102014 time 2 read selection robeco articles by Robeco

TIME2READ

Important information Robeco Institutional Asset Management B.V. (trade register number: 24123167), hereafter Robeco, is licensed by the Netherlands Authority for the Financial Markets in Amsterdam. It is intended to provide the reader with information on Robeco’s specific capabilities, but does not constitute a recommendation to buy or sell certain securities or investment products. All copyrights, patents and other property in the information contained in this document are held by Robeco. No rights whatsoever are licensed or assigned or shall otherwise pass to persons accessing this information. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco’s services are not available. The prospectus and the Key Investor Information Document for the mentioned Robeco funds can all be obtained free of charge at www.robeco.com.

THE MORE WE KNOW THE MORE WE CAN DISCOVER

TIME2READ SELECTION OF ROBECO’S BEST READ ARTICLES

This document is solely intended for professional investors

INTRODUCTORY NOTE

Dear Reader Our 85th anniversary this year has given us an opportunity to renew our vows on what Robeco stands for. We have long considered ourselves to be pioneering and cautious – but can you successfully be both? We certainly believe so. When man first went to the moon, he came back again safely. We have a strong bias for innovation that is deeply rooted in research. Our founder said that “every investment should be research driven”, and we have never wavered from that. If we can’t prove it, we don’t offer it. This year we have produced a wide range of articles to inform investors about everything that we do, from our pioneering work in quantitative and sustainability investing, to our more cautious insights on emerging markets, economics and trends. This book contains an updated collection of our best-read articles on the most popular subjects. Our pioneering instincts took another step forward this year when we became a major sponsor of Team Brunel, the Dutch entry into the Volvo Ocean Race. Time2Read includes an article by Team Brunel skipper Bouwe Bekking and Robeco’s head of equity investments, Peter Ferket, on the many parallels between sailing and investing. We hope you enjoyed reading Time2Read. Hester Borrie Head Global Distribution & Marketing Robeco Group

Contents The dark side of passive investing Anyone who is prepared to do their homework prefers active investing.

Thomas Piketty’s inequality The biggest gap between rich and poor exists in the US. In other countries differences in income are actually narrowing.

Bottom-up Pension scheme members require pension companies to invest in a sustainable and ethical way.

38 Shut out the peripheral noise Sensible investors know that major trends rather than today’s ‘hot’ stocks ultimately determine the direction financial markets will take.

Wanted: top talent Forget Silicon Valley, says venture capitalist and cofounder of Skype, Niklas Zennström. It is human talent rather than location that will determine where the next Google pops up.

CONTENTS

Introductory note

Robeco and Team Brunel – pioneers with a passion for data

Investing and psychology

Hype cycle

Preference for active investing

Factor investing 1

Major trends determine investment results

What is sustainable investing?

China is becoming middle aged, so it’s slowing down a bit

Don’t fall into the value trap

Google’s unstoppable brand rise

Beware of the triple Cs

Factor investing 2

Equities are the top picks for the next five years

Piketty’s inequality

Pension scheme members demand sustainable investments

Extra regulation good for some financials

Factor investing 3

Impact of ESG on the energy sector (long read)

Finding the next Google

Factor investing 4

Same old, sad story

‘The best investments’

Five controversial ideas

OPINION

Robeco and Team Brun pioneers with a passio There are many such parallels between sailing around the world and successful investing. Both combine technical know-how with careful risk management. And both require teamwork to win over the long term. That is why Robeco was delighted to become sponsor of Team Brunel, the Dutch entry in the Volvo Ocean Race 2014-15. This roundthe-world race will see seven boats compete, starting out on 4 October. It will take nine months to complete this epic voyage, calling at nine stopover ports along the route. The sponsorship is a natural fit. A pioneering spirit has long been embedded in Robeco’s DNA. We were the first to take sustainability investing seriously, among the first to invest in emerging markets and one of the original users of quantitative investing models.

BOUWE BEKKING Team Brunel Skipper

Quant on the high seas Quant expertise is also being used by Team Brunel to help with data collection and navigation, and to minimize risks. “We use quantitative analysis by collecting facts just like Robeco does before considering an investment,” says Bouwe Bekking, skipper of the Team Brunel boat. “We try to get as many

facts and numbers as possible. We have to sail through 360 degrees and have to cover all the possible angles for every wind direction, each one requiring different sails.” “There are so many angles involved when sailing over the ocean – the wind, the weather, the size of waves – that we use as many combinations of data as possible to match it to the real conditions of the day. We put it all in the model and then implement this information to predict velocities in all sailing conditions. The more combinations we can check out to see how fast the boat will go, the better.” “Obviously the faster you go at sea, the more you need proper risk management, or the chance of hitting an iceberg becomes very large. It’s the same with investing,” says Peter Ferket, head of equity investments. “We want to take active risks, and we look for opportunities, but at the same time risk

nel – on for data management is key to avoiding the bad parts of the market.” “Our quantitative investment approach is deeply embedded throughout the organization to support this. It is directly connected to the use of as much data and information as possible. But we don’t just look at a company’s past results; we regularly meet with management and look at companies’ qualitative information in order to blend insights that are both forward and backward looking.” Coping with data in all conditions Using quantitative and other research for risk management relies on accurate data, particularly in new terrain. This presents challenges for sailors and investors alike. “Using data works well to sail from Alicante to Cape Town for example, but the real problem is in places like China where the data and charts are really bad,” Bekking says. “So we have to make risk calculations. For example, the draft of the boat is five metres, so we need to know how deep the water is and make calculations so that the keel is always higher.”

‘Typically we aim to perform in all conditions’ “The bigger problem is the weather. In the northern hemisphere the weather forecasts are really accurate and you can even plan on how the wind will change on an hourby-hour basis. But once you get into the southern hemisphere, sailing for example from Abu Dhabi to China, models for weather forecasting are much less developed and can be completely wrong.” Both Robeco and Team Brunel know that taking short cuts can be tempting, particularly if the circumstances are rough. But the Volvo Ocean Race is a marathon, not a sprint, and it is important to keep a steady hand on the tiller. This applies both at sea and in the office. “A short cut can save you time, but you need to be aware of the risks this can entail,” Ferket says. “Typically we aim to achieve good performance in all conditions; we don’t want to be the best when markets are rallying and then the worst when they fall. We want to be the best over a long period and also do well when markets are in decline.” PETER FERKET Head of Equity Robeco

OPINION

PAUL CRAVEN, Economist

Challenge your own instincts and assumptions Investors should recognize that human psychology plays a role in decision – Investors are irrational and prone to biases – Biases can be overcome by awareness and coaching – Biases like herd instinct and conformity can cause bubbles – Behavioral finance adds another dimension to classical economics – Central banks increasingly use behavioral finance in their analysis – Bubbles will probably happen again

making, says Paul Craven, an expert on behavioral finance. “In order to be a successful investor it is important to challenge your own instincts and assumptions.”

Paul Craven isn’t just a theorist: he worked for decades in the City of London. He left Goldman Sachs in 2013 to focus entirely on promoting behavioral finance, a subject he is deeply passionate about. Behavioral finance questions the way traditional economic models say we think; that humans are rational and that we make conscious decisions, he says. “But rather than being rational, logical creatures, we constantly take subconscious decisions.” Craven gives three examples of biases: 1. Herd instinct: we like to do what other people are doing. 2. Conformity: we do not like to hold a different opinion to other people. 3. Anchoring: a word, name or number can subconsciously influence you.

“We can be irrational,“ he says. “The reason is that we have hard-wired biases. We have things inside our head, which are there for very good evolutionary reasons. But when it comes to 21st century financial markets, they often cause us to do things that are suboptimal.”

Three ways to prevent biases So how can investors prevent biases? According to Craven, the first way is to be aware of them: “Then they immediately become less dangerous.” The second way is to challenge your own beliefs: “Why do I think this? Where could I be wrong? You need to play devil’s advocate by reading material that disagrees with your assertions, or having someone around you who can.”

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‘Things inside our head often cause us to do things that are suboptimal’

Warren Buffett of Berkshire Hathaway – arguably the world’s best investor – puts these two solutions successfully into practice, says Craven. “Buffett talks a lot about biases in his newsletters, so he is very aware of them. And he is very humble about his abilities: he admits making many mistakes. Buffett’s devil’s advocate is his business partner Charlie Munger. This former lawyer continuously challenges Buffett’s assertions and decisions.”

‘You need to play devil’s advocate’ The third way to deal with biases is through coaching. For investors, it should not be a sign of weakness to be coached, he says. “It should be a sign of strength. All performance-related sports have coaches. And you don’t have to be better than the person you coach in order to help them. Take the golfer Tiger Woods. He has one, even though this coach is not nearly as good at golf as Woods. But he can spot tiny mistakes. Why not use a coach for investors?”

Behavioral finance can help at the micro level

What are the lessons for central bankers?

Craven does not discard all classical economics, but is not a firm believer either. “I have some issues with the well-known Capital Asset Pricing Model, which uses the assumption that people are rational and markets are efficient. There is no ‘homo economicus’. I do not think markets are efficient. That does not mean that the direction of financial markets is easy to predict,” he says. “However, I do not reject all of classical economics; it has taught us an awful lot on finance. Behavioral finance can add another dimension to it. It helps at the micro level to investigate how people really make decisions.”

The subject of asset bubbles is not just relevant to investors, but also to central bankers. “In analyzing the equity, bond and housing markets, central bankers should take behavioral aspects on board. That is something increasingly being done now.” Central bankers should also realize that a loose monetary policy helps to create bubbles, says Craven. “Fed chairman Alan Greenspan talked as early as 1996 about the ‘irrational exuberance’ of financial markets. But this remark did not prevent the development of the dot.com bubble (1997-2000) because he continued with his loose monetary policy.”

How to spot a bubble

‘It appears that people do not learn from history’

Craven, a Cambridge University-educated historian, is particularly interested in asset bubbles and subsequent crashes throughout history, such as the tulip mania in 17th century Holland, the 1929 Wall Street Crash and the dot.com bubble in the 1990s. “You have to add psychology to the equation to understand why asset bubbles happen,” he adds. “Bubbles can reflect many underlying behavioral patterns, such as the herd instinct and conformity.” Craven refers to Charles Kindleberger, author of the book ‘Manias, Panics and Crashes’, to describe how bubbles start. “They often happen in an environment of low interest rates. That makes it easy to borrow to purchase the asset. A second feature, especially in the later stages, is the use of derivatives to increase the exposure to price rises.”

He also has another warning. “During bubbles, the ‘herd mentality’ can spill over into authorities and governments,” he says. “In the years before the Wall Street Crash of 1929, both US politicians and regulators actively advised people to buy shares.“ Craven is pessimistic about the prevention of asset bubbles: “Bubbles have similar patterns and features. It appears that people do not learn from history. Human behavior is such that people make the same mistakes over different generations. As Mark Twain once said: “History does not repeat itself, but it does rhyme.”

BEST OF THE WEB

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HYPE CYCLE

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

Watch out everyone - the Internet of Things is about to enter the trough of disillusionment! Don’t worry if you have no idea what I’m talking about. As awful as it may sound, it probably won’t have too much impact on the broader stock market. But this graph, updated regularly by Gartner, is one of my favorites. It is not only a good test of seeing whether you are still reasonably up to date with the latest technology trends, it also shows you which technologies finally make it onto the plateau of productivity. A Mecca for any technology. This graph shows the recognizable pattern of the various stages through which a technology passes. Take the dot-com bubble of 1997-2001, or even Bitcoin. At the beginning no one has heard of it and there is just a small group of dedicated insiders. Then the technology catches on, and more articles appear on the subject. The expectations for the future become rosier - more attractive, more extensive. Stories make the front page. By this time our imagination has run away with us and we have reached the peak of inflated expectations. The dismal trough of disillusionment inevitably follows. However, this does not necessarily mean that the technology suffers unduly - after all, the Internet is still going strong. But investors who stepped into the market when these technologies were at their peak will probably be disappointed.

BY LUKAS DAALDER |

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OPINION

– Passive investing is an appealing concept, but there are some serious concerns – Passive investors are free-riders, relying on active investors to do their homework – Passive investing goes against proven factors

The dark side of passive investing Passive investing has become increasingly popular. Despite its undeniable appeal, there are also some considerations which should make investors think again about the desirability of a passive approach.

Passive investing ranks among the most successful innovations of modern finance. We do not deny that it is an appealing concept. In fact, we fully acknowledge that:

DAVID BLITZ, PhD Head Quantitative Equities Research

– a passive manager is likely to outperform an active manager chosen at random, assuming the latter involves higher fees and costs – passive investing is highly transparent, as performance can be evaluated against an index that is independently calculated by a third party – a passive approach can be applied on a large scale because of its high liquidity – passive investing may be considered a safe choice, because by pretty much guaranteeing a return close to the index it eliminates the risk of having to explain a large underperformance sooner or later

However, we also have some serious concerns with regard to passive investing. We argue that if these concerns are also taken into account, the case for passive investing is not so clear-cut anymore.

Concern 1: passive investors are freeriders Lorie and Hamilton (1973) already noted that the market can only be efficient if a large number of investors actually believe it to be inefficient, the so-called efficient markets paradox. In other words, the existence of a large number of active investors is a necessary requirement for efficiently functioning capital markets. Active investors continuously trade on perceived mispricings, thereby ensuring that the price of each security always reflects the market’s best assessment of its (unobservable) true value, and that the market is highly liquid.

‘Factor investing, aimed at systematically capturing the value, momentum, low-volatility and other premiums, holds the future’

As such, active investors play a vital role in financial markets. Passive investors, on the other hand, are basically free-riders, as they do not make any attempt to assess the fair value of a security. Instead, they assume that active investors have done their homework properly, which enables them to simply accept and mechanically follow the observed security weights in the capitalization-weighted market portfolio.

Active investing: a moral responsibility? A famous quote from Benjamin Graham is that the market can be compared to a voting machine. This is a useful analogy, because, similarly to passive investing, voting in a parliamentary democracy involves a big freeriding problem: voting is basically futile so long as millions of others vote. Free-riding appears to be a rational alternative: instead of going out to vote, spend the time on a more useful activity, such as family or a hobby. Interestingly, however, most people are well aware of this logic but still choose to put time and effort into voting, arguably because they see this

as a moral responsibility in a parliamentary democracy. In the same spirit, active investing may be seen as a moral responsibility that comes along with a market economy. An efficient and liquid market benefits everyone, but because this can only arise as a result of large-scale active investing, perhaps every investor should feel obliged to contribute.

Concern 2: passive investing goes against proven factors Our second concern with passive investing is that it goes against proven factors. The literature provides extensive evidence that securities with certain factor characteristics tend to exhibit a very poor performance, while other characteristics appear to be rewarded with better returns. Because passive investors simply buy the capitalization-weighted market portfolio, which contains all securities, they basically choose to ignore such evidence. In other words, a passive approach involves intentionally investing large parts of one’s portfolio in segments of the market that are known to be associated with disappointing historical performance characteristics.

International main fixed markets Exhibit 1 | Illustration of income the diversity of the December 2005 capitalization-weighted market portfolio ...

Value

...

Growth

Fast Winners

High vol

Low vol

Past losers

Source: Figures Internarional

If you believe in factor premiums, passive investing does not make sense The logical implication of factor premiums is not to adopt passive investing and thereby intentionally invest large parts of one’s portfolio in segments of the market that are known to be associated with very poor historical performance characteristics, such as growth, past-loser and high-volatility stocks. In fact, it makes more sense to actively avoid unattractive segments of the market and seek more exposure to attractive segments.

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QUANT: FACTOR INVESTING 1

Factor investing works Factor investing is in vogue. Investors are increasingly focusing on factors such as value, low volatility, momentum and small cap. But what do we know about the relevance of factor investing? Many studies have looked at the concept of factor investing. But how does it work in practice? Robeco quantitative researcher Joop Huij, examined the data of approximately 7000 funds over the 1990-2010 period. His goal was to find out whether active managers with exposure to factor-based investment strategies consistently outperform their benchmarks. He used a regression-based method to show fund exposure to factors. “The results indicate that factor investing works in practice.”

INTERVIEW WITH JOOP HUIJ

How important is factor investing for active management? “My observation is that while factor investing can be highly effective, this does not necessarily hold true for all factors. You can turn the odds of success to your advantage by investing in proven factors. We therefore need to find out which factors do and which do not work. Some factors

JOOP HUIJ, Robeco Quantitative Researcher

have been studied very thoroughly. Take, for example, value and low volatility. For these factors there seems to be consensus on the existence of statistical patterns and their significance after taking trading costs into account. For some factors there is also a vast amount of research into the reasons behind their existence. However, other factors such as short-term reversal and long-term reversal are still relatively unknown and there is as yet no academic consensus on their significance. These less-known factors also formed part of this study. While we see many mutual funds in our database exposed to the small cap and value factors, other factors are less popular. For instance, only 6% of all active-management strategies in our database are identified as low-volatility strategies. Within this 6%, only a small minority consciously engages in this strategy, for example by including screening on volatility. Only 1 to 2% of the mutual funds consistently follow a momentum strategy.”

‘The results indicate that factor investing works in practice’ Are all factors doing well? “No. Short-term reversal is showing very poor performance. A short-term reversal strategy is designed to benefit from stocks that have performed badly in the recent past, but will outperform in the near future, or the reverse. A theoretical explanation for this is overreaction to stockspecific news by investors. However, 96% of all short- term reversal funds underperform the market. This outcome is not a complete surprise, since this strategy requires frequent portfolio rebalancing, which leads to high trading costs that ‘eat’ into net performance. The research shows that what works best is a more conservative approach to factor investing that considers only those factors for which there is a large amount of evidence, as anomalies don’t just disappear.

This contrasts to what I sometimes hear in the market, where brokers may say: ‘’Better to invest now in the latest factor before it is arbitraged away. No point in waiting until all the evidence is there; and don’t be too critical.” But my research shows that some factors, such as short-term reversal, simply don’t work.”

What are your findings on momentum? “If you look at momentum, you will see that 38% of active managers that include a momentum factor achieve outperformance. This is less than in the value or low volatility universe, but still substantially more than the group not exposed to any factors. However, we also show that some managers exposed to momentum generate substantial underperformance. This is not totally unexpected. The literature warns that momentum investing can be a high-risk strategy. You need to implement it well to be successful. It is important to avoid two major pitfalls: first, excessive turnover levels that result in high trading costs; and second, exposures to unrewarded risks that do not contribute to achieving extra performance.”

What is the relevance of diversification to factor investing? “It is better not to invest in just one factor, but ideally to engage in diversification, because a single factor can result in underperformance in relation to the broad market for quite a considerable period of time. Our study shows that a fund that does not engage in factor investing historically demonstrates underperformance by on average 189 basis points per annum. I would call this result alarming. In contrast, a fund that is exposed to one random factor earns 163 extra basis points. With two random factors, this increases to 334 basis points, and with three factors, the result is even better: an outperformance of 353 basis points per annum. If you do not follow a factor-investing strategy as an active manager, your chances of outperforming are 20%. If you invest in one factor, they increase to 51%. This relates to a random factor and a random manager. If you choose three random factors and select a random manager, your chances will increase to 80%. If you choose the right factor and the right manager, your chances of outperformance could be even higher.”

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EQUITIES

Trends underestimated by the investment community Investors are always keen on drivers of the market. Most often they are – Many investors underestimate the impact of long-term trends – Edge is in interpreting trends – Take a long time horizon – Technological change is the trend category with the most investment potential – Demographical change is an important but slow-moving trend category – Trends emanating from political/regulatory change are difficult to successfully invest in – Diversification across different trends helps to reduce risk

focused on short term drivers, like announcements of the Federal Reserve on scaling down its bond buying program, or the latest growth figures of China, or elections in Brazil. In the short term, all are important. But in the long term, financial markets are driven by major trends like demographic changes and industrial advances.

“Trends tend to be underestimated by the investment community,” says Steef Bergakker. He is trendwatcher* within Robeco. He tries to assess the impact of trends on the growth opportunities of companies. “Many investors and analysts focus on the short term, for example the next quarterly earnings, and pay little attention to long-term trends. You can call long-term investing ‘time-horizon arbitrage’. In other words, you can earn a premium by taking a longer time horizon than other investors.”

Edge is in interpretation and long time horizon

STEEF BERGAKKER, Trendwatcher Robeco

In his work Bergakker links trend investing to the inefficiency of financial markets. “Our edge should be in being more successful than others in interpreting trends and taking a

long investment time horizon. So what is the big picture which investors should take into account? Bergakker identifies three main trend categories or trend engines: – technology (e.g. mechanization/ digitization) – demographics (e.g. urbanization, ageing) – politics/regulation (e.g. Basel, US health care regulation, CO2 emission rights) “An awful lot is happening in the world. So it helps to bundle trends into categories that have common characteristics from an investor’s perspective,” he says. ”And distinguish between a ‘good’ and a ‘bad’ trend. The ‘bad’ trends are a threat to the established com panies. Catching the right trends or avoiding

the wrong ones determines the difference between investment success and failure.” To assess a trend Bergakker looks at four features: “A trend needs to have the potential to challenge or change existing business models and / or business ecosystems. It has to be investable, needs to play out relatively quickly and the scope must be broad based.”

Technology has most potential Bergakker sees technology as the trend category with the most potential. “Technologically-driven trends usually have a big impact and their trajectories are often difficult to predict. This lack of predictability may seem negative, but actually is an advantage, because the implications of technological change are not directly clear

‘Technological trends have a big impact and are difficult to predict’

pitfall; it can become investor hype. “You need to stay clear of any hype. Although the longterm impact of technological trends tends to be underestimated, they can temporarily lead to overly high investor expectations.”

to all market participants and tend to be underestimated. This creates opportunities. We use a rigorous framework to assess whether a technology is likely to be successful or not. This helps us in improving our odds of success. Technology has an extra advantage for investors; regulation tends to lag new developments. This decreases the threat of early curtailment,” he adds. But Bergakker warns that this main trend category has a

The second main trend category, demographics, also has pitfalls, he says. “An ageing population is clearly a very important trend. It has implications for a wide range of industries. For example, it influences the beverages industry. Older people are more inclined to drink wine instead of beer. However, it is difficult to gain a sharper insight than other investors, because it is a well-documented trend with easily understood implications.”

Demographics is an important but slow-moving trend category

“Demographically-driven trends are transparent, because there are a lot of statistics on it. Therefore, the possibility that investors are completely caught off guard is small, although demographics can still offer ‘timehorizon arbitrage’ opportunities. Another drawback from an investor’s perspective is that demographic trends are slow-moving. It can take many years before demographics has a big impact on sales and earnings,“ says Bergakker.

Political/regulation trends are difficult to successfully invest in Politics and regulation is the third main trend category, he says. “Take for example regulation on generating clean energy. Companies and households are increasingly generating their own electricity from solar panels or other renewable sources and are selling the surplus. The old ‘hub and spoke network’ of centrally generating power is becoming outdated as power generation is becoming decentralized. This is a clear headwind for traditional utility companies. Because of this, trend-based investment strategies generally avoid these companies altogether.” Although politics and regulation clearly have wide implications for a range of industries, for investors it is often difficult to profit from regulatory trends in practice. “The disadvantage is when government regulation is implemented, its impact is clear to all market participants in finance. You won’t find many investors who haven’t thought about the impact of new regulation. Therefore, the

impact on companies will quickly be fully discounted.” Investors using political/regulation driven trends should be ‘ahead of the pack’, he adds, but admits this can be difficult. “The key to investing in this trend category is to spot regulatory change before its implementation. However, politics can be unpredictable and prone to U-turns. Take for example the German stance on nuclear energy. Germany decided to close down its reactors after the Japanese Fukashima nuclear disaster in 2011. This reaction was hard to predict.“

‘Politics can be unpredictable and prone to U-turns’

to build a balanced investment portfolio. And besides trends, valuation is a key factor in stock selection.“ Furthermore, trend investing is not just about picking winners, but also about considering the downside. “It is not only driven by the upside, but also by the risks. For example, for every winner in adapting a new technology, there are several other companies which lose out.” A way to reduce downside risk to the portfolio is to diversify across different trends, he says. “Using several drivers makes the portfolio less vulnerable to wrong bets or temporary headwinds. The Rolinco fund, for instance, uses four Global Growth trends in this respect: It’s a Digital World, Emerging Consumer, Getting Old/Staying Healthy and Industrial Renaissance.

Diversification across different trends helps to reduce risk

You want to combine different trends with a low correlation to reduce risk. To assess the underlying correlation, we look at the impact of the three main trend categories on our four Global Growth trends.”

Trend insights are very helpful in the construction of a portfolio, concludes Bergakker. But there is more to it. “Obviously it is the responsibility of the portfolio manager

*) Bergakker is also portfolio manager Hollands Bezit. His advice and insights on trends are used by the portfolio managers of the Robeco Global Trend Investing Equity funds: Rolinco, Global Consumer.

Impact of the three main trend categories on the four Global Growth trends Politics/regulation

Demographics

Technology

It’s a Digital World

Emerging Consumer

Getting Old/Staying Healthy

Industrial Renaissance

(-- very negative, - negative, = neutral, + positive, ++ very positive)

SUSTAINABILITY INVESTING

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The many colors of sustainability investing Sustainability is one simple word, but it has many different interpretations. Does it mean excluding weapons manufacturers? Or does it mean certain risk-management practices? The extent to which opinions differ on ‘what is sustainability’ can be seen in the latest research from Novethic, a French group which works to improve knowledge and practices on Responsible Investment (RI).

Novethic’s most recent annual survey asked 165 European asset owners with EUR 5 trillion under management for their views on what sustainability investing means to them. “Asset owners increasingly understand what integrating Environmental, Social and Governance (ESG) criteria in their investment practices means, even if they do not all apply RI policies,” says Anne-Catherine Husson-Traore, chief executive officer of Novethic.

No longer purely ethical Husson-Traore: “ESG integration is no longer seen as a purely ethical or reputational strategy. Moreover, long-term risk management is set to become asset owners’

principal motive to integrate ESG criteria into asset management. They recognize the potential materiality of ESG issues.” However, she says the campaign is not reaching all ears, and in some quarters, is taking steps backwards. “Awareness of ESG approaches is rising, but ESG integration in practice is running out of steam and the implementation of RI policies is stagnating. Some strategies considered as commonplace, such as controversial weapons exclusions, are even declining. And almost 15% of respondents have not yet planned to implement any RI strategy. So there is still a long way to go before RI policies are implemented across all asset classes.”

‘Dutch investors remain quite divided on their definition of ESG integration’ National differences are large Differences in opinion as to what is sustainability can be seen in the Netherlands, which has long been seen as a leader in the concept. “Dutch investors remain quite divided on their definition of ESG integration,” the report says. “Common responses are the exclusion of activities that are deemed unethical and using ESG criteria in investment selection. However, an increasing number of respondents include engaging with issuers on sustainable development and avoiding sectors or securities with ESG risks in their definition.”

What is unique to the Dutch is that all investors have either adopted, or are in the process of adopting, a formal RI policy, even if respondents disagree about what it actually means, the study shows. Leading the field in adopting RI policies is Germany, where 94% of respondents said they had adopted a strategy overseen by top management. They may also be the best informed. “German investors devote more resources to ESG analysis than any other country,” Novethic says. “Above all, they are the top users of ESG information provided by specialized rating agencies.” German investors

see contributing to sustainable development and long-term risk management as the most important reasons behind their enthusiasm. The country also has the highest number of investors who address ethical investing in agricultural commodities, where deforestation is an issue, in their ESG strategies.

Multiple criteria may be confusing In France, 42% of respondents had an RI policy, and “an unusually high majority of French respondents consider that ESG integration involves selecting companies on the basis of ESG criteria,” the study reveals. However,

‘The Spanish have gone back to exclusions and green issues’ the trend for French investors to factor in the long-term risks faced by companies may have peaked. And only 3% considered financial implications to be important. “Indeed, investors seem to be confused by the multiple criteria used by different extra-financial rating agencies and asset managers. They would like to have a clear definition of what ESG criteria are,” Novethic says. Tax havens are an increasing concern in Spain, which has lagged its European peers in adopting ESG, with only half of investors pursuing the concept. The Spanish definition

of what is ESG has shifted towards the more traditional ideas of using exclusion and investing in ‘green’ industries, the report says.

Viewing ESG as risk management The country which places the highest importance on financial performance in defining ESG is the UK, where one in ten investors makes it a priority. The country also leads the field in considering ESG from a risk management perspective. Perhaps the most progressive attitudes towards adopting ESG strategies were found in

Austria, one of Europe’s smallest investment markets. “Austrian respondents’ definition of ESG integration is progressive and multidimensional,” says the report.

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OPINION

China is becoming middle aged, so it’s slowing down a bit In some ways, the rise of China has been too good to be true. Its economy – Authorities will act to prevent any hard landing – Financial crisis is unlikely due to stimulus measures – Country is gradually rebalancing its giant economy – China won’t defy gravity forever however

LÉON CORNELISSEN, Chief Economist

has grown with breakneck speed for decades (an average of 9.1% a year since 1994, with a lowest rate of 6%) – if we can believe the official accounts.

compare the country to someone in middle age who is still enjoying the good life, fuelled by credit, but has started to slow down a bit, and is looking for better balance in their life along with a social safety net.

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

‘Quiet stimulus’ has been preferred

After the Lehman crisis the Chinese authorities successfully prevented a sharp downturn, at the cost of a sharp build-up of debt. In 2014 the economy was struggling once again and the authorities quietly stimulated the economy, fuelled once again by a strong growth of credit. Estimates differ about the current level of debt as a percentage of GDP, but the trend is clear: the debt binge is far from over. You might well

Does this mean that China is on the brink of a financial crisis caused for example by a property crash, followed by a string of corporate defaults? I don’t think this is very likely, although these fears are widespread and to a certain extent understandable. The theme of a ‘hard landing’ has been around for years. It has also been pointed out that the rise of the most successful capitalist economy of the 20th century, the United States, was

China’s total social financing – As % of GDP

Debt to GDP ratios – Total debt as a % of GDP

250

Indonesia India

200

Taiwan Germany

150

Australia South Korea

100

China France

Italy US

0 2002 Total

2003

Bank loans

2004

2005

2006

2007

2008

2009

2010

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

2011

2012

2013

2014

Non-financial enterprises, equity & other

Singapore UK Hong Kong

‘Growth up until now has still been slightly disappointing’ interrupted by the Great Depression and then World War Two, so we should not expect China’s meteoric rise to go on smoothly forever. And indeed, it has not done so: after a ministimulus earlier this year, Chinese growth up until now has still been slightly disappointing. In 2014, China injected a massive USD 80 bln into the five largest banks, equivalent to a 50 basis point rate cut. Chinese leaders sought to assure everyone that they’re not preparing a massive stimulus package, while hinting that they could live with an undershooting of the Chinese growth target of 7.5%. Market participants have since lowered their forecasts of Chinese growth towards 7.0%. On the

other hand, Chinese leaders won’t accept a sharp weakening momentum of the economy because of the risks to employment and social stability that this would imply. Their preferred course of action is what I would call ‘quiet stimulus’ of this kind.

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

Spain Japan 0 End - 2008

100

200

300

400

End - 2013

consequence of state-owned banks lending money to state-owned companies. And so the Chinese government can easily prevent a credit crunch by forcing banks to continue lending, particularly through the shadow banking sector. Known officially as ‘non-bank intermediation’, this sector has more than tripled in size since 2008, albeit from a low base. As a consequence, shadow banking in China is relatively low both as a share of GDP and of financial intermediation. Central government debt is low, so it can absorb a lot of problems if it chooses to do so. The overall debt ratio is likely to continue to rise in the coming years as policymakers give priority to growth.

24 |

EQUITIES

– Stocks are no longer cheap – Avoid simply looking for momentum – Opportunities are in mid and large cap range – Being strict on investment principles is key – Beware of bubbles in the market

Avoid the value trap with global equities Stock markets that have hit record levels in recent months present a challenge for investors in avoiding the value trap, says award-winning fund manager Chris Hart.

CHRIS HART, Manager Robeco Global Premium Equities Fund

Chris Hart, manager of Robeco Global Premium Equities Fund, warns that chasing those companies which are perceived to be higher growth than others can lead to overpaying for stocks that are already expensive. Instead, Hart prefers a more disciplined approach that is based more on finding those companies that are undervalued relative to their prospects. This avoids simply looking for momentum, where a company is able to grow but much of the potential is already priced in. “A drawback of both the bull market and the low-growth economic environment that we are in is that investors chase growth – and sometimes at a price that isn’t really worth paying. The market is currently paying high prices for momentum, top-line and earnings growth. Small cap stocks globally (under USD 2 billion) seem to be somewhat expensive. The portfolio currently has the smallest percentage of small

Valuation How much are we paying?

Business fundamentals What are we buying?

Business momentum Is the business getting better, staying the same or getting worse?

The Holy Trinity The three circles approach Source: Robeco

cap names over the past six years. We’re now finding more opportunity in the mid and large cap range.”

company history), positive momentum (the ability to grow) and good fundamentals (the ability to generate free cash flow).

‘A drawback of the bull market is that investors chase growth’

Dislocation, dislocation, dislocation

Such is his skill in finding the best stocks that Boston-based Hart has won the Morningstar Awards for the best fund a record nine times in Europe. His fund has consistently outperformed its benchmark, and Hart says this is due to strict adherence to what he calls the ‘three circles’ approach. This targets companies that have a low valuation (relative to peers and

“What we’re really looking for is that dislocation between valuation and fundamentals, and earnings,” says Hart. “Over the last five to six years we have been able to find pockets of opportunity at the industry level – names that were generally cheap. We’re now not really finding pockets any more, but one-off names. For example, advertising as an industry was undervalued for a while. There would be 2-3 advertisers that might be interesting, and now it might be one. So it’s even more securityselection driven because of where we are in the market, and what the market is paying for. Being as disciplined as we are with the application of our three circles philosophy and

process, the portfolio will always maintain a quality bias and always own companies that have earnings momentum that is better than the market, with valuation support.” And being strict on principles is key. “We are not going to throw away our discipline and chase momentum and give up our valuation criteria,” says Hart. “The portfolio today has become more value orientated. The level of relative valuation to the universe that we look at is almost as wide as it’s ever been.”

‘Our portfolio today has become more value orientated’

Troubles from bubbles Hart says the only issue that keeps him awake at night is the prospect of bubbles developing in what is already an expensive market. “My concern is twofold – that the market pays excessive levels of valuation for top-line or bottom-line growth, or the somewhat unknowable where the market hits a bubble phase, and then we have a complete meltdown. Bubbles are always easy to identify in hindsight, but if we do have a blow-off or correction in the market, I don’t think it will be a Lehman type of event or anything like that. But we’re starting to see some things out there that are not necessarily positive, and the concern is the market going down because of a speculative nature, or investors overpaying for growth.” This can pose problems for funds such as his which rely on beating the benchmark to create relative outperformance, rather than just absolute returns. Many managers try to do this by chasing these higher-growth stocks in the hope they will do better than the index average. “In this type of market, when it becomes highly speculative and there is a disconnect between reasonable valuations and growth, then it makes me somewhat worried. This can make a fund underperform if it doesn’t contain those highly speculative names for the periods, even if the rises in their share prices can’t be justified. But we don’t go along with the herd and we are keeping up through great security selection of the longerterm names that can see price growth that is backed by fundamentals. If you are disciplined enough you can still find the winners.”

‘The concern is the market going down because of a speculative nature’ Pharma and mature tech have produced opportunities Occasionally, certain sectors provide numerous opportunities through Robeco Boston Partners’ bottom-up fundamental research, and the pharmaceutical industry is a good example of how the prices of stocks were dislocated from the prospects of the companies, Hart says. “We’ve been overweight pharmaceutical companies for quite some time,” he says. “Everyone knew that the patent cliff was

occurring for the major drug companies – when their biggest-selling products become generic and can be made by anyone. But we looked at these big pharma names and the amount of free cash flow that they were generating, and the valuations that were being placed upon them, and a lot of them were priced as if they would be going out of business in 10 years. We recognized that these pharma companies had a lot of competencies to generate new molecules for the health care market, and it was hard for us to believe that with the scientists that they have, they would not create a new round of drugs coming out in the next few years. That’s still how we feel today. They are not as cheap as they were, but we’re seeing a lot of drugs being developed that will come onto the market in the next few years. So we feel that pharma still offers a very favorable risk/return characteristic.”

EQUITIES

– – –

Robeco owns Google but not Apple Google better positioned for growth Coca-Cola a good defensive stock – Amazon is the tech company to watch

| 27

Google’s unstoppable brand rise Google’s inexorable rise to knock Apple off its perch as the world’s most valuable brand comes as no surprise to Robeco fund manager Jack Neele. His Global Consumer Trends Equities fund invests in Google but gave up on Apple some time ago.

JACK NEELE, Portfolio Manager

‘Apple’s prospects have deteriorated – they’re not innovating enough’

Top 10 Most Valuable Global Brands Rank

Brand

Category

2014

Brand Value

Rank

2014 ($M)

Change

2013

Google *

Technology

158,843

+40%

Apple

Technology

147,880

-20%

IBM

Technology

107,541

-4%

Microsoft

Technology

90,185

+29%

McDonalds

Fast Food

85,706

-5%

Coca-Cola *

Soft Drinks

80,683

+3%

Visa *

Credit Cards

79,197

+41%

AT&T

Telecoms

77,883

+3%

Marlboro

Tobacco

67,341

-3%

Amazon *

Retail

64,255

+41%

* Owned by the Robeco Consumer Trends Equities fund. Source: BrandZ, Robeco

Google topped the BrandZ Top 100 Most Valuable Global Brands study, commissioned by the advertising group WPP and conducted by consultancy Millward Brown Optimor. Apple is now in second place. Valuing a brand is not a precise science, since it relies on sentiment and is usually reflected in a company’s share price. The study uses the views of potential and current buyers of the product, alongside financial data, to calculate brand value. Neele: “Google is in a fantastic position because of the shift towards mobile devices, 24/7 access to internet services and huge improvements in online speeds. It is constantly innovating and has been on a steady upward march for years. Its great advantage is you can access its services on any device, whereas you can only use Apple products for Apple services, or Samsung for Samsung, etc.” Neele continues: “Apple is more cyclical and its prospects have deteriorated. After the success of the iPhone, iPad and everything else, they’re not innovating enough, unless they come up with the iWatch or something new. And even that isn’t likely to be big enough to make a difference to revenues and profits.”

Tech leads the table Four technology companies lead the table, with IBM and Microsoft in third and fourth places respectively. However, Neele owns neither. “IBM is basically a business services company now rather than representing a consumer trend, and Microsoft has long-term challenges,” he says. “Microsoft lost their way a little bit and refused to get involved with things like mobiles and tablets, which they are now doing after the strategy flopped and they were overtaken by Apple. They still have market leading products such as the Office suite but growth will be slow.”

‘If there is some sort of shock, people don’t stop drinking Coke’ Of the remaining six names in the top 10, Neele owns Coca-Cola, Visa and Amazon. Coke is one of three firms along with McDonald’s and Marlboro which have slipped down the rankings, a trend that Neele says is due to increased interest in healthy living. “Companies that are not engaged in health or wellness, such as fast food, soft drinks and tobacco producers, are losing their popularity and therefore their brand value,” says Neele. So why own Coke? “We do have some debate in the team about this,” Neele admitted. “But Coca-Cola has very defensive characteristics.

It’s pretty unshockable. If there is some sort of shock in the world, people don’t stop drinking Coke. Its revenue growth will probably only be 1% a year, but it is extremely reliable.”

people are willing to pay for growth stocks is shrinking. This may lead to a lot of volatility and we don’t expect large returns for equity markets this year. This seems to be a period of correction.”

Watch out for Amazon The other two companies in the top 10 owned by Neele are directly related to the growth of e-commerce. His fund owns Visa, due to its revenue potential from e-commerce in which more people pay by credit card, and Amazon, which has revolutionized home shopping. At the recent Robeco World Investment Forum, at which Neele spoke, Amazon was tipped by many to be the world’s largest tech company by 2020. The ability of global brands to outperform lesser-known companies was also highlighted by the survey, which is now in its ninth year. While the value of the companies in the S&P500 index grew by 44.7%, the BrandZ portfolio grew by 81.1% over the same time period.

Preference for strong brands More generally, strong brands are likely to drive growth in the Global Consumer Trends Equities fund after a period of poor performance due to a market correction, says Neele. “We have a strong preference to invest in quality and the big growth names. There has been large outperformance by growth strategies, and the market is now switching from a growth to a value strategy, but the strong brands are providing a bit of defensiveness. Growth is becoming less scarce and the premium that

‘The market is switching from a growth to a value strategy’ Trends are key As the name of the fund suggests, the operative word is ‘trends’, and the three to fiveyear investment horizon that the fund adopts is important, Neele says. “For our fund we still believe that the longer-term trends are still intact, and we think that their strong longerterm growth prospects will be appreciated by the market in the medium term. The internet names that are very well positioned like Google and TripAdvisor are looking fine. We continue to focus more on the established companies where operational performance is rewarded by the market, and valuations are more attractive than some of the mid cap names. We have a lot of strong brands in the fund which can counter-balance the cyclical risks in some of the digital names. That’s why we continue to focus on the fundamentals, but this doesn’t mean the market will reward them in the short term. The philosophy that we have will pay off in the medium term over 3-5 years.”

30 |

FIXED INCOME

Beware the triple Cs The search for yield can come at a price if investors chase bigger returns – Spreads have narrowed with sovereign bonds – Some investors now chasing yields in CCC – Not enough reward for the extra risk taken

without factoring in the extra risk involved, warns Robeco’s Sander Bus. The returns on high yield corporate bonds have progressively come down, for two reasons. Firstly, interest rates have gradually risen, which means bond values fall. In addition to this, the spread – the difference between credit yields and those of benchmark government bonds – have shrunk. This makes them relatively less attractive to government bonds for investors who look to bank the difference

How credit spreads between corporate and government bonds have fallen over the past year between corporate and government bonds have fallen over the past year How credit spreads 550 500

contained in the spread. To compensate for this, many investors are now chasing the higher returns available in bonds with lower credit ratings, but they are not being sufficiently compensated for the extra risk, says Bus. His Global High Yield Bonds fund applies a conservative approach in its investment style, meaning that it focuses more on the betterquality names within the high yield universe and thus has an underweight exposure to the riskier names that would fall in the CCC-rated category. The fund prefers to build exposure to the BB and B-rated corporates, which are below investment grade but carry a relatively lower chance of default than the triple-C category.

450

Price for taking risk is too high

400 350 300 250

Mar 13 Apr 13 May 13 Jun 13 Jul 13 Aug 13 Sep 13 Oct 13 Nov 13 Dec 13 Jan 14 Feb 14 US High Yield (ex Fin) Spread

Source: Bloomberg Source: Bloomberg

European High Yield (ex Fin) Spread

“We aim to get the best possible returns for investors, but there comes a point when gaining a high yield comes at too high a price in terms of the risk taken,” says Bus. “Triple C is a category where returns are high but the risks are also higher. We believe that there is insufficient compensation in that segment for

compromising returns or risks, he says. At the moment, spread curves are pretty steep, which means an investor gets relatively more return in bonds that take longer to mature, when they must be repaid by the issuer. Put simply, switching to longer-dated bonds by extending average maturities in the portfolio gives you more pick-up. “Usually the high yield market has pretty flat spread curves, where owning longer-dated bonds does not make much difference to yields. So extending maturities is a good means of picking up more spread against sovereigns,” Bus says.

The supply of risky bonds has increased lately as private equity sponsors take advantage of the strong high yield market by selling tempting types of bond when they take companies private. “We are seeing more issuance of bonds rated triple C and also Payin-Kind (PIK) notes, where you don’t get cash interest but additional nominal (face value) in the bonds. This is increasing risk on the balance sheets of companies.”

Investors though have tended lately to go in the other direction, demanding bonds with shorter durations because they fear that interest rates will rise. If this happens, the bonds become progressively less valuable, so it can make more sense to buy the securities that take less time to mature. Bus: “However, it’s much smarter to hedge your interest rate risk if you are afraid of a high duration than to chase lower duration bonds,” says Bus. Low-duration funds take out the rate risk but also reduce the available spread. Someone who invests in high yield bonds ultimately wants to be exposed to the spread.”

Maturities and durations are key It is possible though to be more selective within an existing fund universe without

INVESTMENT GRADE

the risk you are taking. It is now wise to largely avoid over-exposure to this segment, because when the market turns, triple-C is expected to be the underperforming category.” Bus: Current spreads just don’t justify investing in triple-C bonds. If you look at the default and recovery rates, you are not rewarded for the average default scenario in CCC. They’ve returned more in the past, but at this phase in the cycle, it is unwise to put too much store in them now. It’s a mistake that some investors make when they focus on return targets and not on risk.”

The credit rating scale: CCC is defined as ‘currently vulnerable’

SPECULATIVE GRADE

‘We should perhaps just all accept that returns will be lower all round in 2014’

AAA

Extremely strong capacity to meet financial commitments. Highest rating

Very strong capacity to meet financial commitments

Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances

BBB

Adequate capacity to meet financial commitments, but more subject to adverse economic conditions

BBB–

Considered lowest investment grade by market participants

BB+

Considered highest speculative grade by market participants

Less vulnerable in the near term but faces major ongoing uncertainties to adverse business, financial and economic conditions

More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments

CCC

Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments

Currently highly vulnerable

A bankruptcy petition has been filed or similar action taken, but payments of financial commitments are continued

Payment default on financial commitments

Source: Standard & Poor’s

32 |

QUANT: FACTOR INVESTING 2

‘All roads lead to Rome’

INTERVIEW WITH ALFRED SLAGER

Interest in factor investing – investing in systematic sources of return – is rapidly increasing. But how are pension funds incorporating factor investing into their portfolios and investment processes? We asked Alfred Slager, professor in Pension Fund Management. He wrote the research paper ‘Factor Investing in Practice: A trustees’ Guide to Implementation’ together with

ALFRED SLAGER, Professor in Pension Fund Management

Professors Kees Koedijk and Philip Stork.

What surprised you most in this paper? “This paper concludes that factor investing can take several forms, but eventually ‘all roads lead to Rome’. There are different ways of implementing factor investing. Little was known about the practical aspects before we started our study (e.g. about incorporating factor investing into your investment process – managing it – the role of the regulator).”

Second, pension funds have become more critical about the role of active management. Pension funds, while willing to pay for the skills of a portfolio manager, are not prepared to do so to achieve factorbased returns that they could also generate in their portfolio by other means. Factor investing contributes to the discussion of the role of active management.”

Why is factor investing in the limelight now?

What is your own experience of the way pension funds look at factor investing?

“Two simultaneous signals triggered this interest. First, the big financial crisis of 2008/2009; diversification turned out to be more of a problem than expected, which caused this and other basic investment principles to become important items on everyone’s agenda. How can we fix things to ensure we emerge stronger from the next financial shock?

“There are funds that implement factor investing and feel that it contributes positively to their portfolio composition. They may use factorbased benchmarks, for instance. Other funds are still watching from the sidelines. They see factor investing as a kind of black box. But they, too, would like to strengthen their portfolio and diversify more effectively.”

Why are Dutch and Scandinavian investors ahead of the pack in this area? “They have large amounts of institutional capital and a long-term investment horizon. But they also want to control the risks of negative shocks more effectively in the short term. In addition, Dutch and Scandinavian funds emphasize transparency, cost control and well thought-out investment processes. Finally, they focus strongly on investing scientifically.”

Will all institutional investors apply factor investing in future? “We will see this increasingly in many different variants. Something for everybody. What all these investors have in common is their desire to combine stable and enhanced diversification with new opportunities for returns.”

Which other professional investors will decide to use factor investing? “I wouldn’t be surprised to see foundations, associations and private wealth funds applying factor investing. There is a barrier to this, however. We are turning away from our familiar equities and bonds. Term spread and liquidity premium are concepts that are more abstract, and also harder to explain. On the other hand, a factor portfolio can be seen to ensure more stable returns.”

What different methods of implementing factor investing are there? “In our research paper we discuss different variants. Institutional investors often implement factor investing in stages. They may initially decide to use the first variant, the so-called ‘risk due-diligence’ method. Without immediately adjusting the portfolio, they consider exposure to different factors. You can use asset allocation to increase or decrease your exposure. An analogy would be a health scan. The second variant entails making a more conscious choice to use factors for strategic asset allocation. In this case, you adapt your investment style and benchmark to these factors. Factors that are not used in your traditional investments can be applied to alternatives. The third variant is the most logical one.

For this, you base your entire portfolio on factor premiums. However, there are only a few parties that currently do this.”

What are the three biggest obstacles to implementation for institutional investors? “Firstly, the language of factor investing is an obstacle. It is less concrete, and the terms are less well known. Secondly, there is the implementation issue of re-balancing; incorporating this effectively into investment processes requires a major effort by investors. And a third obstacle is that these are new and complex investments for many managers. It’s not really in the spirit of our times to try out new and challenging things.”

What are the main differences between these approaches? “The difference lies in how rigorously you wish to implement factor investing. You can apply different variants. But whatever option you choose, you will be fully aware of what is happening in your portfolio.”

‘There are different options for implementing factor investing’ What do the regulators think about factor investing? “There are positive and negative aspects. A robust portfolio is a positive aspect. Increased transparency of costs is another. Factor investing gives pension funds a better idea of what they do and don’t pay for. There is also a clear negative aspect from the regulator’s point of view. The notion of being in control produces potential conflicts between the regulator on the one hand and the manager or pension fund on the other. There is much to regulate. In operating terms, this raises the bar somewhat for those who wish to start factor investing. However, practical experience has already demonstrated that there are many feasible ways to implement this strategy. Professional investors will therefore increasingly be allocating to factors in the future.”

34 |

INSIGHT

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

‘Equities are the top picks for the next five years’

Equities will deliver the best returns over the next five years, with emerging market stocks at the top of the tree, says Robeco’s head of asset allocation. Lukas Daalder predicts that developed market stocks will return 5.5% a year from 2015-19 while emerging market equities are set to deliver 6.75%. This is considerably above the expected returns from bonds, where a gradual normalization of economic growth means interest rates will eventually rise from their historic lows, raising bond yields but lowering their prices. AAA-rated government bonds are seen returning as little as 0.25% a year, below the rate of inflation in most countries, though high yield bonds and emerging market debt should offer more at 2.0%. Of the other major asset classes, indirect investment in real estate (through financial investments rather than physical property) is seen as returning 4.0% a year from 2015-19, while commodity market returns are seen dropping substantially.

Economic growth favors stocks

LUKAS DAALDER , Head of asset allocation Robeco

“Strengthening economic growth and low inflation create a more favorable environment for stocks compared to bonds,” says Daalder, Chief Investment Officer for Robeco Investment Solutions.

“On an absolute basis, the returns for developed market stocks are forecasted to be lower than during the prior five-year period at 5.5% a year. But in relative terms, as an excess return over government bonds, stocks are still expected to yield above-average returns.” However, while equities are the clear favorite, Daalder cautions that stock market returns are seen being lower than those forecast in the previous edition of Expected Returns covering the 2014-18 period. He argues that the long bull run for equities since the market bottomed out in 2009 has made some valuations inflated, and that stock prices will fall more into line with the actual earnings growth of companies. “The continued strong rally in equities recent years has not been matched with earnings growth, leading to stretched valuations (overvaluation) for the asset class as a whole,” he says. “But following a year of underperformance, emerging market stocks look to be the most interesting option, as their valuation versus developed markets is now low. Investors should be mindful of course that volatility for this asset class is traditionally higher, though it has declined in recent years.” The table below shows the volatilities that can be expected from each asset class, with emerging markets clearly showing the highest levels for stocks over bonds.

Three scenarios for recovery Daalder and his team use three scenarios for predicting returns. The preferred one is a ‘gradual normalization’, which he and his team believe has a 60% probability of occuring. There is a more pessimistic one of ‘secular stagnation’, which is given a 30% chance of happening; and a more optimistic one of ‘strong recovery’, which has a 10% likelihood of coming to pass. Daalder sees the US economy, which has been going from strength to strength, taking the global lead. “The central idea with a gradual normalization scenario is that all hangovers eventually lift, even those from a financial crisis,” he says. “Given the fact that the subprime mortgage crisis in the US (2007-2009) erupted earlier than the Eurozone crisis (2010-2012), it is not surprising that the US will take the lead in this process.” “Interest rates will be raised, although policymakers are expected to choose a gradual approach, rather than being too aggressive. Growth will be supported by a recovery in labor markets and investments, but at the same time will be held back by demographics and (especially for Europe) the slow healing process of the recovery of the banking sector. Inflation in this scenario will pick up, but is not likely to pose a threat for financial markets.”

Expected volatilities Asset class

Expected returns for 2015-19

Expected returns for 2014-18

Difference since last edition

Volatility levels

Emerging market equities

6.75%

Developed market equities

5.5%

7.25%

-0.5%

25%

6.75%

-1.25%

18%

High-quality government bonds Investment grade credit bonds

0.25%

0.5%

-0.25%

0.75%

1.5%

-0.75%

High Yield bonds

2.0%

3.5%

-1.5%

12%

Emerging market debt

2.0%

3.5%

-1.5%

10%

Commodities

1.5%

4.0%

-2.5%

25%

Indirect real estate

4.0%

5.25%

-1.25%

20%

‘Stocks are expected to yield aboveaverage returns’

In the ‘secular stagnation’ scenario, the world continues on the path which we have seen over the past five years, with modest growth for the world economy as a whole, and no growth or mild deflation in the Eurozone. “In this scenario the weight of an ageing population and the lack of meaningful technological change that helps the whole of the economy (rather than the lucky few) prevents growth from moving into a higher gear,” says Daalder. “It would mean that ‘Abenomics’ fails in Japan and China weakens. Bonds and real estate would be the relative winners in this scenario, as monetary authorities will continue to push yields lower in hope of reviving the ailing economies.” He says a far happier outcome for the world economy as a whole would be the ‘strong recovery’ scenario, where investments are thriving, productivity gains translate into higher earnings, and economic growth is gathering strength globally. But don’t hold your breath – the chance of this happening is put at no higher than one in 10. “And this scenario is not without its own drawbacks,” says Daalder. “Inflation would at long last return to haunt central banks and investors alike. As such, with the exception of cash, most asset classes would end up with a lower return compared to our central scenario. Higher refinancing rates and higher wages would pressure earnings margins, while bonds would suffer from an across-theboard sell-off.”

The past predicting the future Daalder says one of the reasons why the next five years are not expected to be as lucrative as the past five is because abnormally low interest rates since the financial crisis have artificially distorted returns since 2009. “Five years out, returns have to be seen within the context of the current state of the world economy, and the developments we have seen over the past five years or so,” he says. “From an investor perspective, the past five years have been pretty

impressive – all of the major asset categories have yielded returns well in excess of their longer-term average, with listed real estate leading the pack, boasting a 16% annualized return,” he says (see chart below). From an economic perspective however, the developments have been a lot less impressive. “The world economy as a whole managed to keep up its average growth rate, but this was mainly thanks to the very strong growth performance of the developing countries: growth in the advanced economies has been lagging,” he says. “There has been no strong rebound from the major blow that was dealt during the 2008-2009 recession, with especially Europe only showing lackluster growth. Recoveries following a financial crisis are usually weak and the current one is no exception. It has pushed central banks around the world to keep interest rates close to zero, while trying to revive their economies by embarking on various unconventional monetary measures, all aimed at flooding the system with ample liquidity.” “This has been the driving force for the returns we have seen in the various asset classes. Liquidity has pushed interest rates and bond yields to unprecedented lows, forcing investors to look for returns elsewhere. Valuations in various asset categories have been pushed to stretched levels, which have a clear impact on the expected returns for the years to come.”

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

BEST OF THE WEB

INEQUALITY

The biggest hit of the last six months in the world of economics is Thomas Pikettyâ&#x20AC;&#x2122;s publication Capital in the Twenty-First Century. In this 700-page book the French economist takes a close look at the disparities in income and assets in Europe and the US. His statement that inequality has increased in the last few years caused something of a stir and his suggestion that a tax on assets should be implemented ruffled even more feathers. Every selfrespecting economist had an opinion on this â&#x20AC;&#x201C; not to mention the rest of the world.

BY LUKAS DAALDER |

Now there is little doubt that the differences between rich and poor in the US have increased significantly over the last 20 years. The issue here is that the American winner takes all mentality certainly does not apply to the rest of the world. The chart above shows the global distribution of income in different periods. It shows that this has actually become more balanced since the seventies, peaking at around USD 5000. If we also take a look at the poorest parts of the world, the trend over the last forty years has been towards less, rather than more, inequality.

| 37

38 |

SUSTAINABILITY INVESTING

– More fund beneficiaries are setting mandates – Move from a negative to a positive approach – ESG scoring adds to sustainability awareness

People power for pensions Sustainability investing is often seen as a ‘top-down’ initiative, where pension funds instruct their asset managers to include it in the investment process. But it is increasingly being driven by ‘bottom-up’ pressure, where fund beneficiaries themselves demand it for their own varied reasons. This has become evident by growing ‘grass-roots’ movements, where people of working age demand that sustainability practices are adopted by those who manage money for their future retirement.

‘People want to know what is being done with their money’

“People want to know what is being done with their money,” says Hans Rademaker, chief investment officer of Robeco. “They want to have more control themselves and have an impact, provided that in the end they optimize their financial returns. Pension funds and other institutional investors must meet these requirements.” Bottom-up demand tends to be professionally specific. In many instances these requirements revolve around exclusions of investments that are unacceptable to the group of workers concerned. In other cases, fund beneficiaries are taking a greater interest in more general ESG principles, from workers’ rights to religious grounds. For example,

journalistic freedom is the highest priority for members of the Dutch PNO Media pension fund. “So we refuse to invest in Chinese government bonds because of the restrictions on the press there,” says Jeroen van der Put, CEO of Media Pensioen Diensten, the fund’s administrator. However, the fund does not have a problem investing in tobacco companies, not least as many of its journalist members smoke. Conversely, the Zorg & Welzijn pension fund for healthcare workers specifically excludes cigarette manufacturers along with other producers of unhealthy products.

‘We have been on this journey for some time’ No longer ticking boxes

Towards a more positive approach Anders Thorendal, Chief Investment Officer of the Church of Sweden Fund, says interest in responsible investing has been growing among his members, who include church employees and lay people engaged in its work. “We have been on this journey for some time, starting with a negative approach – using screening to exclude polluters, weapons manufacturers or companies engaged in child labor, for example,” he says. “But this has now moved on to a more positive approach i.e. investing in the best companies, using for instance ESG scoring, as there is a growing awareness today that it also make sense financially to

have a sustainability approach, because these investments perform better.” He says climate change is in many ways important for the Church of Sweden. “That affects our investments as well. So the biggest issue today from a negative screening point of view is actually to avoid the large fossil fuel extractors, i.e. the oil and coal companies.” According to Thorendal, retail investors mainly want to make sure that the investments are ethically sound. “But they do not yet appreciate in the same way as institutional investors are beginning to realize, that a sustainability approach could also be a way of getting a better return on your investment.”

From the asset managers’ perspective, the pressure from pension funds adopting more sustainable practices can be seen in Requests for Proposals (RfPs). Analysis by the UK’s Aviva Investors showed that 89% of their RfPs contained questions about ESG issues, and funds asked on average 6.5 questions per proposal. “We no longer see RfPs without ESG questions in them,” says Edith Siermann, Robeco’s chief investment officer for fixed income. “Investors feel they do need to address the whole issue of sustainability; this is no longer a few guys sitting in a back office ticking boxes. Much more effort is being put into it and this is likely to continue.” However, the pressure from members to include sustainability is not universal. In a recent Workplace Pensions Survey by the UK’s National Association of Pension Funds, 42% of respondents said they would invest in a fund where sustainability factors were dominant. But 11% said they would not, and 48% had no opinion. This means there is still a long way to go before the issue becomes widely accepted, but in comparison to a decade ago the trend is clearly into the direction of more awareness and more pressure for sustainability in investments.

40 |

EQUITIES

Regulation creates opportunities for financials The effects of the last major financial crisis have been far-reaching for banks – Higher capital requirements lead to more expensive banking and insurance services – But European payment transactions offer opportunities for newcomers – IT companies benefit from increased outsourcing

PATRICK LEMMENS, Portfolio Manager Robeco New World Financials Equities

and insurance companies worldwide. Investors tend to look at the negative aspects, like higher capital requirements that put pressure on returns. “But regulation creates opportunities too,” says portfolio manager Patrick Lemmens of Robeco New World Financials Equities, who received the Lipper Fund Award on 31 March for his fund’s strong track record.

The banks are responding to the higher capital requirements by charging more for their banking services, says Lemmens. The new global regulatory system for banks, Basel III, is responsible for raising these capital requirements. This system is pushing up the requirements for capital and liquidity, while financial leverage needs to be reduced. Basel III is being introduced to tackle the inadequate regulation that contributed to the major financial crisis of 2008. Lemmers explains the consequences. “This helps banks boost returns on their capital in order to retain access to the international capital market. There are not many other options for improving profitability. Reducing costs is harder, as cuts have already been made here.”

In his opinion, this also applies to insurance companies. The introduction of Solvency II is impacting the European insurance sector. The objective of this European directive is to make sure insurers have sufficient capital reserves. “Covering longevity risk costs more in the Netherlands than in other countries as a result of the regulators’ high capital requirements.” There is also another reason why higher capital requirements can lead to raised costs. The regulators are scaring off newcomers with more stringent capital requirements and reporting obligations, says Lemmens. “They are putting up daunting barriers that make it increasingly hard for newcomers to enter. This prevents new companies that are willing to slash prices from gaining access and thus benefits the established order.”

‘It is becoming increasingly hard for newcomers to gain access’ But European payment transactions offer opportunities for newcomers There is one section of the banking world where competition is increasing, however, and where this monopoly is being broken: European payment transactions. The reason for this is that banks in the European Union are required to provide client data to competitors to make it easier to switch from one company to another. “This should make payment transactions cheaper and easier. In the case of client data, for instance, this includes account holders’ direct-debit and standingorder authorizations. The banks’ monopoly on payment transactions is disappearing. Competition will increase as new players start processing payment transactions for stores and webshops, for instance. A power shift is taking place amongst those parties handling payment transactions, making way for new innovative players. This is why I invest in companies such as Optimal Payments and Wirecard. These companies are expected to show rapid growth in the coming years.” Lemmens sees opportunities in payment transactions mainly for innovative companies that challenge the established order, and therefore does not invest in large technology

companies. “I often wonder what Google is up to in the banking sector. I don’t think they intend to become a bank. Clearly, they have a lot of search data that can make them money. And they can simply buy up a bank to obtain a banking license. But the downside of such a takeover is that it puts you in full view of the regulator, who could then easily decide that Google is a systemically important bank and must maintain additional capital buffers.”

IT companies benefit from increased outsourcing The pressure of regulation on banks and insurance companies has increased in the aftermath of the financial crisis and has led to the outsourcing of IT activities, says Lemmens. Banks and insurance companies can no longer handle these activities on their own and are finally prepared to outsource them. In his opinion, dealing with IT has become too great a challenge to handle alone. “Just providing the regulators with all the different loan data is a massive task for the banks. This does not happen simply by pushing a button – it is a complex process. Much of this data is sourced from diverse IT systems and is subject to different methods of administration. Nevertheless, you are expected to provide it in a uniform way, and so banks have to process, match and check their loan data.This requires extra investments in IT. Banks now no longer want to do the work themselves and are engaging third parties to handle it for them. An added advantage of outsourcing IT is that it enables you to make the related costs more variable, causing you to become less sensitive

to the economic cycle. Companies such as Cognizant, Simcorp and Temenos that supply IT services for banks will benefit from this outsourcing trend. They also happen to be the companies I have in my Robeco New World Financials portfolio.” Robeco New World Financials Portfolio

Benchmark

2004

12,45%

9,63%

2005

34,42%

28,33%

2006

11,14%

10,65%

2007

-19,26%

-17,29%

2008

54,29%

-51,66%

2009

36,66%

27,00%

2010

13,40%

11,87%

2011

-23,08%

-15,77%

2012

30,91%

27,37%

2013

26,23%

21,83%

YTD*

0,14%

-0,73%

Net returns based on net asset value. * January and February 2014 The value of your investment may fluctuate. Results achieved in the past are no guarantee of future results

The table shows the net returns for Robeco New World Financials Equities (in EUR) relative to the MSCI World Financials Index (net return).

42 |

FACTOR INVESTING 3

A smart approach for factor premiums in credit markets Scientific research shows that focusing on the characteristics (â&#x20AC;&#x2DC;factorsâ&#x20AC;&#x2122;) of equities results in an improvement of the risk-adjusted return. However it is less well known that factor investing also works for credit portfolios. Research in credit markets shows that investing based on factors results in a better Sharpe ratio than investing in the market index. Scientific research in equity markets shows that investing based on factors results in an improvement of the Sharpe ratio of portfolios in the long term. Well-known factors are Lowrisk (low-volatility stocks), Value (stocks with a low price/book ratio), Momentum (stocks with a high return over the past twelve months) and Size (small companies). These factors are also referred to as anomalies because their returns cannot be explained with traditional investment theories. Research carried out at the request of the Norwegian Government Pension Fund showed that the largest part of the active return of this fund could retrospectively be attributed to the exposures to these factors.

Better Sharpe ratio PATRICK HOUWELING, Portfolio Manager

Basing its approach on factor investing in equities, Robeco carried out research into

the construction of corporate bond portfolios using the following factors: Value, Momentum, Size and Low-risk. Martin Martens, Head Quantitative Fixed Income Research at Robeco: “Our research shows that investing based on factors results in a better Sharpe ratio than investing in the whole market index. This applies to both investment grade and high yield. So factor investing indeed works for credits.” According to Patrick Houweling, Quantitative Credits portfolio manager and researcher, the challenge is to use a definition for each factor that is specific for credits and not to just ‘simply’ copy the equities definition. “For example, the objective for Value is to determine whether a company’s credit spread is too high or too low and not whether the shares are expensive or cheap. For ‘credits Value’, the trade-off is generally between the market estimate of the risk – the credit spread – and the objective risk as for example estimated by a rating agency. Another example: for the low-risk factor for equities historical volatility is often used. For credits, the maturity and the rating are generally regarded as generic risk measures: the longer the maturity and the lower the rating, the riskier the bond.”

Smarter definitions In addition to a generic definition of each factor, Robeco also uses a ‘smarter definition’. Robeco examined whether the Sharpe ratio of the general definition could be improved by estimating risks more precisely or avoiding unnecessary risks. Martens: “For Value, instead of looking at ratings, you can look at

theoretical credit risk models that combine a company’s balance sheet information, such as leverage, and a company’s equity information, such as its volatility, in a smart way.” Houweling: “You can construct a low-risk portfolio by avoiding the longest maturities and the worst ratings. This already results in a better Sharpe ratio than the market. However, we have found smarter risk measures than ratings. Our study shows that a better Sharpe ratio can be achieved for each factor than with the generic definition.”

‘Avoiding losers is more important than selecting winners’ Low-risk credits Analogously to low-risk equity investing, Robeco developed a strategy two and a half years ago for low-risk corporate bond portfolios. Houweling: “Our empirical research shows that, in a full investment cycle, lowrisk corporate bonds have the same return as ordinary corporate bonds, but with a 50% lower volatility. This results in a better Sharpe ratio. The key is that you implement the low-risk factor by investing in low-risk bonds of low-risk companies.” Martens lists three rules of thumb for the implementation: avoid unnecessary risks, do not go against other anomalies and avoid unnecessary turnover. Martens: “Avoiding losers is more important than selecting winners. In addition, you can

decrease risks by constructing a diversified portfolio. Do not select companies only based on Low-risk characteristics, but also make use of Value and Momentum. And finally, opt for a buy and hold strategy to avoid unnecessary turnover and high transaction costs, and to earn the illiquidity premium.

Fundamental check In addition to quantitative analysis, fundamental analysis by the Credit Team is also important in order to monitor non-quantifiable risks that are difficult to capture in a model. What does the structure of the company look like? Has the parent company issued a guarantee for the entity that issued the bond? Did the management announce a planned acquisition that will result in higher leverage? How does a company score on ESG criteria, such as sustainability, labor conditions and the quality of the management? Houweling: “These types of risks are not reflected in the existing balance sheet data. Our analysts identify the non-quantifiable risks timely and thus help further reduce the risk of the portfolio.”

Robeco Conservative Credits Within Robeco Conservative Credits, the lowrisk factor is implemented by investing in a disciplined manner in low-risk bonds of lowrisk companies. Conservative Credits is being applied in various mandates with a total size of EUR 2.6 billion as at the end of April 2014. Robeco is currently carrying out research into the implementation of other factors in disciplined strategies.

44 |

FIXED INCOME

The impact of ESG on the energy sector Policy makers around the world are issuing regulations to limit CO2 emissions and climate change. Not only does this change the global energy market, it also influences the credit quality of sectors and individual companies. We use real portfolio examples to show the impact of this sustainability theme on credit portfolio construction.

Robeco Credit team

In both the US and Europe governments have introduced new regulations to reduce air pollution. The impact of both is felt globally across many sectors and introduces systemic regulatory risks. Robeco’s credit analysts and portfolio managers discuss the impact of these measures on the different industries and the implications for Robeco’s credit portfolios. It illustrates how sustainability is integrated into Robeco’s credit process.

Coal losing its shine The increased use of biofuels and shale gas caused the percentage of coal used in the energy mix for US power plants to decline from 48% in 2008 to 39% in 2013, primarily in favor of gas as a fuel source. This trend has had, and continues to have, a profound effect on the investment landscape.

45 Reduced importance of coal

As Robecoâ&#x20AC;&#x2122;s credit investment strategy is partly based on avoiding defaults, we underweight high cost, often more risky underground mines. Higher cost miners like New World Resources, which recently announced a capital restructuring, are examples of companies we avoid in the high yield portfolios. At the same time, we constantly evaluate companies that might survive under a conservative scenario. We regard more efficient producers like BHP and Rio Tinto, which operate cheaper and more efficient open pit mines in Australia, as more interesting investments. Not only is their production closer to growth markets in Asia, including Japan where nuclear plants have been idled, their coal also has a higher energy content with less impurities. These large scale operators are more diversified and are biased to OECD countries with less country risk, better regulation and legal protection for their assets.

Reduced importance of coal | U.S. Fuel Mix 2001 - 2012 4500k 4000k Thousand Megawatthours

Many thermal coal producers had highly levered balance sheets after the commodity boom up to 2008 and suffered severely when the coal price dropped below their cost of production. Many expensive underground and remote mines were closed. Mining companies are capital-intensive businesses and they need high EBITDA margins to fund the nessecary capex requirements. Only the lowest cost producers have sufficiently high margins to cope with the declining coal price and have the ability to generate cash flow to service the debt. Small sized higher cost miners have gone bankrupt and the larger more competitive miners have started to export their coal into Europe.

3500k 3000k 2500k 2000k 1500k 1000k 500k 0k Coal

2001 Oil

2002

2003

2004

Natural Gas

2005 Nuclear

Source: EIA

Longer term beneficiaries are producers like Siemens and General Electric. These companies can benefit from building gas turbines that fit more emission light policies and help develop smarter power and more efficient power grids. We have also looked at investing in renewables equipment producers like Vestas (wind turbine manufacturer) and Gamesa. However, these producers suffer from severe overcapacity in their market and from unstable government support in both the US and Europe. This makes them too risky for us as a bond investor.

The shale revolution The improvement in drilling technology, so-called horizontal drilling coupled with hydraulic fracturing, and supportive oil prices, have allowed the US to tap unconventional resources at unprecedented levels. Onshore oil

2006

2007

Hydro

2008 Wind

2009

2010

Other

2011 Biomass

2012

â&#x20AC;&#x2DC;The International Energy Agency expects that the US will become one of the three largest oil producers in the futureâ&#x20AC;&#x2122;

and gas production has risen by a whopping 63.5% since 2007. In contrast to conventional dry gas wells, unconventional wells often produce crude oil plus associated other liquids like natural gas liquids. Such wet gas components make drilling more attractive due to the more profitable crude oil and NGLs in the production mix. The International Energy Agency (IEA) expects that the US will become one of the three largest oil producers in the future, narrowing the gap with Russia and Saudi Arabia. The US is also expected to become energy independent in the foreseeable future. Despite low gas prices, in our credit portfolios we invest in companies that are successful in unconventional drilling like Continental Resources, Anadarko Petroleum, and Devon Energy. These companies are winners as they have more oil and liquids in their production mix, or are shifting to this, which boosts overall profitability. They also belong to the group of early movers into the unconventional regions and production methods which gives them a clear cost advantage. These companies also have proven to divest non-core assets to fund the large capital requirements to further develop the unconventional liquids reserves. However, we do acknowledge that these huge capital investment activities bear risks to the cash flow of the companies as well.

Negative impact on gas-centric E&P companies Rapid increases in natural gas production, combined with infrastructure constraints in

the newly producing areas, and the limitation on export facilities for gas caused the natural gas price to fall to a historically low level in the beginning of 2012. The ongoing strong supply from the unconventional plays, the limited growth in domestic gas demand, and constraints on current export facilities have delayed the recovery of the gas price. Exploration & Production companies that have a large portion of gas in their production mix are suffering from the very weak gas prices. Hence, most E&Ps have reallocated their capital investment to more profitable unconventional liquids producing areas. Consequently, the lack of near term cash flow generation (due to lead times) and the (potential) deterioration in balance sheet leverage figures should put the credit profile of these companies under pressure in the short term. The winners will be companies that are early movers into the unconventional oil plays as they benefit from cost advantages; companies that own a diversified asset base and are willing to use asset sale proceeds to fund large capital requirements; and companies that have capabilities to develop the unconventional reserves to grow their liquid production. The rapid increases in crude oil, NGL and natural gas production in onshore unconventional plays and the existing limited infrastructure facilities will continue to prompt strong demand for new midstream facility assets, creating many opportunities for midstream companies. On the other hand, midstream

companies with asset bases concentrated in the conventional gas areas are likely to suffer from declining demand for their facilities. Companies like KMP and El Paso Energy Partners are nice portfolio examples in the investment grade team. Very stable take-or-pay contracts make them good investments.

US chemical advantage over many other regional production centers US chemicalproducersâ&#x20AC;&#x2122; producersâ&#x20AC;&#x2122;cost cost advantage over many other regional production centers

Increasing regulatory scrutiny in the oil and gas industry

40%

The oil and gas industry is under increasing regulatory scrutiny in the US amid concern that chemicals used in the fracking process may contaminate drinking water. The EPA is investigating the safety of hydraulic fracturing in the US, and the results are expected in the fall of 2014 (delayed from 2012). However, according to a Moodyâ&#x20AC;&#x2122;s study, new regulations for horizontal drilling and hydraulic fracturing seem remote now. National security and economic considerations make it extremely unlikely that the US will ban hydraulic fracturing, or even impose restrictions. The expectation is that the US government could make additional requirements concerning recordkeeping, permitting, well testing and completion methods, and water handling. Such requirements would raise the cost of drilling and completing a well.

20%

Shale gas reorders competitiveness in chemicals Most large volume chemicals products are based on natural gas and/or oil-based feedstocks. With the increase in shale gas extraction and the related boost in the production of NGLs, US-based chemicals

90% 80% 70% 60% 50%

30%

10% 0%

2007

2008

CostIHSadvantage Source: Chemical over Europe

2009

2010

Cost advantage over NE Asia

companies have seen their relative cost position in the global industry improve significantly. Unsurprisingly, the widening competitive advantage has led chemicals producers to plan new capacity in the US. Projects currently in planning would increase North American ethylene capacity by 42% from 2011 levels through 2019, when the last project currently in planning is scheduled to open. On a global basis, these investments would represent a 19% capacity expansion. What will the net effect be? Significant development plans are ongoing and although slower than expected, there will likely be a significant step-up in US-based chemicals capacity in the coming years. This could pose a risk for producers globally, if the new capacity

2011

2012

2013

Cost advantage over SE Asia

is insufficiently absorbed by new demand, a common risk for this cyclical industry. Also likely is an increase in US chemical exports, and this presents a competitive issue for Europe-based producers, who will see an increase in lowercost imports. European-based producers are already cutting capacity, mostly due to the recent Eurozone recession, but also given their higher cost profiles. The main investment implications of shale gas for chemicals is that US-based producers have been enjoying, and are likely to continue to enjoy, very favorable cost profiles in the coming years, and until the new capacity comes online, they may be able to sustain aboveaverage margins (as long as the economic recovery is sustained). European producers with geographic diversification and/or a lowcost position within an otherwise higher-cost environment will continue to be viable, but there may need to be additional compensation for investments in such companies. Mergers & Acquisitions around this theme are likely to continue, and could result in additional investment opportunities (e.g. the planned tie-up between IG-rated Solvay and HY-rated Kerlingâ&#x20AC;&#x2122;s European PVC assets). We continue to invest in Solvay as the companyâ&#x20AC;&#x2122;s scale, market positions and more specialty product orientation make it a clear leader that can survive the ongoing shale gas competitiveness shift. Our underweight position in Kerling is partly due to its exposure to an eventual rise in US imports, despite it occupying a low-cost position within Europe.

Lower wholesale and higher retail electricity prices Nevertheless, the increase in wind and solar electricity generation is real. These electricity sources have zero marginal cost and their large introduction has caused a decline in wholesale electricity prices which substantially hurt utilities’ profitability. This is especially true for peak electricity prices (during midday, when the sun shines) which have come down drastically and which have always been the backbone of utilities’ profitability. At the same time, renewable electricity generation is still expensive to very expensive, as evidenced by the massive European subsidies needed to convince investors to build renewable generation: now around EUR 30 billion per annum and rising. The end result is low

55000 50000 45000

Demand (MW)

2012

75000 70000 65000 60000 55000 50000 45000

90 80 70 60 50 40 30 20 10 0

(€/MWh)

65000 60000

80000

1.00 3.00 5.00 7.00 9.00 11.00 13.00 15.00 17.00 19.00 21.00 23.00

70000

90 80 70 60 50 40 30 20 10 0

(MW)

2006

75000

(€/MWh)

80000

1.00 3.00 5.00 7.00 9.00 11.00 13.00 15.00 17.00 19.00 21.00 23.00

In Europe, the climate policy has spent vast amounts of public money, sent power utilities to the brink and done little to reduce emissions of carbon dioxide. How has this come about? In brief, the combination of massive investments in renewable electricity and lower demand for electricity, caused by economic decline and the move of the European industrial base to China, has caused a very large oversupply of CO2 permits. This has caused very low CO2 prices which – in conjunction with low coal prices imported from the US – has helped especially the European coal-fired electricity producers. As CO2 reduction is much more about curbing coal plants than about the increase in renewable generation, the net result is an increase in emissions of carbon dioxide.

European peak electricity prices havehave comecome down down drastically European peak electricity prices drastically | Average Demand vs. Average Intra-day Power Prices in Germany Average Demand vs. Average Intra-day Power Prices in Germany

(MW)

Problems for European utilities

Power price (€/MWh)

Source: Bloomberg ENTSO-E Source: Bloomberg

wholesale electricity prices (hurting utilities’ profits) and rising retail electricity prices paid by end consumers (which include the subsidies). Energy poverty is back on the political agenda in Europe. European utilities expect this situation of oversupply and low (wholesale) power prices to continue for a long time and basically predict an almost collapse in profitability in their generation divisions. German energy policy has led to a dramatic deterioration in the profitability of energy generators like E.on and RWE. The consequence is much lower profitability and impairments on traditional unprofitable generation plants. Some have even been taken out of business. RWE recently reported its first quarterly loss ever. The consequence is that the credit profile deteriorates. We expect a rating migration close to, or even into high yield territory, coming from strong AA in the past. This may be accelerated if trading activities are increased to make up

‘German energy policy has led to a dramatic deterioration in the profitability of energy generators’ for the loss in the generation business. The portfolio managers are fully underweight these German generators until credit spreads reflect their much higher risk profile. In the future a new theme will be utilities closing inefficient assets like the marginal gas turbines. At the same time a disequilibrium will emerge when renewables are off line and electricity demand is high. The will cause system stress. In the future we will probably need a system that rewards utilities for having reserve capacity in place.

Global CO2 emission targets â&#x20AC;&#x201C; Grams of CO2/km emission targets around the world

R&D needed to comply with stricter regulation in the automotive industry

Global CO2 emission targets | Grams of CO2/km emission targets around the world

280

Reducing the CO2 emission of cars is getting a lot of media attention at the moment. Recently the EU agreed on reducing the average emission of new vehicles to 95 g/km in 2021. In the past decade the industry has already accomplished a large reduction in CO2 of new vehicles. Getting less attention, but at least as important is the reduction of harmful NOx emissions that has been achieved.

260 240 220 200 180 160 140 120 100 80

2000

2005

US & Canada light vehicles China Korea

2010 US & Canada cars only

Source: Source:Bloomberg ICCT, Continental AG, SG Cross Asset Research/Equity

2015E Europe

2020E Japan

2025E

Reducing emissions is capital intensive for the auto industry as it requires high Research & Development spending and investments. For the coming years we expect an acceleration in R&D spending. Europe and the United States are targeting lower emissions. But

also emerging markets require a reduction in emissions as their megacities are suffering from pollution from car fleets. Fully electric vehicles are seen by the media as the Holy Grail to reduce emissions. In our view this is only the case if electricity is generated â&#x20AC;&#x2DC;emission-freeâ&#x20AC;&#x2122;. Furthermore there are still many issues with battery capacity and pollution generated by battery production. An alternative could be hydrogen fuel cells. However, apart from technological issues, a lack of infrastructure will be holding back the penetration of these new powertrain techniques. We expect that in the next decade improving fuel efficiency of combustion engines will be the most important factor in reducing emission.

In our portfolio we have a preference for parts suppliers like Continental, Robert Bosch and Valeo which are active in improving the fuel efficiency of combustion engines. The market for these products will continue to grow in the coming years and suppliers have strong pricing power due to the high innovation level in these products. Furthermore, we believe that scale becomes increasingly important in the auto industry as high R&D costs have to be earned back. The profitability of, for example, Daimler and BMW has yet not been under pressure. However, these companies guide to lower profitability in the coming years because of heavy R&D spending. Auto companies with insufficient scale will have difficulty competing on a global level. For the automotive sector we are wary of

the fact that companies like VW and FIAT do make a disproportionate part of their profit in countries like China or Brazil. Country risks must be reflected in spreads too.

Conclusion: understanding ESG trends is important This article shows that when policy makers change the rules, it has repercussions for whole sectors. The US mining sector that used to be profitable is full of restructuring stories and US chemical plants are suddenly the most competitive. At the same time in Europe policies did harm the utilities sector but did not make the economy greener. Understanding ESG trends like this is crucial when constructing portfolios and optimizing the risk-return profile.

52 |

OPINION

Finding the next Google Great companies that turn an industry upside down can come from anywhere, and the next Microsoft or Google is just waiting to be found. To find them, you need to be more aware of talent than of location, says entrepreneur Niklas Zennström.

NIKLAS ZENNSTRÖM, CEO Atomico

– Big success stories come from unexpected places – Biggest problem is locating and nurturing this talent – Looking outside America’s Silicon Valley is key

‘We have a clear purpose to enable high-growth companies to develop disruptive products’

Zennström now runs investment firm Atomico trying to find and develop the high-tech winners of tomorrow. He was speaking to a knowledge-sharing session with the RobecoSAM Private Equity team, which was one of the first institutions to invest in Atomico. And Zennström certainly knows a thing or two about nurturing young companies into a global giant worth billions. He is best known for co-founding Skype, which he and business partner Janus Friis sold to eBay in 2005 for USD 2.5 billion, reacquired it in 2009, and sold it to Microsoft for USD 8.5 billion in 2011. The two men had previous co-founded the filesharing internet service Kazaa which became the most downloaded software in 2003. Zennström, a 48-year-old Swede, is now trying to find the next Skype, searching for young tech companies that have strong business models but need venture capital and/or expertise to expand. The companies must be internet orientated and have a proven business model. But his most important rule is that the

companies should generally be based outside Silicon Valley, challenging the hegemony of the US high-tech epicenter that has produced companies such as Google and Facebook. He specializes in developing companies with ‘disruptive’ products – those which are capable of challenging, and beating, leaders in established industries.

Big disruption from small places “Great companies can come from everywhere – it is one of the biggest investment opportunities in the world today,” says Zennström, who retains his entrepreneurial zeal despite never having to work again. “This is the core reason why we started Atomico. We have a clear purpose and focus to enable highgrowth companies from outside Silicon Valley to develop disruptive products.” Skype was the ultimate disruptive product. Developed from small offices in small countries – Estonia, Sweden and the Netherlands – it

took on the entire international telecoms market by offering the ability to make free phone calls over the internet. Skype now accounts for 40% of the international calls market. “We look for growth companies, based outside Silicon Valley, for a global market. That’s how Skype started, and it can happen again,” he says. “When we were building Skype 10 years ago, it was quite unusual for a couple of Swedes, a Dane and an Estonian guy to try to disrupt the global telecommunications industry. Very few people believed in us – we were seen as crazy.” He was rejected by 25 investors, including a prominent firm which demanded that the fledgling firm move to Silicon Valley, which he declined to do. “All this negative feedback didn’t stop us from trying to build a successful international business – which we did,” he says. “It was a big competitive advantage for us coming from a small country like Sweden, where the home market is too small. It forced us to think of the global market.”

Finding global talent is the challenge Since Skype was founded, 30 technology companies which now have market values above USD 1 billion have been created within Silicon Valley and another 10 in China, but 40 were created elsewhere. “This tells us you don’t have to be there to create a great company,” he says. “It’s actually more likely that the next USD 1 billion company will come from outside it. The challenge is to find them. Geography is becoming less and less relevant, and the reason for this is fundamentally about talent. Talent is everywhere – just like in sports and music, entrepreneurs are all over the world. But to enable them to blossom and build great businesses, they need ecosystems around them.”

‘Geography is becoming less and less relevant - it is fundamentally about talent’ Historically there have been significant barriers to creating large technology companies. You needed to have access to computing power, bandwidth hubs, and information, along with capital of course. This has changed completely over the past decade. Zennström “Thanks to the internet, entrepreneurs from all over the world have access to the same type of

information, whether they are in Rotterdam or São Paolo. It’s a level playing field now you have open-source software, and thanks to cloud computing, you no longer need access to data centers.”

Access to capital is still a barrier However, access to capital is still a significant barrier to growth for new companies, he says. The acquisition of ‘non-native’ skills is also important as most tech companies tend to be started by engineers who lack wider business acumen. There are often also differences in national markets, cultural issues and problems with making the right contacts in larger markets where a small company would not know where to start. “For us, this creates a huge opportunity, as we found with our own journey with Skype, where we had to build partnerships and develop knowledge to get into foreign markets such as Japan,” he says. “This is now something we bring as an asset manager to the companies that we invest in. We don’t just provide capital: we provide real, practical help to enable these companies to reach their full potential.” Finding the right exit strategy for a company – a mainstay of any private equity firm’s business – is also important. Atomico was able to introduce one of its investees, the Finnish games maker Supercell to Gung-ho in China to crack the Chinese gaming market. It led to the Japanese investor Softbank buying a 50% stake in Supercell, valuing it at USD 3 billion and making instant multi-millionaires of the founders.

‘We don’t just provide capital: we provide real, practical help’ In another example, investee company Climate Corporation, which sells weather insurance to farmers, was sold for USD 1.1 billion to Monsanto, an agricultural giant not previously known for buying technology companies. “Neither side could have predicted that something like this would happen when the business was started,” he says. “It proves that a great company can come from anywhere and also that a great exit can come from anywhere.” Zennström: “It’s hard to predict where the next ‘big thing’ will come from. But what’s really interesting is the coming together of offline and online. In the future it will no longer be relevant, because consumers will buy products and decide whether it is cheaper to buy the same thing offline or online. It will be the same showroom but in different environments.”

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QUANT: FACTOR INVESTING 4

‘Factor investing will unleash a revolution’ “A revolution in investment management is about to happen due to factor investing,” says Professor Andrew Ang. “Factor benchmarks to assess investment managers will contribute hugely to this change.”

INTERVIEW WITH ANDREW ANG

Understanding the nature of risk and return in asset prices is at the heart of Professor Andrew Ang’s research. The professor of Columbia Business School was keynote speaker on the Robeco Factor Investing Seminar. After his lecture for approximately 100 professional investors we took the opportunity to speak with him separately.

How would you define factor investing? “Factor investing is an investment style that aims to make money over the long term. It involves harvesting a long-run risk premium. Factor investing involves risk, so sometimes there are short-term losses. Some of the factors involved are very simple factors and well known such as equities and bonds. These are the extra returns you get when

ANDREW ANG, Professor of Columbia Business School

‘The biggest challenge lies in the mindset of the investor’

investing in these markets. And some are more sophisticated dynamic factors such as value, growth, momentum, volatility, credit and duration. Factor investing is a way of making strategic choices – what drives returns? But it can also be a source of diversification or alpha compared to traditional market-weighted benchmarks. Just like ‘eating right’ requires you to look through food labels to understand the nutrient content, ‘investing right’ means looking through asset class labels for the underlying factor risks. It’s the nutrients in the food that matter. And similarly, the factors matter, not the asset labels. To take the food analogy further, the advice you would give for a baby with regard to nutrients is not the same as the advice you would give to an adult. There is no optimal mix for allocating factors either – it all depends on investor preference.”

You spoke of factor investing in terms of a revolution, but this is a slow process. Isn’t this more an evolution? “Actually, it has already unleashed two revolutions. The first revolution in investment management on harvesting factors occurred when the first market-index funds started in the 1970s. The first revolution was very slow.

Now a second revolution in dynamic factors is about to take place. The second revolution is complicated, but the first one to create marketindex funds was also complex. Just take the constantly changing price of the underlying securities. It may seem easy now, but the people who started these funds did not think so. And the second one will also take time. This has to do with how people think and how the industry is structured. It is hard to get people to change.”

What is the biggest challenge for factor investing? “The biggest challenge lies in the mindset of the investor. Organizational issues are also significant. Where does factor investing belong in an organization? We need to have structures in place to make sure we can stay the course, as factors are not always going to work. Sometimes they will fail, and sometimes skittish investors will get out right at the wrong time. Factor investing takes commitment and knowledge. Portfolio management is not the biggest challenge. Clearly, there are more ways than one to manage a factor portfolio, but wanting to manage one is what counts most. There are already asset managers who can deliver on factor investing.”

How do you see factor investing in the debate on active versus passive management? “The debate is wrong. Everything is active – even just choosing the proportion of equities in your portfolio, or how often to rebalance it. These are active decisions.”

became mainstream for investors in the 1990s and into the 21st century (i.e. 30 - 40 years). The first academic factor papers appeared in the late 1970s. Much empirical research took place in the 1980s and 1990s. We are only 20 years further now. Some developments take a long time.”

What part of factor investing needs more research? What about the discussion of investment-management fees? “You should never overpay for something you can get more cheaply. The discussion about costs is linked to the use of factor benchmarks to assess investment managers. We need transparency on the underlying factors that drive performance. How much of a manager’s performance is alpha and how much is factor exposure? Unfortunately, investors do not evaluate enough. Take the case of hedge funds – they do not evaluate performance against a factor benchmark. But they should! Why pay 2/20 (2% management fee, 20% performance fee) when you can get it for free? If you evaluate, you pay only where this is warranted. Besides performance evaluation, factor benchmarks can be used for strategic allocation choices. Choosing between factor benchmarks – which differ just like long-only equity benchmarks – is an active decision. Factor benchmarks can also be used to keep your active portfolio manager from deviating too much. For you, as an investor, these benchmarks represent optimal exposure to risk premiums.”

‘We need transparency on the underlying factors’ Will factor investing become mainstream? “Like market-index funds, this will become a mainstream trend. This is not in evidence yet, however, and even when the trend sets in, only a minority of investors will be willing to follow it at first. The capital assetpricing model started being applied in the 1950s and 1960s. It only

“The real research challenge lies in illiquid markets like private equity, infrastructure and real estate. How do you separate and measure their factor exposures? How do you measure returns? Can we make this area less opaque? Those are the big questions we should ask ourselves. Some of my recent papers are focusing on this subject. It would be of tremendous benefit for investors if we could bring public benchmarks to those markets. But we don’t have them yet.”

The report you helped to write for Norway on its sovereign wealth fund put factor investing on the agenda of professional investors in the Netherlands. Did you expect that? “No, it was an assignment for the government. I am glad to hear it made an impact. Norway was very transparent about our report on the value of active management. The country has provided a great service to the investment community.”

BEST OF THE WEB

SAME OLD, SAD STORY

This rough sketch on a paper napkin shows what many studies have already demonstrated: that there is a significant difference between market returns and the returns investors generate. To illustrate: the market return is the return that you would have generated if, for example, you had bought an index. Your return as an investor is what you receive because you actually bought a couple of stocks, sold them and bought them back again. This is exactly where things go wrong: investors carry out too many transactions, hold their loss-making positions for too long or take profits too quickly on stocks that have performed well. This sort of irrational behavior is in fact so general and persistent, that it leads to anomalies in the market. The study of behavioral finance looks into these anomalies and has already come up with a number of trading strategies that actually take advantage of these human â&#x20AC;&#x2DC;mistakesâ&#x20AC;&#x2122;.

BY LUKAS DAALDER |

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OPINION

‘Google Glass has caused a backlash before it has even been launched’

JACK NEELE, Portfolio Manager Global Consumer Trends

BEN HAMMERSLEY, Futurist

How to find investable trends? Investors need to look beyond the traditional labels of sectors, countries and markets to find the best investable trends.

– Inventions must be socially acceptable – Don’t be limited by country borders – Find investable trends via communities – Connectivity with customers is key – Look for sustainable trends, not bubbles

PARAG KHANNA, Globalization Expert

The latest Robeco World Investment Forum enjoyed state-of-the-art insight from global ization expert Parag Khanna, futurist Ben Hammersley and Robeco’s consumer trends portfolio manager Jack Neele on what are the biggest trends of tomorrow. Hammersley says it is important to realize what new inventions are acceptable to society, citing Google Glass as “creepy technology” that does not have general acceptance. Khanna believes that globalization and a defragmentation away from allegiance to nation states means investors should look more at social groups to find the best opportunities. Combining both themes, Neele advises that the best investments will be in communications or connectivity services rather than gadgets per se.

Some inventions are uninvestable Hammersley warned the conference that some inventions will become unsellable, and therefore, uninvestable. He cites the example of Google Glass, which allows users to record things using wearable eyeglasses and have already been banned in restaurants and other public places before they even go on sale. “The biggest trend is not what is possible, but what is the reaction to it,” said Hammersley, a leading author, ‘digital guru’ and trendspotter who is credited with inventing the word ‘podcast’ to describe bite-sized video streaming. “This will rule out the adoption of certain technology like Google Glass because people think it is creepy. Google Glass has been banned in many places before it has even been launched – even producing a term ‘Glassholes’ for users of them – and has caused a backlash because it is socially unacceptable to many people.”

Beware of ‘context collapse’ Hammersley introduced delegates to the threat of ‘context collapse’ – where inventors forget about the wider implications of their products. “The issue of context collapse will be the biggest driving force over the next 10 years, because so many people are freaked out by many new technologies,” he said. “There is a clash between an engineering mindset of what is possible and a social science mindset of what is acceptable.” Regarding investable companies, he believes investors should look past ‘surface trends’

and avoid fads that can turn into bubbles. “Facebook is a medium-term bubble but Amazon is a good old-fashioned sales business that is undervalued,” he said. Bitcoin? “That’s a bubble because no-one really knows what it is: is it a payment processing system or a virtual currency? We need to look past ‘surface trends’ to find the long-term technology trends where there is a common platform and everyone agrees with the principle behind it, such as electric vehicles.”

‘Bitcoin is a bubble because no-one really knows what it is’ Resilience of globalization Globalization is another factor determining how the future will play out for investors, according to Khanna, director of the Hybrid Reality Institute and a Senior Fellow at the European Council on Foreign Relations. “You cannot plan a portfolio without taking into account the resilience of globalization. As the majority of flows are occurring across regions,

the old borders drawn up centuries ago no longer exist, and investors must incorporate this lack of boundaries into their thinking. Globalization is an anti-fragile phenomenon - it is the one thing we all participate in, and it will carry on. Its resilience comes from having more connectivity and pathways rather than less.”

Embracing connectivity This theme of big corporations embracing connectivity – even when it goes away from their core businesses – was endorsed by Neele, manager of the Robeco Global Consumer Trends fund. “One of the biggest trends has been that news now breaks on Twitter, and not in your newspaper, and we are all publishers now. That’s why the best investments will be in communications or connectivity apps. The emphasis now is on finding disruptive technologies and the future now is on companies providing services to platforms such as killer apps, rather than in the hardware. We need to look for the structural winners, where there is an underlying disruption to an existing industry.” Example? “LinkedIn is disrupting traditional job boards for recruitment. There is also a trend for companies to embrace technology to make it easier to buy their products.” Neele cites the examples of Starbucks offering ways to pay for coffee using smartphones and Nike becoming a tech company because it began offering wearable gadgets so that users could upload the results of their workouts. Neither has anything to do with their core businesses of selling coffee or sneakers in physical stores.

‘The best investments will be in communications or connectivity apps’ Thinking outside the box All three technology experts urged delegates to think outside the box if they wanted to embrace what is the real world rather than outdated interpretations of how it is painted. “Stop thinking about stupid made-up acronyms such as BRICS,” said Khanna. “It is far more complex than that, and true growth isn’t a simple matter of looking at population size; the regional deepening of institutions within countries are more powerful forces. It is also about finding those emerging markets that have invested in infrastructure. One of the dark sides of globalization is the growth of Asian and African mega-cities such as Mumbai or Lagos where population growth has not

been matched with infrastructure. And we talk about targeting the ‘middle class’, but the term is misleading, because being middle class in emerging markets is not necessarily directly linked to education or economic status. What we really mean by the middle class is the consumer who has more disposable income.”

Can you be replaced by a machine? Hammersley questioned the old theories that professions such as being a doctor, lawyer or accountant meant a job for life because unlike a worker in a car factory, you couldn’t be replaced by a machine. “If you think about it, much of what doctors, lawyers and accountants do can mostly be replaced with an app,” he said.

“The market premium will be on those creative jobs where you can’t be replaced by a computer. And that’s a really good thing. In an ironic way, the rise of artificial intelligence will make human endeavor become more human.”

The biggest investible trend Neele said the trend for mobile payments will be the biggest investible trend over the coming years – but the biggest winners may well be companies that in 2014 are unknown. He conducted a poll of the audience as to who would be the world’s most valuable company in 2020. Some 39% of delegates said Google – while 48% said it would be a company “we have currently not heard of.”

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OPINION

TOMÁŠ SEDLÁČEK, Economist

Five controversial ideas Czech economist Tomáš Sedláček suggests that politicians have a growth – Take budgetary power out of the hands of politicians – Stop fetishizing growth – Build up reserves in prosperous times – The euro is the best revolution we’ve had – Tackle the addiction rather than the hangover

fetish. Sedláček’s ideas on the relationship between politics and budgetary policy are just as controversial as his notions on the economy. Here are five statements made by this unorthodox thinker.

Take budgetary power out of the hands of politicians

“Politicians must stop making budgetary decisions. What we’ve done with monetary policy, we also need to do with government finances. Two or three generations ago, we shifted control over monetary policy from politicians to independent institutions – the central banks. Politicians are no longer able to print money and this transfer of power has proved to be a great improvement. But they are still in charge when it comes to budgetary policy and their actions can cause a huge mountain of debt and other related problems. But would this be an undemocratic move? No, in fact it would create a more democratic

society. After such a step, politicians would still be able to decide whether a country is to have high or low taxes and what level of government expenditure is appropriate. And they will continue to debate on the details of the proposals in their election manifestos. Now they clash mainly on the size of the budgetary deficit.”

Stop fetishizing growth

“We need to stop focusing on economic growth. It is excess debt rather than a lack of growth that is dangerous. After all, slower growth doesn’t cause national crises. It’s building up high debt levels in prosperous times, which causes the problem. That debt has to be paid back.

You could compare it to an individual or a business. A person does not need a higher salary to survive. And a business doesn’t go bankrupt if it fails to grow. However, both individuals and businesses go to the wall if they accrue too much debt. In the period of growing prosperity up to 2008, nobody thought debt was a problem. We made the mistake of regarding the upward phase of the cycle as a permanent growth trend. We were blinded by our economic models. This was nothing less than the ‘fetishization’ of growth. We thought the world would collapse if we stopped growing. But sustainable growth is growth without the government stimulus. Artificial growth is a trick that only works for a few years. I’ve nothing against growth, but in my eyes, it’s priority number five or six. I prefer to focus on economic stability and on solidarity. This is not a crisis of capitalism, it is a crisis of growthobsessed capitalism.”

Build up reserves in prosperous times

“The lesson we need to learn here is simple: if the economy grows, then we need to cool it down and save some of the ‘energy’ for leaner years. If you wander through unknown territory, you need to be careful and take extra supplies in your backpack, as you never know when you’ll come out the other side. And this is how we need to treat the economy.”

The euro is the best revolution we’ve had

“Some European regions are having a difficult time. But this is also the case in the US and Japan, as these countries too have states or regions that are struggling. The problem is that they do not see Europe as a unified entity. But our joint government debt is quite a bit lower than that of the US and of Japan. What’s more, the crisis didn’t start in Europe, but originated in the US. I’m a big fan of European integration. I think the euro is the best revolution we’ve had, as we seem to have learned lessons from the past. Just think what Europe and the euro have given us. During the crisis, European countries did not throw up trade barriers and the single currency meant countries did not have to devalue their national currencies.”

Tackle the addiction for once, rather than the hangover

“We’re trying to cure the hangover by drinking more. But beware: softening the impact of economic decline with government spending only builds up new debts that further feed the addiction. My idea of taking control of budgetary policy away from the politicians can be implemented in the short term. If we were to announce that this was to become the responsibility of central banks rather than governments, it would have an immediate impact on the financial markets and boost confidence overnight. It is a short-term solution

with long-term consequences, as it avoids sowing the seeds of the next crisis. I am a member of a board that advises European Commission President, Barroso. He’s aware of my ideas to take budgetary policy out of the hands of politicians. My ideas might be controversial, but all good ideas are at first. However, they are turning out to be less controversial than I had expected, and even German Chancellor Angela Merkel is leaning towards my way of thinking.”

This document is solely intended for professional investors

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