and enhanced low-volatility strategies. When low volatility is expensive (about one third of the time), low-volatility stocks that score well in terms of valuation and momentum outperform generic low-volatility stocks by a hefty 6% per year. 1

Over the past ten years, the Robeco Conservative Equity approach has lived up to its promise to deliver equity-like returns with less risk. We believe that it is necessary to include valuation to achieve

‘Robeco Conservative Equity has lived up to its promise to deliver equity-like returns with less risk’ superior long-term returns. A previous long-term study on this topic, with data going back to the 1920s, supports an enhanced low-volatility approach which includes valuation and momentum.

Especially when generic low-volatility stocks are relatively expensive, as they are today, it is important to mind the valuation gap.

Relative Valuation

Let’s take a look at the numbers. The graph below shows the changes in the relative valuations of generic low-volatility strategy MSCI Minimum Volatility World Index (orange line) and our Global 1. Van Vliet, P., Enhancing a low-volatility strategy is particularly helpful when generic low volatility is expensive, Robeco client research paper, June 2012 Conservative Equities strategy (blue) relative to the MSCI World (black) over the past ten years.

Relative valuation of Minvol Index and Conservative Equities 2006-2016 As a result of the good relative performance, the 120% multiples of both the Conservative Equities Fund and the Minimum Volatility Index quickly expanded by 110% about 20% during 2008. After multiples contracted in the following years, we witnessed another increase 100% in multiples during the sovereign debt crisis of 2011 (in Greece and the European periphery). This was also 90% followed by a period when multiples contracted again.

Since 2013 we have again observed a gradual increase in relative valuations.

80% Sep-06

Anyone who believes in the merits of value investing, including us, should be worried about generic lowvolatility stocks becoming more expensive. But what the figure also shows is that Robeco Conservative Equities

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Sep-08

Sep-10

Conservative Equities 'cheap'

MSCI world

Sep-12

Sep-14

Sep-16

MSCI Minvol 'expensive'

The relative valuation is based on a robust mix of five valuation multiples: price to earnings (P/E), forward price to earnings (Forward P/E), dividend yield (DY), price to book value (P/B) and EBITDA to enterprise value (EBITDA/EV).

The MSCI World Index is fixed at 100% throughout the period to control for market movements.

Source: Robeco, FactSet, MSCI

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LAST BUT NOT LEAST

Facing the challenges The asset management industry is lagging behind in terms of introducing new technology. Customization of products as well as thinking in terms of solutions versus pushing products is not yet widespread. We think there is a great opportunity for asset managers to use technology to deepen their customer understanding. The competition is not asleep though, and partnerships might be a good strategy that allows for a quick rollout. During the past years a lot of robot advisors have been launched in the US and the UK. These are online platforms that, in their current form, offer personalized asset allocation advice which is mainly used for pension investing. Since actually advising people on investments is strictly regulated, these companies are not truly advising, rather ‘informing’ clients. In that way they do not have to comply with all regulations within asset management yet, but we expect regulation to pick up quickly.

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The future of asset management Patrick Lemmens and Jeroen van Oerle During the past decade, the asset management industry has mostly been occupied with regulatory changes dictating costly compliance procedures. In addition to increased regulatory costs, fee pressure has had a large impact on the industry as well. In the coming years we believe these two forces will remain top of mind, but the drivers are different now.

Technology has entered the asset management industry. This will add costs because asset managers have to live up to ever-increasing customer demands regarding immediacy, connectivity and ubiquity.

At the same time, this leads to an increase in fee pressure due to growing transparency, comparability and competition from nonfinancial companies. We think the asset management pie is still growing strongly, but not everyone will be invited to take a piece.

In this article we will address three questions: – What is driving change in the asset management industry?

– How will this influence asset management?

– Who will the winners and the losers be?

Six drivers of change in the asset management industry We believe a range of categories are indicative of change in asset management. We will first look at the overarching themes of demographics, technology and regulation. Subsequently, we will zoom in on three trends that are changing the asset management industry in particular, namely the popularity of indexation, the shift from institutional to retail money and the growth in demand for multi-asset solutions.

The most important demographic trends, such as population growth, aging, working longer and the emerging middle class, are positive for asset management. The pie is growing.

There are several social trends that can impact certain demographic developments, such as the increasing influence of the developing world on asset management in combination with social, political and cultural differences. In itself, the asset shift towards developing countries is positive, because it will bring new clients. However,

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in several emerging markets the attitude towards investing is very different from that in the developed world. Investing is sometimes seen as gambling rather than as a tool for long-term asset accumulation. Most of the social trends, such as immediacy, transparency and demand for personalization, require large investments in technology.

An additional complicating factor is the problem that social trends relate to a cross section of the entire population. Generational differences play an important role and result in a wide-range of different requirements. The baby boom generation has very different needs from the younger generation. It is focused on asset preservation, while younger generations require asset accumulation. Different generations have different thoughts about using technology, trusting advisors and managing money. Demand for customization is increasing.

Technology: digitization versus digitalization Technology is the fast changing element in the transformation.

It is very important to differentiate between digitization and digitalization. Referring to the definitions in the Oxford dictionary, digitization is the process of making analogue input digital. Digitalization refers to the process of using technology to better interact internally and externally (with clients). The asset management industry in particular is at the forefront of digitization, but is far behind in terms of digitalization.

One of the competitive advantages of asset management versus technology companies is their abundance of decade-long customer data. Contrary to popular opinion the increased quantity of data as well as the introduction of tools such as blockchain is in itself not a disruptive threat to the asset management industry. Software and capabilities are readily available to many companies. Although not a threat to incumbents, it is costly to maintain records and implement new technologies. Companies that are only focusing on costs will have a hard time making the crucial strategic investment decisions.

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Whereas the asset management industry is on top of developments in the processing of data, it is lagging far behind developments related to the interaction with clients. Customers that were previously not interesting (low-wealth individuals) are now becoming a new market because technology enables them to be serviced at low cost and in large volumes.

The emergence of robo-advice is one of the most recent results. These technology companies step in between the asset management industry and their clients.

There is a real threat that the customer relationship will be lost. To counter this threat, asset managers need to invest heavily in technology and form strategic alliances with technology providers. Most robo-advisors do not offer alpha creation, but focus on the unmet need for beta allocation. By combining the need for beta with low-cost technology, this has become available to a group of people who could not previously be serviced. In a 2015 survey by CaseyQuirk, 70% of US financial advisors indicate they want more digital investment oriented advice from their asset managers.

their institutional portfolios (source: Greenwich Associates, 2014).

When combining the separation of alpha and beta with a greater focus on risk and the lower expected returns on the fixed income side, the increase in popularity of index funds is not solely the result of cost considerations. The high liquidity and flexibility of core index funds also offer an easy route to obtain and rebalance tactical asset allocation. Since alpha and beta can now be separated, the customer is only willing to pay for true alpha creation which implies ‘benchmark hugging’ is no longer acceptable. The ‘true’ added value of active management in terms of generating alpha is becoming a focus point.

‘New technology, new opportunities, new players, new threats’

Continuing trends Regulatory focus on capital, liquidity and market stability has grown. The amount of regulatory change that will be fired at the asset management industry in the coming years will be substantial.

According to a 2015 study by Morgan Stanley, this is estimated to increase compliance costs by an average of between 1 and 5 percentage points. If all the costs are added up, the operational margin impact is estimated to be between 50 and 100 basis points.

This burden will most likely hit smaller asset managers hardest, because the large asset managers have already been preparing for regulatory compliance for a long time.

A trend more specific to the asset management industry is the popularity of index funds. Exchange traded funds are currently a USD 3 trillion market with 6,780 products traded on 60 exchanges (source: Bloomberg). Although the cost component is often assumed to be the main reason for switching from active to passive, the main reason why people are looking for lower cost solutions is that the alpha and the beta components are being separated.

An increasing number of institutional investors are no longer willing to pay for the alpha component as not many asset managers have been able to deliver alpha after fees. In the past this relative alpha underperformance was accepted because investing in active mutual funds was a way to generate international diversification in a cost-efficient way. With the introduction of exchange traded funds this has changed as beta exposure is now available at low cost.

69% of asset managers use ETFs primarily for core allocation in

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Another strong and very important trend observed in the asset management industry is the shift of power from institutional investors to retail investors. The declining role of institutional clients is a result of pension withdrawals by retirees, sovereign funds that are no longer growing (such as oil related sovereign funds) and the insourcing of asset management capabilities by large asset owners such as insurance companies.

Changing demographics require a change in asset mix. Pension changes across the world increasingly support liability driven investing (LDI) and low-volatility solutions. Both require a mix of equity, fixed income and alternative investments. However, the growth in demand for multi-asset solutions is not just the result of aging. The fact that multi-asset product solutions have become available at very low cost is also contributing to their popularity.

Multi-asset strategies are not easy to implement though. Managers need scale and a very highly skilled team that can handle the complexities associated with combining multiple asset classes.

There are only a few asset managers that can offer these services in a cost-efficient way.

How will these trends influence asset management?

We think there will be three main impacts, i.e. consolidation, the re-organization of the sales force and a dramatic change in the wholesale channel.

1. First, the trends of fee pressure, regulatory cost increases and demand for multi-asset solutions will increase the need for scale.

Fee pressure is likely to continue. Not only has competition from within the industry increased with the introduction of low cost passive solutions, competition from non-traditional companies is also growing. Increasing regulatory cost is another reason why

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scale is important. Compliance costs are simply too high for small asset managers to be able to be cost-competitive.

2. The second general impact from the trends we describe above is in our view the re-organization of the sales force due to the shift from institutional to retail. Currently many asset management sales teams are focused on creating cost-efficient ways to target institutional clients. These processes are generally efficient in terms of ‘sales effort per unit assets under management (AuM)’. The sales process to retail clients is very different and in many cases less efficient when expressed in terms of the effort per unit of AUM. The only solution to this is to use technology and standardize.

3. The final general impact is on the changing role of wholesale.

We believe we will end up with two customer groups for asset managers, either retail or institutional. We think the retail client is either going to be approached directly by asset managers that use customer-centric technology, or will search aggregator platforms for solutions. Paying a hefty sum of money in order to receive fund advice is likely to become less appealing, given the abundance of comparability enabled by technology. There is significant potential for aggregator sites and robo-advice to cut out business from wholesale. The execution-only model is likely to shrink with demand increasing for discretionary management propositions.

We believe the growth in advisory will not be through traditional wholesale channels, but rather through online platforms.

Institutional market: cost efficiency and alpha generation

Costs on the retail side are of lesser importance in our view. The average retail client does not regard a difference of a couple of basis points in fees as material. The complexities that come with managing individual investments are large, however. For the retail client the focus is on different areas such as transparency of fees and the investment process, advice and customer centricity. Also thinking in terms of solutions instead of pushing products is an import difference with the institutional side, where this is more common. This all requires investment in technology, which adds to the cost base. On the other hand, fees are higher on the retail side than for institutional clients, compensating some of those costs.

There are not many asset managers that can efficiently service both institutional and retail clients though, because of the difference in the operational set-up required. We think the majority of asset managers will have to choose which clients to service and rethink their strategy if they change focus.

In order to serve the retail client, asset managers need to invest in technology. Not only must they become more transparent in terms of the investment process and the associated costs, but they must also provide financial advice services. The risk for the asset management industry is that if they do not invest in technology and platforms, they will lose the relationship with their clients and become dependent on being allocated clients by those who ‘own’ the customer relationship. A short period of good or bad performance can lead to large flows in such a scenario, which can be costly.

‘Aggregator sites and robo-advice will cut out business from wholesale’

The effect of the trends on the institutional side of asset management is mainly concentrated in cost efficiency. Fees are coming down while reporting costs are increasing. Institutional asset managers will have to add alpha (after fees) in order to remain competitive versus index funds. Although that sounds logical, only a small percentage of active managers have been able to generate positive returns after deducting fees.

We believe the focus on performance will grow further on the institutional side. The ability to generate alpha will increasingly be measured versus investible ETFs rather than ‘un-investable’ benchmarks. We think transparency and immediacy in terms of reporting will become the standard. This all implies that institutional asset managers will have to become lean and mean alpha generating machines. Blockchain technology might be one of the best possibilities for cost savings in the long run. It requires legacy system replacement and a high level of initial investment though.

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Retail market: customer centricity

Lagging behind in innovation

The asset management industry is lagging behind in terms of introducing new technology. Customization of products as well as thinking in terms of solutions versus pushing products is not yet widespread. We think there is a great opportunity for asset managers to use technology to deepen their customer understanding. The competition is not asleep though, and partnerships might be a good strategy that allows for a quick roll-out.

During the past years a lot of robot advisors have been launched in the US and the UK. These are online platforms that, in their current form, offer personalized asset allocation advice which is mainly used for pension investing. Since actually advising people on investments is strictly regulated, these companies are not truly advising, rather ‘informing’ clients. In that way they do not have to comply with all regulations within asset management yet, but we expect regulation to pick up quickly.

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Whereas prior to the introduction of cost efficient technology only the high- and ultra-high net worth individuals were being given customized financial advice, robo-advice allows for basic services to be offered to the less wealthy segments. This implies the total potentially addressable market for robo-advice could be as large as USD 10.8 trillion currently. Global AuM of automated services was USD 20 billion in 2015 and is forecasted to have grown to USD 450 billion in 2020 (source: MyPrivateBanking, 2015).

managers to integrate advice capabilities into their platforms. This is likely to have an effect on fees for advisors. Although we expect Cyborg advice, fee pressure for human advice is likely to continue.

We believe the integration of technology is vital for asset managers, which implies that those managers that have not invested in their technology capability will be challenged.

We do not think pure robot advice is the future, though. We believe there will be a mix between human advice and pure robot advice which we will call Cyborg advice.

This hybrid really represents a paradigm shift in the asset management industry. The bottom of the pyramid can easily be served through internet solutions, while the top of the pyramid requires a human touch. The Cyborg advice market is estimated to be a USD 3,700 billion market in terms of assets under management by 2020 and USD 16,300 billion five years later (MyPrivateBanking, 2016).

In our view, winning companies excel on six focus points: customer centricity, distribution, simplification of business models, information advantage, innovation and, finally, managing risk, regulations and capital. Important characteristics of companies that are able to implement these steps are scale and investments in technology.

The winners will convert a digital advantage into a competitive advantage. A better understanding of the client can be created by implementing platforms and omni-channel communication. We mentioned that cost efficiency is key for institutional clients. The integration of technology is also essential here. Automatic market monitoring, report generation and a high level of customization can for example only be implemented if the right technology investments have been made.

‘We do not think roboadvice is the future, though’

The average break-even point for current robot advisors is about USD 20 billion in AuM (Morningstar research, 2015) which implies that scale advantages will lead to a winner takes all scenario. We expect consolation in this area too. Strategic alliances between large asset managers and robot advisors are already happening.

BlackRock bought FutureAdvisor, Schwab has started its own roboadvice unit and Schroders took a stake in Nutmeg.

Winners and losers There are three possible scenarios to deal with the trends we described.

– Asset managers keep customer connection through technology integration – Asset managers become just infrastructure and lose customer relationships – Cooperation develops between the asset management industry and technology companies We think it would be best for the eco-system as a whole if scenario three were to unfold. However, this outcome boils down to a prisoner’s dilemma. The incentive not to cooperate is large as it is still not clear how the current market potential will be divided.

Taking the entire market is better to some than having to share it with others.

ETFs enable the separation of alpha and beta. Increased transparency combined with aggregator technology will expose non-alpha generating asset managers. In addition, we expect asset

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Winners have scale, integrate technology and offer multi-asset solutions

Despite the many changes in the asset management industry, the core business has not changed. Understanding the risk-return relationship, allocating assets, generating alpha, integrating smart beta and managing pensions are all examples of services that belong to the core capabilities of asset managers. New industry entrants have been nibbling at the borders, but have not yet reached the core activities. Winners will recognize their strategic advantage and will either develop the missing capabilities internally or acquire them.

This article is a summary of the white paper ‘The future of asset management’, April 2016, by Jeroen van Oerle and Patrick Lemmens. It is available on www.robeco.com.

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Peter Ferket & Edith Siermann

‘Investing is like running a marathon, not a sprint’ Interview

Stability and reliability are very important to investors. We talked with Peter Ferket, CIO Equities and Edith Siermann, CIO Fixed Income, about the remarkable continuity in Robeco’s investment teams. What is the added value of this, how do you keep teams together and how important is having the right culture?

It was a very eventful year, with some major changes in Robeco holding company’s management team. Were clients concerned about this?

Ferket: “Yes, clients do think about it and have some questions.

But the changes are happening in the management board – at group level. They have little effect on the investment teams. Not a single client has withdrawn their assets, and the eight who promised to deposit funds with Robeco, have all done so since the news came out. They realized it would not affect our investment strategies at all.”

Siermann: “It’s simply a case of the governance structure becoming more transparent, there will be more focus on the investing itself. And our strategy is the same as before. We’ll stick to the ambitious 2014-2018 growth plan. The restructuring is a step in the right direction.”

The investment teams didn’t seem too troubled, either.

Siermann: “They are all professionals who prefer to focus on what they do best. They have proven they will not be sidetracked by secondary issues. Besides, our market is exciting, and very volatile.

So it demands your full attention.”

Ferket: “Four years ago, after Rabobank sold Robeco to ORIX, there were many big changes. We weathered those well and managed to keep the teams together then too. The momentum is also strong. Products such as Lux-o-rente, High Yield and Global Credits, as well as the Conservative strategies, are doing well, which also helps.”

The stability of the investment teams is very characteristic of Robeco. What’s your secret?

Ferket: “It’s mostly down to culture and tradition. Investing is

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like running a marathon, not a sprint. We take a long-term view and not just with investing – we hire portfolio managers and analysts in much the same way. Last year, seven of our investors celebrated their 25th Robeco ‘anniversary’ – that surely means something; they are true Robecans. We look for people who are excited to work at Robeco. We also expect them to shoulder a big responsibility. The annual Employee Engagement Survey also showed that direct colleagues highly appreciate each other.

That’s partly because team members can trust and count on one another’s expertise.”

Siermann: “It’s disastrous when people think they have nothing left to learn. We put together teams of professionals who want to keep learning, acquire new knowledge – who challenge each other and keep one another focused. Obviously, all the conditions have to be right, but above all, we look for people who truly are professionally driven. We have real team-based culture. That’s at odds with the star-manager approach so prevalent among asset managers in the English-speaking world. There, many people are financially driven and a hire and fire culture has evolved, with the ensuing risk of high levels of staff turnover among investment teams.”

What tangible added value does this continuity offer clients?

And is there a flip side, as well?

Siermann: “It means your investment strategy is stable and so performance is stable. That’s important for clients, who want to know what exactly they’re buying. The flip side may be that teams lose their focus and reach consensus too easily. However, we avoid that by having various team members challenge each analysis. The combination of both quant and fundamental investors also keeps the teams on their toes. There are differences in performance, which you analyze and which enhances the expertise of both teams.”

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Ferket: “Stability is not the same as status quo. Many of our teams have expanded over the years and we always strive for diversity when recruiting new members.

Not necessarily gender-wise, but more in terms of education, personality and experience. We felt that someone with a ‘red’ personality was missing from the Emerging Equities team, So you keep that in mind when you recruit a new member. That way, the team stays sufficiently motivated. Additionally, the fixed income and equity teams have been on the same floor for a few years. This has a positive effect on the exchange of knowledge and cooperation.

For example credit analyses are also taken into consideration in the equity team’s decisions.”

‘At Robeco, our portfolio managers also have a personal life’

How hard is it in this sector to keep teams together? It is not uncommon for entire teams to move from one asset manager to another, causing considerable outflow.

Siermann: “The culture and working environment are more important than a pile of money. Of course, the pay is important, but it’s not everything. If that’s your highest priority, you probably won’t end up at Robeco, anyway. It’s the big picture that counts, and pay is just one aspect of that.”

Ferket: “In the Netherlands, the whole package is good. You can make more in London, but the cost of living is much higher, too.

What’s more, the workplace culture is very different. Sure, we work hard, too, but we’re not nearly as extreme as in places like London. Robeco’s portfolio managers also have a personal life.”

Robeco QUARTERLY Robeco QUARTERLY • #1 /•SEPTEMBER #1 / SEPTEMBER 2016 2016

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Column

The cult of the central banker In this era of overreliance on monetary policy and the cult of the central banker, the yearly jamboree in scenic Jackson Hole, Wyoming, dedicated to the theme of the future of monetary policy, received plenty of media attention. And there is certainly cause for concern for the future. Should the US economy slip into recession, not necessarily because of the current rather lengthy and unexciting upswing, but as a consequence of an exogenous shock, the Fed is severely limited in terms of the room it has to maneuver using conventional interest rate measures. Still, the US does have a positive short-term policy rate of 0.5%, whereas the Euro area has a negative rate of -0.4%, Japan -0.1%, Sweden -0.5% and Switzerland -0.75%. There are clear but as yet untested limits as to the extent to which interest rates can move further into negative territory.

At some point, banks will have to penalize deposit holders incentivizing them to withdraw their money and hoard cash. But as there are costs (deposit boxes, insurance, transaction costs) associated with this, central banks should still have some further leeway to break through the zero bound before this occurs. But as boosting the economy could require much lower interest rates, it’s not surprising that the

abolition of paper money was discussed at Jackson Hole as a potential tool for enabling much lower interest rates. Marvin Goodfriend made a case for liberating interest rate policy as, in his opinion, this option is far superior to balance sheet initiatives “of questionable effectiveness” that exert stimulus through distortionary credit allocation, the assumption of credit risk, and maturity transformation, all risks which are taken on behalf of taxpayers. Anyone willing to defend the thesis that economics is not politics?

Goodfriend rightly foresees public resistance to the abolition of paper money primarily citing cost factors.

To be fair he also mentions the fact that paper money offers “a certain amount of privacy” in financial management compared to e-money. At these times when interested governments have the potential to undertake big data mining, I can understand that this is a primary concern among members of the public. Furthermore, virtual money is not tangible, an important psychological aspect aptly expressed in the German saying Bar ist wahr (cash is true).

The discussion on the abolition of paper money reminded me of the Freigeld (free money) proposed

by Gesell and discussed in Keynes’ General Theory.

Gesell’s proposal was a form of money which would lose its value if not periodically stamped by an authority for a small, variable fee, introducing a de facto negative interest rate, the optimum level of which was determined through trial and error. Keynes was sufficiently intrigued by this idea to discuss it at length in Chapter 23 of his magnum opus. He also points out that paper money is not unique and there would be a host of alternatives if it were subject to an automatic depreciating mechanism: “debts at call, foreign money, jewellery and the precious metals generally, and so forth”. At that time, he couldn’t foresee that ramen (instant noodles) would be the preferred currency in US prisons today. It seems to me that it’s not that easy to further free up monetary policy and attention should probably shift to focus more on fiscal policy.

Léon Cornelissen, Chief Economist

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Robeco QUARTERLY • #1 / SEPTEMBER 2016

Important Information Robeco Institutional Asset Management B.V., hereafter Robeco, has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. Without further explanation this presentation cannot be considered complete. It is intended to provide the professional investor with general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. All rights relating to the information in this presentation are and will remain the property of Robeco. No part of this presentation may be reproduced, saved in an automated data file or published in any form or by any means, either electronically, mechanically, by photocopy, recording or in any other way, without Robeco's prior written permission. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco's services are not available Additional Information for investors with residence or seat in France RIAM is a Dutch asset management company approved by the AFM (Netherlands financial markets authority), having the freedom to provide services in France. Robeco France has been approved by the French prudential control and resolution authority (formerly ACP, now the ACPR) as an investment firm since 28 September 2012.

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Additional Information for investors with residence or seat in Switzerland RobecoSAM AG has been authorized by the FINMA as Swiss representative of the Fund, and UBS AG as paying agent. The prospectus, the articles, the annual and semi-annual reports of the Fund, as well as the list of the purchases and sales which the Fund has undertaken during the financial year, may be obtained, on simple request and free of charge, at the head office of the Swiss representative RobecoSAM AG, Josefstrasse 218, CH-8005 Zurich. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. The value of the investments may fluctuate. Past performance is no guarantee of future results. The prices used for the performance figures of the Luxembourg-based funds are the end-of-month transaction prices net of fees up to 4 August 2010. From 4 August 2010, the transaction prices net of fees will be those of the first business day of the month. Return figures versus the benchmark show the investment management result before management and/ or performance fees; the fund returns are with dividends reinvested and based on net asset values with prices and exchange rates of the valuation moment of the benchmark. Please refer to the prospectus of the funds for further details. The prospectus is available at the company’s offices or via the www.robeco.ch website. Performance is quoted net of investment management fees. The ongoing charges mentioned in this publication is the one stated in the fund's latest annual report at closing date of the last calendar year.

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Additional Information for investors with residence or seat in the Dubai International Financial Centre (DIFC), United Arab Emirates: Robeco Institutional Asset Management B.V. (Dubai Office), Office 209, Level 2, Gate Village Building 7, Dubai International Financial Centre, Dubai, PO Box 482060, UAE. Robeco Institutional Asset Management B.V. (Dubai office) is regulated by the Dubai Financial Services Authority (“DFSA”) and only deals with Professional Clients and does not deal with Retail Clients as defined by the DFSA.

Robeco QUARTERLY • #1 / SEPTEMBER 2016

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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 Follow us: