Robeco Quarterly December 2017 by Robeco

Robeco

Intended for professional investors only

QUARTERLY QUANT investing SUSTAINABILITY investing

#6 / December 2017

GRAPH OF THE YEAR: BUND OR BITCOIN – 40 THE OUTLOOK FOR CREDITS – 7 WILL QUANTITATIVE TIGHTENING HURT? – 17 BURTON MALKIEL ON SMART BETA – 28 LONG READ: BIG DATA GOES MOBILE – 36

‘The question is if Xi Jinping, now firmly in power, will change course and, like a modern Hercules, choose the narrow, difficult path of virtue, full of potholes or, alternatively, the wide, straight and easy path, effectively kicking the can further down the road for a couple of years’ Léon Cornelissen, Chief economist

Robeco QUARTERLY • #6 / DECEMBER 2017

SUSTAINABILITY investing

An answer to the Solvency II capital buffer paradox

In theory, financial regulation should discourage risk-seeking behavior. But is that really always the case? Well, probably not. The Solvency II Directive, for example, creates an incentive to buy risky stocks, in our view. Losing money with passive investing

EM equity data help dynamic duration management

Mixed versus integrated multi-factor portfolios

Sustainability investing is on the rise in Asia 22 Sustainability investing is sometimes seen as a ‘nice to have’ invention of the affluent West, amid the belief that it is little used – or even pointless – in other regions. This is a myth. What makes a quality board?

ESG is often mis-implemented in portfolios

Behold the wind turbine as big as the Shard

Robeco QUARTERLY • #6 / DECEMBER 2017

And MORE

QUANT investing

CONTENTS OPINION The outlook for credits: addicted to short-term performance

OPINION Will Quantitative Tightening hurt?

RESEARCH Finding value in a momentum market

GREAT MINDS – BURTON MALKIEL ‘Academic research absolutely supports smart beta’

RESEARCH The research culture is crucial for the success of an asset manager

LONG READ Big Data goes mobile: how will our infrastructure cope?

INTERVIEW ‘All you need are two lines to make the perfect graph’

COLUMN Jerome Powell: a lesser, but low-risk choice

Sustainability

Robeco launches climate change policy Robeco has launched a climate change policy to explain its approach to combatting global warming and make clear how seriously the issue is being taken by the company.

RobecoSAM in developing this policy, including determining the exclusion thresholds. Both work together in integrating sustainability and climate change issues into their respective investment decisions. RobecoSAM also provides the environmental impact data and the fossil fuel screening that will underpin the implementation of the policy.

Taking a clear stand on global warming is becoming increasingly important as clients seek to address challenges relating to the Paris Climate Agreement, the recommendations of the Task Force on Climate-Related Financial Disclosures, and the requirements of their own beneficiaries. There are five pillars to the Robeco Climate Change policy: • Integrating ESG into the investment process • Using active ownership to effect change • Decarbonizing portfolios • Divesting carbon-intensive thermal coal • Reducing our own carbon footprint Part of the climate change policy is

Bitcoin frenzy The total market cap for crypto currencies surpassed the USD 200 billion in November. These are the top players. 1. Bitcoin 2. Ethereum 3. Bitcoin Cash 4. Ripple 5. Dash 6. Litecoin 7. IOTA 8. Monero 9. NEO 10. NEM

USD 138.0 billion 35.2 billion 20.0 billion 9.1 billion 4.4 billion 3.9 billion 2.6 billion 2.3 billion 2.3 billion 1.8 billion

that the carbon footprint of Robeco’s sustainability funds will be reduced to ensure they are at least 20% below that of the benchmark, and by divesting from thermal coal activities, with a 20% threshold for power generators and 10% for mining operators. Robeco has worked closely with its sustainability specialist sister company

“We aim to make our contribution to the Paris Agreement ambition to keep the global temperature rise well below 2 degrees Celsius above pre-industrial levels, and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius.”

In privacy we trust Or, do we? Consumer trust is key. Companies need to find a balance between utilizing data and maintaining consumer trust in the longer term. However, the attitudes towards sharing data and trust in a company differ per age 50 Figure 1

group. For example, millennials appear to be more accepting of the idea that they ‘pay’ for the free services that are provided by the large Internet platforms with their data, and that a lack of privacy on the Internet is part of modern life.

| Trust in companies to keep personal information private (by age group) 44%

40 32% 30

32%

33%

29%

28%

32%

35%

20 10 0

Trust little/none of the time

Trust all/most of the time Millennials

Source: CoinMarketcap, as per 22 November 2017

“Robeco acknowledges the responsibility of the investment industry towards climate change risks through the investment decisions that we make and the contact we have with investee companies and other institutions,” says Carola van Lamoen, Head of the Active Ownership team.

Gen Xers

Baby Boomers

Traditionalists

Source: Gallup, 2016

Robeco QUARTERLY • #6 / DECEMBER 2017

The cost of passive investing

Public investment in infrastructure in advanced economies has dropped to near historic lows as a percentage of GDP after decades of almost continuous decline. The low interest rate environment does, however, offer excellent opportunities to improve the quality of the existing infrastructure stock. According to the IMF, countries with deficits in infrastructure spending include Australia, Canada, Germany, the UK and the US. The fund suggests that upgrading surface transportation and improving infrastructure technologies (in highspeed rail, ports, telecommunications, broadband), as well as green investments should be given priority. Probably not much can be expected from the Anglo-

Saxon countries in the short term, but the new German government will most likely increase infrastructure investment for the next year. Global investment has picked up since the third quarter of 2016 and the IMF expects (conventionally) that growth of gross fixed capital formation in advanced economies will rise to a strong 3.4% next year. The composition is of course important as the worst investment binges are generally linked to the property sector. Fortunately, so far, residential investment has not been a key contributor to the growth rate.

Robeco QUARTERLY • #6 / DECEMBER 2017

Editorial

Economy

Spend it!

The innovation of passive investing has been an important and positive development. It has given investors more options to choose from. However, it would be naïve to consider it the holy grail. Passive investing’s growing popularity is mostly due to the low costs. While that’s basically a good thing, we need to guard against oversimplification. Of course it’s not as easy as all that. Even with passive investing, there are active choices involved. In our industry, it is not only about costs, expected returns and risk are equally important. If you buy the broad market cap-weighted index, you will automatically also have stocks in your portfolio that lower your returns – equities with a negative premium compared to cash or government bonds. Investors must be aware of the consequences of choosing a simple passive strategy at low fees. And then there’s the issue of sustainability. If you buy the market capitalization index, the role played by sustainability is pretty insignificant. ESG factors are not accounted for; there is no active engagement. Of course, you can also decide to follow index products with a smart beta or SI layer, but strictly speaking, that would no longer be true passive investing and would also involve additional fees. This does show that there are shades of gray in the issue of active vs. passive investing. The time when it was “four legs good, two legs bad” is behind us: there is a whole spectrum of options in between purely passive and active products. Many of these are, in fact, nothing more than passive solutions with an active twist to circumvent the typical drawbacks of purely passive approaches. This has definitely enriched the range of products offered by the investment industry, significantly raising the bar for traditional active fund providers. Despite the discomfort this may bring, overall it is a positive development. It has led to more concentrated portfolios and a higher active share for active investors. Add to that the growing range of passive products in every color of the rainbow and it is clear that investors must make choices. Passive investing is not just some kind of no-brainer that allows you to pick the best and least expensive index solution in your sleep. So you have to remain alert: otherwise, a cheap solution might just end up being an expensive mistake.

Peter Ferket, Head of Investments

Winner takes all

A truly big number. Germany’s economy grew by an unexpected and very healthy 2.8% year-on-year in the third quarter. It has been six years since Germany last saw such impressive growth. It’s also a pace that many economists considered impossible until very recently. An aging population, slower growth in China, Germany’s biggest trading partner, and structural reform issues in the Eurozone were expected to have prevented that. However, recent growth numbers show that we should

There is a remarkable shift underway in the US corporate sector: fewer and fewer companies are producing an ever-increasing share of the total earnings pie.

Economy

Column

Wirtschaftswunder

Back in 1975 it took the top 109 companies to produce 50% of all earnings, whereas in 2015, this was achieved by just 30. One popular notion is that this is a reflection of the new business model ushered in by the likes of Facebook, Airbnb and Amazon. For these platformbased companies, the size of the customer base has been a critical factor to their success. As the match between supply and demand is most effective on a platform with the biggest customer base, the winnertakes-all principle seems to be more prevalent among these web-based businesses than brick and mortar companies. Additionally, these new companies have set up their businesses according to the spec of the modern world and are therefore not burdened by high overheads and legacy costs. As such, they can also

be considered to be a disruption. Whatever the cause may be, there is a clear concern about the trend. Concentration may ultimately lead to monopolies, with all the associated negative consequences of higher prices and the reduced flexibility. But maybe the real risk is of a completely different nature. The rise of the number of top earners seems to have coincided with that of the so-called zombie companies, whose survival depends completely on creditors overextending financing to keep them afloat. To quote a study by the Organization for Economic Cooperation and Development (OECD), “a 3.5% rise in the share of zombie firms is associated with a 1.2% decline in the level of labor productivity across industries.” If this is indeed the main cause of the rise of top earners, the solution may be simple: central banks should end the current period of lax monetary policy to weed out those zombie firms.

not underestimate just how powerful the positive feedback loop brought about by a synchronized global economic upswing can be. Even Italy and Japan, two of the most indebted nations in the world, are growing at a rate that is above potential. This is, of course, also good news for stock markets, as stronger GDP growth eventually translates into higher earnings growth. A welcome result that should help to extend the duration of the multi-year bull market.

Jeroen Blokland Senior Portfolio Manager

Robeco QUARTERLY • #6 / DECEMBER 2017

The outlook for credits: addicted to short-term performance Opinion

Robeco’s Credit team is growing increasingly uncomfortable. Valuations are at all-time tights. Central bank buying, one of the main supporting factors over the past decade, is about to come to an end. However, Sander Bus and Victor Verberk, co-heads of the Credit team, see plenty of opportunities for investors who pursue active issuer selection.

The global economy is enjoying solid, synchronized growth. The big question is: how long can this cycle last? For the time being, everything looks fine. The labor market and housing markets are solid both in Europe and in the US and this supports consumer spending and confidence. Neither are there signs of big asset bubbles in financial markets, at least not in developed markets. The US is in its eighth year of economic expansion and markets are enjoying one of the longest uninterrupted bull markets in history. Inflation remains largely subdued. Despite this, we are growing increasingly uncomfortable. Too much money has been chasing too few assets as central banks have been crowding out investors. Volatility and credit spreads, both measures of risk, have declined to historic lows. This is an indication of risk fatigue: investors no longer dare to take risk scenarios into account as this has been hurting them. Central bank policy has forced people to go with the flow and close their eyes to risk.

The US cycle is maturing As we have noted in the past, there are several indicators that the cycle is in its mature phase, at least in the US. We see peak leverage for US companies and a tightening of monetary policy. Even though in general consumers appear to be in good shape, it is important to realize that not everyone is benefiting. Younger generations and low income groups have seen little improvement in their financial situation and struggle to service their debt levels. This is evident in the rising non-performing loan (NPL) levels for

Robeco QUARTERLY • #6 / DECEMBER 2017

subprime car loans and student loans. These are also the same people who often cannot afford to buy a house and have been exposed to stiff rent inflation. The unequal distribution is a risk for growth and stability in the US. Corporate leverage is much more contained in Europe, where companies have not been affected by the same animal spirits. European consumer spending and sentiment are strong, with Italy being the only exception. Exports are still going strong as well, but are no longer the sole driver of economic expansion. It really is domestic consumption that is propelling growth. This makes the economy more resilient and less vulnerable to the stronger euro.

No wage inflation One of the most discussed topics amongst economists these days is the absence of wage inflation in an environment of tight labor markets. There is one camp that believes that structural changes in the labor market (non-unionized temporary workers) and technological changes (automation) have weakened the bargaining power of workers permanently, hence making the Phillips curve, which shows an inverse relationship between unemployment and inflation, obsolete. The other camp believes that wage inflation is in the pipeline and points to indicators such as ‘vacancies hard to fill’ and the ‘quits rate’.

Risks are not being priced in We do not know how much more time there is for this cycle. It does not make sense to spend too much time trying to predict a

Opinion

recession, it is enough to conclude that risks are not being priced in at all. This is no longer the time to stick your neck out and take risk. With central banks backtracking, investors are less likely to buy on dips. We are not adopting an aggressively underweight stance, but we are positioning our portfolios cautiously in terms of beta. We do still see plenty of opportunities for active issuer selection and it will probably pay to focus on conservative credits, which will outperform once spreads start to widen. Many investors feel the need to be fully invested. Negative yields on cash are a punishment for being conservative, pushing people into uncomfortably long positions. We advocate not taking too much beta risk in this environment and avoid becoming addicted to short-term performance.

Credit has rarely been richer Spread products have performed strongly this year. Most credit categories are trading close to all-time tights on a risk-adjusted basis. People often justify tight valuations saying that they do not see a catalyst for things to change. Well, letâ&#x20AC;&#x2122;s remember that a catalyst for change is mostly something we only see with hindsight. The forest is dry; you do not need to know which match in the matchbox will set it on fire. It is enough to conclude that markets are not discounting any negative surprises and that the cycle is in its mature phase. Reason enough to be cautious. Corporate hybrids and financials still offer value in investment

grade. For high yield and emerging markets, we are tilted as much as possible towards high quality without compromising too much on the beta. Technicals are worsening. They will no longer provide support with the end of central bank balance sheet expansion nearing. As for supply & demand, Asian investors have been the largest contributors of inflow into the US credit market. This is now slowing down and with the Fed likely to hike rates further, the flow will probably slow still more, if not reverse. Higher US short-term rates are also increasing hedging costs, while a steeper yield curve in Europe and Asia than in the US means that investors can now pick up more attractive yields in non-US assets. The high yield segment has been facing shrinking supply. The main reason is competition from the loan market. Many companies are refinancing their public high yield bonds with private loans. There is almost a total absence of discipline in the loan market and companies have access to virtually unlimited funding without having to offer covenant protection or early redemption fees.

Positioning: betas close to neutral We are now running almost all our portfolios with a beta close to one. For high yield and emerging markets, this means that the beta might end up just under one, since we want to avoid the cyclical companies. For investment grade, it is easier to achieve a neutral beta as we can still find attractive yields in financials. For a long time, we preferred European to US credit. For high yield this is still the case, but investment grade valuations have now tightened due to ECB buying and are vulnerable to a reduction in purchases. Here we have a more neutral regional allocation. The European portfolios are skewed towards bonds that are noneligible for ECB buying. We prefer companies in more stable sectors that will be less exposed if the cycle turns. We are generally underweight commodities and like banks. In our issuer research, we stress-test the financial models of the companies in which we invest to determine their resilience in higher interest rate and recession scenarios.

Robeco QUARTERLY â&#x20AC;˘ #6 / DECEMBER 2017

QUANTinvesting

Risky business In theory, financial regulation should not encourage risk-seeking behavior. But is that really always the case? Well, probably not. The recently implemented Solvency II Directive, for example, creates an incentive to buy risky stocks, in our view. Thatâ&#x20AC;&#x2122;s because securityspecific differences in risk are not taken into account in the calculation of equity solvency capital requirements, a capital buffer designed to help insurance companies overcome adverse shocks in financial markets. As a result, the Solvency II investor does not face a riskreturn trade-off, and can seek the highest return regardless of the financial or economic risk. Taking into account the volatility of equity portfolios relative to overall market volatility would offer institutional investors better incentives, and would also contribute to market efficiency.

Robeco QUARTERLY â&#x20AC;˘ #6 / DECEMBER 2017

QUANT INVESTING

An answer to the Solvency II capital buffer paradox Solvency II regulation should prevent insurance companies from going bankrupt. However, it also has unintended, potentially harmful consequences that could encourage these companies to take more risks. In a research paper1, Robecoâ&#x20AC;&#x2122;s David Blitz, Winfried Hallerbach, Laurens Swinkels and Pim van Vliet propose a more effective approach. risk within developed or emerging markets are not taken into account. This has two unintended consequences: it encourages risk-seeking behavior and could sustain or even cause structural stock mispricing. Reinforcing the low risk anomaly Indeed, because the implicit risk within each category of stocks is assumed to be the same for all securities (see Figure 1), and because investors tend to assume more risk equates to higher returns, this regulation creates an incentive to buy risky stocks. The Solvency II investor does not face a risk-return trade-off, but can seek the highest return regardless of the financial/ economic risk.

Since 2016, insurance companies in the European Union must comply with the Solvency II Directive, which imposes equity solvency capital requirements (SCR), a capital buffer to overcome adverse shocks in financial markets. Most European pension funds are still subject to local regulation, but these local frameworks tend to resemble Solvency II. Solvency II sets out different SCRs for developed market stocks (39%) and emerging market stocks (49%). The SCR is adjusted up or down by a maximum of 10 percentage points, depending on the equity marketâ&#x20AC;&#x2122;s performance over the past three years. This makes sense, as there is a difference in financial/economic risk between the two types of markets. However, differences in financial/economic

warranted by their economic risk, while the price of low risk stocks tends to be pushed down more than may be justified by their economic risk. Such a distortion between risk and return is observed in practice, and is commonly referred to as the low risk anomaly. Oversimplified regulation may reinforce this effect.

Moreover, when large enough pools of capital are exposed to Solvency II-type regulation, the price of high risk stocks tends to be driven up more than may be

Figure 1 | Expected return, economic risk, and Solvency II risk Solvency II risk High risk Expected return

Market Low risk

Source: Robeco

Economic risk

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We urge European regulators for institutional investors to improve Solvency II by aligning it with more sophisticated European regulations already in place that are aimed at private investors in mutual funds. Specifically, we propose multiplying the standard solvency charge of 39% by the ratio of the company’s equity portfolio volatility to the broad equity market’s volatility.

Capturing relative risk This would be a way to capture a portfolio’s relative risk. The ratio would be above one for riskier portfolios and below one for less risky portfolios. High risk stock

‘This regulation creates an incentive to buy risky stocks’ portfolios would require more solvency capital than the market, and low risk stock portfolios would require less. It would no longer be necessary to distinguish between developed and emerging stocks. For the broad equity market, we propose using the MSCI World Index. For volatility, we propose taking the five-year volatility and reviewing this on a quarterly basis. If the company’s equity strategy does not have a representative five-year history, we

propose backfilling the equity return history with a representative alternative proxy return series, such as an index that follows a similar investment strategy. This approach is a straightforward and cost-efficient way for asset owners to assess risk, and is already used in the regulation of European retail investors. It would offer institutional investors better incentives. It would also contribute to market efficiency and is difficult to manipulate. 1 D. Blitz, W. Hallerbach, L. Swinkels and P. van Vliet, ‘Equity Solvency Capital Requirements: What Institutional Regulation Can Learn from Private Investor Regulation’ (available at: https://ssrn.com/abstract=3024484)

Losing money with passive investing Passive investing may be popular, but it also raises serious concerns. In particular, it means getting exposure to stocks that not only don't add to performance, but actually have a negative impact on it, says David Blitz, head of Robeco’s Quantitative Equity Research.

A century of empirical evidence shows that although equities exhibit high volatility in the short run, they are rewarded with a higher return than bonds and cash in the long run. In order to capture this so-called equity premium, many investors have an allocation to equities in their strategic asset mix. An increasingly popular way to earn the equity premium in practice is by replicating a broad capitalization-weighted equity market index which serves as a good proxy for the theoretical equity market portfolio. Such a passive investment approach allows investors to earn the equity premium at a minimal cost. It also takes into account that more expensive actively managed funds have failed to outperform as a

Robeco QUARTERLY • #6 / DECEMBER 2017

whole, although that is not surprising given that active investing is a zero-sum game before costs, and a negative-sum game after costs.

this expected return premium with the least risk. The literature on minimum volatility strategies shows that it is not very difficult to create a portfolio which is less risky than a broad capitalization-weighted market index. Clearly, therefore, passive investing in a broad market index is not a logical course of action if one expects every stock to have the same expected return.

Not a logical course of action Passive investing boils down to investing a little bit each in thousands of individual stocks. These thousands of investments combined should earn investors the equity premium. But does each of these individual stocks really help you capture the overall equity premium? The answer could be yes if the expected return premium for every stock were the same and equal to the overall equity premium. In that case, however, investors would be better off investing in a minimum volatility portfolio, as that would allow them to earn

So which assumption would justify passive investing in a broad capitalizationweighted market index? The above implies that at the very least, one must assume that certain stocks have higher expected returns than others. More specifically, if one assumes that the Capital Asset Pricing Model (CAPM) holds, it can be shown that the market portfolio is, in fact, the optimal choice for investors. The CAPM postulates that the expected return on a stock is proportional to its level of systematic risk, or beta. In other words, a stock that is half as risky as the equity market portfolio

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Figure 1 | Passive investing: Return premium over cash and government bonds

Return premium

14% 12% 10% 8% 6% 4% 2% 0% -2% -4% -6%

Top 20% Return over cash

2 3 Return over government bonds

Bottom 20%

Source: Robeco

should earn only half the equity premium, while a stock that is twice as risky as the equity market portfolio should earn double the equity premium.

empirically disappointing CAPM. Examples of such models are the three-, four-, and five-factor models of renowned professors Fama and French, and others.

So does the CAPM work?

What do these widely known insights imply for the expected return of individual stocks? In order to answer this question, we created a simple model, inspired by the literature on which characteristics drive stock returns. Specifically, we ranked stocks, dividing them into five groups every month, based on their total score in terms of a combination of commonly used value, momentum, quality, and low volatility factors. Next, we looked at the performance of these five portfolios from 1986 to 2016, which is the longest period for which we have data on global stocks. Figure 1 shows that our simple model is highly effective at separating stocks with high average returns from those with low expected returns. Think twice

So passive investing according to a broad capitalization-weighted index is justified, assuming that the CAPM works, but is that a reasonable assumption? Based on the popularity of the CAPM in standard finance textbooks, one might be inclined to think that it is. Empirically, however, the model has a very poor track record. Studies which have tested the predictions of the CAPM using real data have failed to find a positive relationship between systematic risk and stock returns. The actual relationship appears to be flat, or even inverted, i.e., if anything, riskier stocks tend to generate lower rather than higher returns. Whereas systematic risk turns out to be a poor predictor of future expected stock returns, various other stock characteristics, such as the size, valuation, momentum and quality features of a stock, have been found to be powerful indicators of future expected returns. Models which include a combination of such factors have effectively replaced the theoretically elegant but

Particularly interesting is the finding that the 20% of the stocks with the least attractive factor characteristics generated a negative premium over this period of more than thirty years, amounting to minus 2.5% per annum versus cash, and even minus 4% per annum versus

high-grade government bonds. If all stocks earned a positive premium at the very least, one might still shrug off the whole discussion about factor characteristics by arguing that although some stocks may have lower returns than they ought to, they do at least still contribute positively to performance. These results, however, show that a significant portion of a passive portfolio is actually invested in stocks which contribute negatively to performance1. Next time you hear someone arguing that passive investing is a prudent approach, think twice about that. And bear in mind that the model which we used here to rank stocks is still quite simple. Quant asset managers such as Robeco have developed more sophisticated models which show an even bigger return spread between attractive and unattractive stocks. What is the intuition about these results? Well, taken together, stocks may earn a healthy premium, but that does not mean that every stock individually can be assumed to do so. In particular, if a stock is expensive based on straightforward valuation multiples such as P/E, is in a downtrend, has low profitability, and is also very risky, then decades of historical data tell us that such a stock should not be expected to deliver a positive, but rather a negative premium. Passive investors, however, choose to ignore this evidence, and happily invest in stocks with such a deadly cocktail of characteristics just as they do in any other stock.

Inefficient portfolios Proponents of passive investing might counter that they are neither believers nor disbelievers in factor premiums. If all you can be reasonably sure about is that there is a long-term equity premium and you are agnostic about the existence of factor premiums, isnâ&#x20AC;&#x2122;t passive investing a sound approach? The problem with this

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QUANT INVESTING

argument is that the investment choices one makes point to certain implicit views, or ‘revealed preferences’ as economists call them. Investing passively in the capitalizationweighted index means that one implicitly assumes that a model such as the CAPM holds, and that the factor premiums which have been observed in historical data are either not exploitable in real life, or will no longer materialize in the future, e.g. because they were a mere historical fluke or have by now been arbitraged away. Clinging to a theoretical construct from the 1960s and simply dismissing everything we have come to know about stock returns since then is not prudent, but seems more like wishful thinking, an intentionally contrarian strategy, or denial of inconvenient facts. So, passive investing means putting a significant chunk of the portfolio in stocks which have a negative expected premium, i.e. which not only do not add to performance but actually have a negative impact on it. But what are the

‘Next time you hear someone say passive investing is a prudent approach, think twice’ investment implications of this insight? In other words, if investors do not want to suffer passively due to stocks that only cost them money, what can they do instead? One alternative would be to invest passively in all stocks, except, for instance, the 20% of stocks with the least attractive factor characteristics.

A more efficient approach That is not as easy as it sounds though, because factor characteristics of stocks are not constant but are continuously evolving. This means that the 20% of stocks that are least attractive this month will be different from next month’s 20%. Since factor characteristics do not change drastically overnight, one does not need to completely reconstitute the portfolio all the time, but still, active maintenance is required, and this involves some periodic turnover.

A more efficient approach is to not only avoid the least attractive stocks according to a multi-factor ranking model, but to also invest the proceeds in the most attractive stocks according to the model. These stocks not only exhibit the highest expected return based on their factor characteristics, but are also the ones that are least likely to drop down to the worst category in the near future, which helps to save turnover. Our enhanced index and factor index strategies are based on such principles, and are specifically designed to avoid the pitfalls of passive index strategies. For more information on our efficient alternatives to passive investing, please contact your local Robeco client relationship manager. 1 Stocks with negative premiums can also exist in the CAPM world. According to the CAPM, stocks with negative betas, i.e. stocks which tend to move in the opposite direction of the overall market trend, should have a negative premium, but do not need to be removed from the market portfolio because their poor returns are entirely offset by their powerful diversification benefits. Stocks with negative betas are very rare in reality though. They make up less than a fifth of the entire universe. Moreover, the bottom quintile portfolio shown here actually exhibits a beta higher than one.

EM equity data help dynamic duration management Empirical research confirms that equity markets provide valuable signals to accurately forecast bond returns. Moreover, using data from emerging equity markets, in addition to the information already provided by developed equities, helps improve predictions for developed bonds, says portfolio manager and quantitative researcher Johan Duyvesteyn.

For over 20 years, our duration model, which determines the active duration positioning of our QI Dynamic Duration strategies, has been successfully forecasting returns in the major bond markets using financial market data.

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Recent research carried out by Robeco showed that incorporating data from both emerging and developed equity markets further improves the model’s ability to derive economic growth expectations and forecast bond returns. This enhancement was recently implemented.

Over the past decades, emerging countries have seen their influence on the global economy increase dramatically. Not only do they now contribute more to growth, they also represent an increasingly important export destination for developed economies. Over time, emerging countries have also become major holders of government bonds issued by their developed counterparts. Given this increasingly important role of emerging economies, it seemed logical

QUANT INVESTING

5,0 1 | Relation of GDP growth with bond and equity returns Figure

about growth prospects (see figure 1). All else being equal, this should lead to negative bond market returns. Conversely, weaker equity market performance usually signals deteriorating economic prospects, pointing to positive bond returns.

4,0 3,0 2,0

t-statistic

1,0 0,0 -1,0 -2,0 -3,0

4 Quarters before

3 Quarters 2 Quarters before before

Equity market returns

1 Quarter before

Same quarter

Moreover, our research analysis showed that the model’s ability to derive growth expectations improves consistently when the returns of emerging equity markets are included. “Including information from emerging equity markets clearly adds considerable value to the model,” says Johan Duyvesteyn.

1 Quarter after

Bond market returns

Note: The figure shows the t-statistic of a regression of GDP on either the bond or equity market return for various predictive horizons, where a value larger than 2 or lower than -2 indicates a significant relationship with a 95% confidence level. The relationship with GDP growth in a given calendar quarter and equity market returns in the preceding quarters is significantly positive, as indicated by the t-statistics exceeding 2. For bond market returns, only the contemporaneous relationship is significant, i.e. the t-statistic only exceeds -2 for the relationship between bond market returns and GDP growth in the same quarter. The GDP growth, equity and bond returns are the average of Germany, Japan and the US and all measured on a quarterly basis. Source: Robeco, Datastream, Bloomberg.

Better, more stable performance

Figure 2 | Cumulative return back-test simulation current and enhanced growth variables 50

Indeed, this enhanced approach generates a better and more stable performance (See figure 2). Taking into account information from emerging equity markets to derive growth expectations improves the backtest results for the entire model. This further strengthens Robeco’s Dynamic Duration strategies’ proposition to benefit from periods with declining bond yields while keeping returns protected when yields rise.

40 30 20 10

Current Growth

Dec-2014

Dec-2011

Dec-2008

Dec-2005

Dec-2002

Dec-1999

Dec-1996

Dec-1993

Dec-1990

Dec-1987

Dec-1984

-10

Dec-1981

Enhanced Growth

Note: The current growth variable is based on local developed equity markets, the performance is based on a portfolio for Germany, Japan and the US. The enhanced growth variable is based on an equal-weighted combination of the developed and emerging equity market returns. Sample period January 1982 – June 2016. Source: Robeco.

to investigate the added value of using information from emerging equity markets in our duration model.

A good growth indicator Because of its forward-looking nature, to derive expectations for the fundamental drivers of bond markets, such as economic growth, inflation and monetary policy the model relies on financial market data, rather than official economic statistics such as GDP

growth. Such statistics are, by definition, backward-looking, published with a delay and prone to revisions. But until now, the financial market data the model had been using came solely from developed equity markets.

“On a daily basis, developed bond market investors may overlook economic data coming from the emerging world and focus on other important issues making headlines, such as monetary decisions from major central banks, for example,” says Duyvesteyn. “And when investors do finally focus on hard global economic growth data, our strategy is already

‘This approach generates a better and more stable performance’

Our study confirmed that strong equity market performance is a good indicator for improving growth expectations or reduced uncertainty

well positioned thanks to our enhanced approach to deriving economic growth expectations.”

Robeco QUARTERLY • #6 / DECEMBER 2017

QUANT INVESTING

Mixed versus integrated multi-factor portfolios: the contest Finding the best way to harvest factor premiums remains a hotly debated issue. One particular bone of contention is whether investors should take an integrated or mixed approach to building multi-factor portfolios. Looking at very recent empirical evidence, David Blitz, Viorel Roscovan and Milan Vidojevic, from Robeco’s quantitative research team, find that both approaches are viable. But that does not mean the way portfolios are constructed should be overlooked.

Although some investors may have good reasons to focus on a single factor or a set of particular factors, the general consensus is that one should hold a portfolio which is well-diversified across various factors that have been shown to deliver significant premiums in the long run. A multi-factor allocation offers investors exposure to various factors, avoiding large concentrations in any single strategy that expose their capital to the risk of short-run underperformance of any given style. However, there is still the key question of whether to mix stand-alone factor ‘sleeves’ or construct a bottom-up integrated factor portfolio. The factor mix approach entails allocation to singlefactor strategies that are constructed to

Robeco QUARTERLY • #6 / DECEMBER 2017

provide maximum exposure to a chosen factor. This approach is transparent, convenient for performance attribution, and also allows for tactical factor allocation. In most cases, however, this approach ignores the fact that a strategy which targets one specific factor may implicitly result in undesired negative exposure to other factors. As a consequence, mixing single-factor sleeves can result in sub-optimal and unintended exposure at portfolio level. The proponents of the integrated approach use this as their main argument, claiming that one can achieve better performance characteristics by combining factors optimally from the outset. They do so by selecting stocks with the highest integrated factor scores. Some other

advantages of this approach are transaction cost netting and a moderate decrease in turnover.

Generic versus enhanced factors Another important distinction should be made between ‘generic’ single-factor strategies based on a single factor model, and ‘enhanced’ single-factor strategies that are designed to eliminate unintended exposure to other factors. Generic single-factor factor strategies tend to be suboptimal compared to enhanced factor strategies. For instance, some generic value strategies do not provide much exposure to the value premium to begin with, while others provide a high degree of value exposure, but are only able to do so by accepting significant negative exposure to other factors. Enhanced single-factor strategies provide many advantages similar to those of the single-factor sleeves, while overcoming the pitfalls mentioned above. For instance, adding some momentum and quality exposure to value strategies helps to avoid the so called ‘value traps’

QUANT INVESTING

(stocks that are cheap for a reason) and adding value to momentum or quality helps to avoid the most overpriced stocks. As the integration of other factors is only partial, the main return driver remains the selected factor premium. These ‘enhanced’ factor strategies can also be further mixed into multi-factor vehicles, but interestingly, this approach has so far not been a subject of thorough investigation by the literature that explores the ways in which factors can be combined into multi-factor portfolios. Two viable options Investigating which approach is better – bottom-up integration or mixing single-factor strategies – Khalid Ghayur, Ronan Heaney and Stephen Platt argued, in their 2016 paper, that a preference for one or the other ultimately depends on the main objectives of the asset owner. They found that both approaches are viable options. In another paper published this year, Markus Leippold and Roger Rüegg looked at a richer set of factor combinations, robust statistical tests, and longer time periods to conclude that the integrated portfolios do not outperform the mixed ones. Although they found that the integrated approach lowers the overall portfolio risk through better portfolio diversification, they also discovered this lower risk is accompanied by a lower return. In fact, any difference in risk between the two approaches can be explained by the integrated portfolio’s higher exposure to the low-risk anomaly. The authors found no evidence to support one approach over the other. To summarize, it seems that, empirically, there is not much difference between the integrated and mixed approaches. This is also the conclusion if we look at the theory for guidance on this problem.

Expected stock returns are modeled as a linear function of exposures to factor premiums in the commonly used asset pricing models that underpin the entire philosophy behind factor-based investing. While there is an abundance of evidence supporting the existence of factors, the academic literature has not yielded any proof that combining them into integrated portfolios leads to superior

But in reality investors can only invest a dollar once, transaction costs are important, and the application of leverage is severely constrained. Attractive factor solutions are the ones that deliver the highest amount of factor exposure for any chosen level of active risk and never disregard other factors, even if their aim is to target a single factor.

‘Regardless of whether they are mixed or integrated, enhanced factor strategies tend to be preferable to generic single-factor solutions’ factor solutions. That is, there is no evidence that integrating factors gives access to an additional source of alpha that cannot be obtained by mixing factors. And while we do not dismiss the possibility that the real world is much more complex than the one described by these linear factor models, and that there are many nonlinear and interaction relationships that these models fail to account for, to date there is a lack of solid evidence to confirm this. If there is no intrinsic difference in terms of the superiority of the two approaches, does this mean that it does not really matter how one goes about constructing factor portfolios? Absolutely not! In a theoretical world without transaction costs and with the flexibility to adjust portfolio leverage as much as one likes, any desired factor profile may be obtained using whatever factor strategies are available.

Suboptimal singlefactor strategies

Taking these aspects into consideration, generic single-factor strategies tend to be suboptimal. For instance, some generic value strategies do not provide much exposure to the value premium to begin with. Other generic value factor strategies do provide a high degree of value exposure, but are only able to do so by accepting significant negative exposure towards other factors. When generic value, momentum, quality, and low-volatility strategies are combined, factor exposures at portfolio level are diluted because of these conflicting underlying exposures. Meanwhile, regardless of whether they are mixed or integrated, enhanced factor strategies tend to be preferable to generic single-factor solutions. They apply partial factor integration to ensure that stocks that have negative expected return contributions from other factors do not end up in the portfolio. Subsequently, these enhanced single factors can be further mixed into multi-factor vehicles or, alternatively, the investor can opt for an integrated strategy that is designed to provide high exposures to multiple factors in the most efficient way.

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Will Quantitative Tightening hurt? So here we are. The S&P, Nasdaq, Dow and many other major stock market indices have hit all-time highs. Equity rallies that have moved into ‘extra time’ could result in penalties with the dawn of quantitative tightening, says strategist Peter van der Welle.

Speed read

Opinion

• Stock markets at record highs, volatility at record lows • Bull market is once again ‘climbing a wall of worry’ • S&P500 has decoupled from the Fed’s balance sheet evolution

Stock market volatility had dropped to record lows. To date, the year’s maximum drawdown on the S&P has been 2.8%, one of the lowest levels in history. The old bull market that used to be referred to as ‘climbing the wall of worry’ seems to have morphed into a more exuberant version of itself, which is typical for a mature phase of a bull market. Judging by market action year-to-date, we are now in extra time. The wall (consisting of high stock market valuations, leverage and geopolitical uncertainty, to name but a few) still very much exists, but people just worry about it less.

compared to the VIX, market participants do not appear to be naïve about external shocks, and are willing to pay up to hedge tail risks while joining in the positive momentum. Though equity investors in this phase of the bull market may exhibit signs of exuberance, it does not yet seem to be the type of irrational exuberance that could spell the imminent demise of a bull market. Indeed, this stock market is still about much more than ‘close your eyes and buy’. Stock market indices may have surged (with emerging markets in the lead with a 30% gain year-to-date), but so have numerous consumer – and producer – confidence

Absence of an external shock For instance, the record low VIX has recently shown an unusual divergence from measured levels of geopolitical risk. The prospect of missing out on price action has captured the imagination more than the fear of shaky fundamentals, a phenomenon also seen in current cryptocurrency markets. At first glance, this appears to be a momentum-driven market, where every dip is steamrolled by new demand for risky assets. As in physics, momentum for any system is only conserved in the absence of an external shock. Upon closer examination of the very high SKEW (which measures the price of tail risk on the S&P 500)

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Opinion

300

325 300

250

275 250

200

225 200

150

175 150

100

125 2008 = 100

100

50 2008 2009 2010 Fed balance sheet (l)

2011

2012

2013

2014

2015

S&P 500 (r)

Source: Bloomberg, Robeco Robeco Source: Bloomberg,

2016

2017

average once every five years. With this expansion now in its 75 2018 eighth year, we are overdue for a recession, which begs the question; how long can this period of extra time last for the equities bull market? Equity markets typically start to decline four months prior to a recession.

‘This market is more than ‘close your eyes and buy’…’

indices, indicating a resilient global expansion that is accelerating and broadening. Very solid reported corporate earnings growth in major equity markets over the year also provide evidence of sustained macro-momentum. According to analysts’ forward earnings projections, forward 12-month earnings growth will be around double digits in the US and Europe.

Recession is overdue This is not unrealistic in our view, as we expect the Eurozone and US economic expansions to power ahead at a solid pace in 2018, with the Eurozone even boasting above-trend growth. In the earlier stages of this bull market, profit margins rebounding to record highs have led to a recovery in earnings. With labor markets strengthening and the peak in monetary easing behind us, this earnings driver will be gradually losing strength. In the third half, we see earnings growth becoming more reliant on rebounding sales growth on the back of an optimistic consumer. Rebounding global sales activity year-to-date reflects global consumers (especially those in the US, which are leading the global cycle) who are confident of improvements in future disposable income driven by wage growth, housing wealth and lower tax rates. Of course, confidence in the rise of future incomes would quickly erode if the global economy hits an obstacle that triggers a recession. Since 1854, recessions in the US have occurred on

Judging by the ISM manufacturing survey, the risk of recession still seems fairly low. Based on the past ten US recessions, it takes an average of 35 (median 31) months after a cyclical peak in the ISM manufacturing survey for a recession to develop in the US. This suggests that even if the recent ISM (at 60.8 at its the highest level since 2009) has marked the peak of the US economic expansion since the financial crisis, a recession remains a pretty remote risk, and the current growth in trade can continue for the time being.

Balance sheet reduction With earnings growth now largely underpinning stock market returns instead of easy money, it comes as no surprise the S&P 500 has recently decoupled from the Fed’s balance sheet evolution, as shown in the graph. This chart should reassure Fed board members that their balance sheet reduction, of which they have given extensive warning, will probably not bring the stock market to its knees. Still, the rising interest rates that will result from balance sheet reduction and further conventional tightening could limit multiple expansion further down the road, especially as US stocks have already moved up considerably in the expensive phase. It seems more likely, however, that the current positive momentum will push stocks even higher.

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Finding value in a momentum market Finding bargains as stock markets continue to hit record highs is increasingly difficult, says value investor Josh Jones. The ongoing rally means the prices of equities are rising significantly faster than their underlying earnings, creating record price/earnings ratios.

Speed read

Research

• Ongoing rally means multiples hit sky-high levels • Dislocation between share prices and earnings widens • End may be in sight due to end of central bank stimulus

It has largely been propelled by growth stocks led by tech companies, prompting fears of another market bubble. The high valuation multiples make it harder to find inexpensive stocks – those companies whose share prices do not reflect the true earnings potential of the company.

are marginally better, but European indices are pretty heavy on banks, whereas the US indices are heavy on tech. And as much as I think that some of the US tech stuff is expensive, Microsoft deserves a higher multiple as a business than BNP Paribas does.” “So when you adjust for that, Europe is not cheaper than the US; in fact, free cash flow yields are about the same, which is telling you that the market is anticipating a lot of earnings growth in Europe. But we think that earnings growth will deteriorate – the strong euro is having an overwhelmingly negative impact on the ability of European companies to generate earnings growth relative to the better macro data that is flowing through.” “The US still has a lot of momentum, but it’s increasingly very expensive. Basically, if you want value, you have to go elsewhere.

“What we’re seeing is a very growth-driven late-cycle market, where growth indexes are 6-8% above the core indexes,” says Jones, a portfolio manager with long-time value investors Robeco Boston Partners in London. “Since late 2014, earnings on the S&P have cumulatively grown by 4%, and the index is up almost 30%. So there’s not a lot of earnings growth. People are very optimistic, they’re chasing top-line growth and concepts, and that’s very characteristic of late-cycle investing.” “We’re now at the point of the cycle where a lot of what’s driving the benchmarks just looks increasingly really expensive. Value stocks for the most part have underperformed this cycle, and it’s increasingly challenging to find positive momentum in stocks.”

Europe vs. the US Two regions that are now relatively expensive are Europe and the US, Jones says. “Europe coming into 2017 perhaps not surprisingly had worse momentum than the US did, but it had better valuations,” he says. “Now with the run that we’ve seen in Europe, valuations

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Research

Pockets of the domestic UK market are still cheap – not quite as cheap as they were post-Brexit, but they’re still cheaper than the rest of Europe or the US. Earnings growth in Japan has been reasonable this year – some of that is cyclical businesses – while China and Asia have improved a little bit.”

‘If something goes wrong in the world, that would become an opportunity for value investors’

“Emerging markets are reasonably valued – they’re not super-cheap, but there’s enough earnings momentum there. We’re still cognizant that emerging markets are the tail of the dog, so if we do go into a downturn, that’s where the most operating leverage will be and emerging markets will underperform. So if something goes wrong in the world, that would become an opportunity for value investors.”

The challenge of ETFs Jones says part of the relentless rise in stock markets has been because passive investors use Exchange Traded Funds (ETFs) to join in the party by buying the entire index. “ETFs are a real trend and a lot of money is flowing into them,” he says. “But the problem

with ETFs is they are indiscriminate buyers of all stocks and all indexes – they buy anything regardless of whether it’s justified or not. There are certain stocks where ETFs are net buyers because they buy them indiscriminately, but where active managers are net sellers because they don’t want to own this business at this price.”

“So if we go into a market correction – and we’re not predicting one, but if we do – and the ETFs become net sellers, then those are the stocks that would be disproportionately hit because an active manager won’t want to buy them. Because of that relationship, I think more of the active management alpha over time for value investors like me is going to accrue from bear markets. It may mean trying to get out of the way when ETFs are still buying indexes, and trying to avoid the stuff that could go down a lot if something does go wrong in the world.”

Is a crash coming? So, is a bear market coming? Not necessarily, says Jones. “The two best indicators of whether things are going to start to deteriorate are the credit markets and the yield curve,” he says. “The credit markets are signaling tons of liquidity, while central banks continue to support liquidity in the market, at diminishing valuations with diminishing impact to the real economy. So that presents a really challenging environment for investors, and it’s why you’re seeing benchmarks go up well above and beyond the underlying earnings growth.” “Intrinsically, the markets are ahead of themselves, but I don’t think there’s a lot of systemic risk – it’s not like we’re sitting on a sub-prime crisis in the US or something. And it’s not obvious to people because it’s not like the tech bubble where you could see that this is absolutely insane because people were buying businesses with no revenues or earnings.” “However, the Fed has started to unwind its balance sheet, so this is the start of tightening liquidity, and we’re probably nearing the end of this cycle. The current high valuations would tell you to be careful. Certainly, history would suggest that paying really high multiples for companies based on a belief in the growth concept is a dangerous thing.” “The current high valuations would tell you to be careful. People have been prepared to pay high prices for businesses when stocks are getting very expensive. These things are always cyclical, and value investing will come back into style.”

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SUSTAINABILITY investing

Land of the rising ESG Sustainability investing is sometimes seen as a ‘nice to have’ invention of the affluent West, amid the belief that it is little used – or even pointless – in other regions. This is a myth, as was proven by a recent trip to Asia by Robeco’s head of Environmental, Social and Governance (ESG) integration. She found not reticence or apathy, but a growing enthusiasm for adopting and integrating ESG, by companies and investors alike. And even highly traditional societies like Japan were increasingly adopting sustainability practices, in the growing belief that it will aid future performance. Times are changing, and many investors may end up being positively surprised by how far sustainability investing has now come.

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SUSTAINABILITY INVESTING

Sustainability investing is on the rise in Asia Sustainability is rising in importance in Asia as companies and investors look for ways to enhance performance and apply stewardship and governance codes. That was the main takeaway of Masja Zandbergen, Head of ESG integration at Robeco, following a recent tour of the region.

“I was positively surprised by the amount of genuine interest in the topic after visiting many Asian institutional investors to talk about sustainability investing,” she says. “There was considerable appetite for knowledge sharing, and most investors informed us they were starting the process of implementing sustainability in their investment portfolios.”

corporate governance, with a lack of independent directors and low returns to shareholders among the main complaints. “The clear momentum in this country is being driven by the introduction of the corporate governance and stewardship codes, and by the fact that large institutions are taking the lead and committing parts of their portfolio to responsible investing,” Zandbergen says. “Some are more vocal about it than others. I met with one large pension fund that has actually been investing in a best-in-class ESG portfolio for many years, but has not really communicated this to the outside world. As humility is wisdom in Japan, most investors emphasize that they are still in the early stages, and are still learning about sustainability investing. Let’s hope this will lead to action in the future.”

‘As humility is wisdom in Japan, most investors emphasize that they are still in the early stages’ “Their success in achieving this will depend on the extent to which the many parties active in the field of sustainability offer sufficient research on local companies, and whether the right investment solutions exist. In both cases, a more Asiaoriented approach is needed.” “Furthermore, it struck me how important the human element is, and that those investors who are genuinely interested in and committed to the topic will be the most successful in achieving change.”

Land of the rising ESG Zandbergen says Japan – a land steeped in traditions – is a good example of how ESG is picking up. The country has been particularly criticized for lacking good

Institutional investors in other Asian countries are developing ESG questionnaires to use in their selection process to assess managers’ sustainability investing strengths. This has been standard practice for asset managers working with Northern European clients for some time, but has yet to catch on in other parts of the world. “I believe it will soon be a prerequisite globally,” says Zandbergen. “It is no longer enough to be a signatory of the UN Principles for Responsible Investment. How you implement the UN principles; how you structurally take ESG into account and

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SUSTAINABILITY INVESTING

engage with companies and keep track of results, are what it’s all about.”

Having a local flavor “Asian institutions are also working on implementing ESG integration in their own (local) portfolios, but they face many hurdles. These include low coverage of local small and midcap companies by ESG research providers, and how to effectively set up engagement with companies and collaborate with other investors. Sharing our knowledge with them will speed up the process.” On the private and retail banking side, Zandbergen says there is a clear need to show clients the alpha potential of an ESG strategy, and to develop products that customers can relate to. And here, there

‘Building human capital is extremely important in furthering ESG efforts’ is work to be done in Asia, she says.“Even though research shows that private investor demand for sustainable investment solutions is increasing, this was not the general feeling I got from the banks I met,” she says. “There is demand from ultra-high net worth clients and this will be fulfilled, but it is still a challenge to provide solutions for high net worth clients and others.”

Power to the people So what was the highlight of the trip? “The meetings I enjoyed most were those attended by top management and the

people actually responsible for implementing ESG in portfolios,” she says. “Both top management and the ESG specialists were highly motivated, and of course there were questions on alpha creation, but it seemed as if this station had already been passed.” “Those present were very engaged and asked relevant questions on the implementation of voting, engagement, quantitative ESG research, manager selection and so on. It reinforced my opinion that building human (intellectual) capital is extremely important in furthering ESG efforts in our industry. It all comes down to the people.”

What makes a quality board? Good corporate governance can make all the difference in whether a company can succeed sustainably – the tone comes from the top. But what makes a quality board? Michiel van Esch, an engagement specialist in Robeco’s Governance and Active Ownership team, has spent three years finding out.

He spoke directly with many representatives of companies, including chairmen, lead independent directors and corporate secretaries, to try to see how boards are improving. Robeco has long encouraged good corporate governance – the G in ESG – believing that it leads to better performance, and therefore better returns for shareholders. The main issues over recent years have been complaints about a lack of independent directors or gender diversity, though the scope of corporate governance is much more wide ranging. Tackling the lack of transparency by supervisory boards that are supposed to

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be acting as a check and a balance for management has risen up the agenda for engagement specialists, particularly since most operate behind closed doors whereas executives have higher public profiles.

the best interest of shareholders and other stakeholders.” “From many board members, we hear that responsibilities have increased. The time when people could easily sit on a double-digit number of boards is over. Depending on the market, they are also expected to assess company risk management and compliance systems, set appropriate remuneration and oversee accounting practices.”

Agency problem “The publicly listed company, in which ownership and management are separate, is inherently faced with an agency problem,” says Van Esch. “This means that management’s actions and interests might not always be aligned with the interests of shareholders or other stakeholders. In most markets, the board has a role in countering this problem. It supervises management in

“To meet all of these expectations, people with a variety of qualities are needed. Nomination committees therefore need to allocate sufficient time and resources to find appropriate board members.”

Incentives, checks and balances He says critics of boards have attributed at least part of the financial crisis to poor

SUSTAINABILITY INVESTING

governance practices that led to risky decisions. “Perverse incentives for top management, a lack of risk oversight and poor checks and balances are often cited as causes of irresponsible corporate behavior in the banking industry,” he says. “Nevertheless, financial companies often score well on many corporate governance practices such as independence criteria for board members, pay-for-performance structures and transparency via all sorts of reporting. However, box ticking will not help investors to gain good insight into the quality of corporate governance. A different approach is needed.”

Engagement project Robeco subsequently started an engagement project with banks and insurance companies in 2014, with five main objectives. These were to

understand and improve the quality of public disclosures and biographies, board nomination processes, the independence and objectivity in corporate boards, diversity (in a broad sense) and selfevaluations of board performance.

credibly reflect a company’s market? Sometimes companies provide useful disclosures that help investors. Often however, these disclosures are formalistic, which makes this analysis hard to carry out.”

“A proper analysis of a board takes a lot of time, but basic insights can already be gathered from public disclosures; it makes an excellent starting point,” Van Esch says. “How many of the independent board members have credible experience in the industry? Does the board appear entrenched, judging by average tenures? Do the backgrounds of board members

“Much of our work has focused on making sure companies have good nomination policies. We have found that companies do not need prescriptive rules for nomination, but require guidelines, planning and sufficient time to start a search process. It requires constant attention from the nominations committee and frequent reviews of board composition in terms of skills, gender, experience, and so on.”

‘Box ticking will not help investors to gain good insight into the quality of corporate governance’

Supervising the supervisory boards

Van Esch says supervisory boards are incrementally becoming more transparent, giving an insight into how they operate. “Having a strong composition doesn’t necessarily guarantee that the board is going to work well; it simply means that on paper it has the right capacities to do so,” he says. “In practice, shareholders have very little information about how supervisory boards actually function.” “Whereas executive management can often be judged on several Key Performance Indicators (KPIs) and have substantial exposure in the media, supervisory board members mainly operate behind closed doors. However, supervisory boards are increasingly reporting on their activities and the evaluation of their performance. A trained eye can read between the lines and assess whether boards are doing more than rubber stamping.” “Still, the best way to gain real insight is

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SUSTAINABILITY INVESTING

to speak to board members themselves. During our engagement project, we managed to speak with the chairmen and lead independent directors of several boards. These meetings allowed us a peek into the boardrooms of our investee companies and rendered the most fruitful conversations.”

dual mandates – chief executives who are also the chairman of the board – and

“We have seen positive developments in the insurance sector. Transparency and disclosure have improved markedly, making it easier for investors to gain a picture of board composition. Disclosure of board self-assessments has also become more prevalent, giving investors a look behind the scenes. And as for those candidates who gain a seat on the board, whilst more pressure is placed on their time, they also tend to have more relevant skills.”

‘These meetings allowed us a peek into boardrooms and rendered the most fruitful conversations’

Dual mandate concerns And there were a number of pleasant surprises, Van Esch says. “All the companies we engaged with met local standards for the required number of independent directors,” he reports. “We had concerns, however, about companies that traditionally held on to

which had led to dualism in several cases.”

the level of industry experience of the independent board members. Increasingly, new regulations including Solvency II have set governance standards. In some instances, that helped our cause to a certain extent, by requiring the splitting of key responsibilities for top management

ESG is often mis-implemented in portfolios Sustainability principles are often mis-implemented in portfolios due to biases towards certain factors, says quant specialist Ruben Feldman. It is therefore important to use as much information as possible, as removing these biases can have major benefits on longterm performance.

The rise of factor investing has led many investors to focus on stocks that display low volatility, value, momentum, quality or size. Use of these factors has consistently been shown to enhance returns, since it serves as a means of separating the ‘wheat from the chaff’ in stock selection. In parallel with this, the rise of sustainability investing has enabled investors to simultaneously chase companies with strong environmental, social and governance (ESG) credentials. Indeed, some investors now question whether ESG should be considered as a factor in its own right.

Robeco QUARTERLY • #6 / DECEMBER 2017

However, experience has shown that some factors such as size and quality have a more natural bias towards ESG than others, says Feldman, Senior Quantitative Analyst at Robeco’s sustainability specialist, RobecoSAM. And while it is an important consideration, ESG also doesn’t tell the whole story about why a company is successful or not, he says.

Taking it out of context “ESG generally is mis-implemented throughout the investment industry,” says Zurich-based Feldman. “When you rank companies according to pure ESG criteria, and you take that out of

SUSTAINABILITY INVESTING

context without allowing for anything else, you end up with huge biases.” “For example, first generation ESG indices, launched over 15 years ago when data was too limited to identify ESG data biases, use scoring and rank companies according to their sustainability directly. Subsequently there is a very significant overweight to Switzerland, for example. Most of the return there doesn’t just come from ESG, but according to how well the Swiss economy is doing, the strength of the Swiss franc versus the US dollar, and so on.” “Similarly, the index has a huge bias towards Europe, and a bias towards large caps, because they’re often able to report their information in a better way, which means it’s easier for us to find it. So all these biases mean you’re no longer

investing in ESG, but in some sort of random mix of extraneous factors which may be good or bad, producing positive or negative results.”

Smart beta biases Meanwhile, the ‘smart beta’ factors also generate their own biases, he says. “If you invest in an ESG portfolio you will get a strong bias to the style factors that are positively geared towards ESG such as size and quality. If you have fewer problems at a company, then the quality factor obviously means that the company is more sustainable.”

“But if you have so much quality or size in your portfolio, then you’re not really exposed to ESG, but to those factors instead. We did some research that showed ESG has sometimes over 20% risk exposure to the size factor, which is hugely significant. If size does well, then ESG does well, and vice versa.”

Rules based “ESG can be rules based, but it can’t be pure data processing. At some point you need to have someone estimate whether a corporate governance scheme is good or bad, or somewhere in-between. It’s not as simple as assigning exposure to value where one can just take price-to-book or similar.”

‘The index has a huge bias towards Europe, and a bias towards large caps’

“There are a lot of different themes as well. Corporate

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SUSTAINABILITY INVESTING

governance, for example, is more important in certain sectors; health & safety is always going to be more important for a materials company than a financial firm, for example. You have to make allowances for certain things. So it can be rules based, but there is still the requirement of sustainability research expertise.”

You can still cut risk So is it still worth doing? “I think integrating ESG can be very beneficial, even if it doesn’t yet have the same academic grounding as other factors,” he says. “It doesn’t have the same grounding because it’s not as easy to interpret; the ESG data isn’t simple. Indices generally only take into account the general ESG scores, which have huge biases.”

“Once you extract the pure ESG signal by getting rid of the unintended biases, you actually get an independent source of risk that is totally autonomous of the other sources of risk, and integrating that into your portfolio means that the actual idiosyncratic (unattributed) risk in

RobecoSAM’s research shows that ESG as a factor can provide an additional risk factor, independent of the factors usually present in models, with significant explanatory power and a positive Information Ratio. This means that bringing this into a model would enable the user to benefit from information that is otherwise ignored, and it facilitates the creation and control of portfolios with better riskadjusted returns.

‘ESG can be rules based, but it can’t be pure data processing’ your portfolio is reduced. More of your portfolio risk is explained by an additional factor, and since that factor actually has positive long-term returns, your overall portfolio returns will be better in the long term.”

“Therefore, if it’s calculated well and integrated well, then it can actually benefit your portfolio,” Feldman says. “Information is key, and using it properly is even more important.”

Behold the wind turbine as big as the Shard Wind turbines have come a long way since the first windmills centuries ago – with the next generation among Europe’s tallest structures.

The need to extract increasingly more power from turbines to make them commercially viable without subsidies means the core structures will stand over 200 meters tall. To the tip of the blades, they’ll reach over 300 meters, making them taller than the London skyscraper, the Shard, the tallest building in western Europe.

They will have a total generation capacity of 13-15 megawatts of electricity, making them over a thousand times more powerful than the biggest commercial windmills of the 19th century. To this day, the world’s largest windmill – standing in Schiedam in the Netherlands, built for the gin industry in 1803 – is only 33 meters tall.

Competitive alternative The blades alone will be longer than the wingspan of an Airbus A380, currently the largest passenger jet in the world. Built by Siemens and Vestas Wind Systems, the new ‘monster turbines’ are due to come online by 2025, though their eventual buyers have yet to be finalized.

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Power yields from turbines have needed to rise to make them competitive with traditional energy sources and avoid taxpayer-funded subsidies that have raised domestic energy bills. The first generation of commercial wind turbines in the 1990s (standing about 50 meters

tall) had a total generation capacity of about 0.5 megawatts of electricity. “Wind has finally become a competitive alternative to conventional energy,” says Chris Berkouwer, an analyst with Robeco’s Global Equities team. “Over the lifecycle of a wind turbine, it will return 35 times more energy back to society than it consumes, compared to a negative return for coal power plants.” “The era of subsidies for wind energy is also coming to an end. After the first hype, most turbine companies massively restructured, resulting in much better business models. Now that balance sheets are restored and profitability has improved, ‘wind’ is a very interesting financial investment too.”

Burton Malkiel

‘Academic research absolutely supports smart beta’ Great Minds

For over four decades, Burton Malkiel has advocated for broad passive exposure to financial markets. More recently however, this Princeton professor and author of the best-seller book ‘A random walk down Wall Street’ has also been recommending a prudent and low-cost approach to factor-based strategies. Although his views may not necessarily match those we share at Robeco, we consider this as a very interesting development. In our Great Minds series – a set of interviews with renowned academics and investment experts – we talked to him, about passive investing, smart beta, and more generally his most important professional achievements.

The popularity of passive investing has grown tremendously over the past decades, to the point that some academics and practitioners fear it may have damaging consequences on the way financial markets operate. Do you share those concerns? Is there an optimal level for passive investment? “No, I don’t share these concerns. I am not sure whether you are aware of this study, but S&P Dow Jones Indices, the index provider, publishes a report every six months on active versus passive management in the United States. And interestingly enough, the findings tend to be the same every time. In any given year, two thirds of active managers are outperformed by a low-cost indexing strategy. And if you go back ten and fifteen years – Standard and Poor’s has been doing this for that long – as many as 90% of active managers were outperformed by passive indices. This is not only true for large-capitalization stocks, but also for small-cap stocks. It is even true for the less efficient emerging markets, where passive investing has shown itself to be effective.” “Now, a lot of people say that, if passive eventually accounts for 100% of the market, there will be nobody left to make the market efficient, and it will be horrible, it will be chaos. Well, right now, a third of all funds are managed passively in the United States. That means there are still lots and lots of active managers who are around to make

sure the market is reasonably and efficiently priced. I will start to get worried if we reach 95%. But even then, I think there would be enough people around to make the market efficient.” “Moreover, suppose you were 100% passive and there was, in fact, a real opportunity to actually beat a passive approach. For me, it is inconceivable that in a capitalist system, some hedge fund, somebody, would not come along and take advantage of it. So, the paradox is, yes you do need a few active managers, in order to make sure information gets reflected in stock prices. But I think you could do this with 5%, I think you could do this with 1% active. So, as far as I am concerned, with somewhere between 30% to 35% of people’s money in indexed funds in the United States, we are nowhere near a point where we have to worry.” So, does passive investing have any disadvantages, in your view? “I thoroughly believe in low-cost passive investing. Nowadays, in the United States, you can buy a total stock market fund and pay as little as 3 basis points, with exchange traded funds (ETFs). In the book A random walk down Wall Street that I wrote in 1973, I suggested there ought to be indexed funds before they even existed. And if there is one idea that I’m thoroughly convinced has shown its merits, it’s passive investing or indexing. Now more than ever.”

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Burton Malkiel is Professor Emeritus of Economics, and Senior Economist at Princeton University. He is currently the Chief Investment Officer of Wealthfront, an automated investment advice firm with almost USD 8 billion under management in the United States. In 1973, Burton Malkiel authored the famous book ‘A random walk down Wall Street’, now in its 11th edition, which has sold more than 1.5 million copies across the world. In the book, Malkiel claims that ‘a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts.’ As a consequence, he advocated striving for broad and low-cost exposure to the stock market, instead of actively trying to beat it. Before joining Wealthfront in 2012, he served as a director of the Vanguard Group for more than 28 years, from 1977 until 2005. He also served as President of the American Finance Association in 1978, and as Dean of the Yale School of Management from 1981 to 1988. He was also an appointee to the President’s Council of Economic Advisors (1975-1977).

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Great Minds

Still, in a recent article published in The New York Times1, you seemed to be slightly tweaking your message on passive and advocating some kind of factor-based, or ‘smart beta’, approach. Specifically, they called you “an index fund evangelist who is straying from his gospel”. Could you explain that? “Sure. First of all, I think the reporter’s impression was not really accurate, because he was suggesting that I had given up on passive. In my book, I had used a metaphor that a blindfolded chimpanzee could pick stocks as well as the experts, and the reporter suggested I had given up on the monkeys. That’s not really true. Having said that, I have done quite a bit of work on some of the newer methods of portfolio management. And, as you can imagine, this is just the beginning.” “So let’s talk about smart beta. One of the things that we’ve learned from the academic research is that the so-called Capital Asset Pricing Model (CAPM), where risk is only one variable involved in relative volatility, is not a sufficient model. What we know is that there are probably many sources of risk. In other words, the CAPM beta, which is just volatility, is not sufficient and there are other sources of risk. One is that, in general, stocks that have very low valuations relative to their assets and earnings have historically yielded a slightly higher rate of return.” “Now, there is some controversy as to why, and my own feeling is that it is a risk element. It is another beta, not mispricing. It’s being paid a little more for taking on more risk. And the example I would give is that, during the financial crisis, stocks of most of our major banks, for example Citicorp, Bank of America or JPMorgan Chase, traded at a fraction – like 50% – of their asset values. That’s often the way you measure this beta factor, low valuation relative to assets and income. And I would argue that they did so because the risk was enormous. We indeed worried that some of our banks might go under. We thought of that as very risky.” J. Stewart, ‘An Index-Fund Evangelist Is Straying From His Gospel’, The New York Times, 22 June 2017.

“What smart beta says is that you can you can tilt a portfolio in certain ways, such as buying more of these low valuation stocks, such as buying small-capitalization stocks. Smaller companies are probably less able to ride out a deep recession than somewhat larger companies, and therefore size is another element in the smart beta mix. Moreover, you can tilt the portfolio in those directions passively. That is what smart beta is. And the claim is that you can get a higher rate of return. It is compensation for taking on more risk, but that’s fine if the investor can take on more risk. Maybe you want an index fund, but you want to tilt it toward riskier securities.” OK. But then, what’s your view on the current smart beta offering? “In general, I have not been a fan of smart beta for the following reasons. Not that the academic work does not support it, it absolutely does. But most of the smart beta offering has very high expense ratios, despite the fact that a lot of these products are ETFs. One of the reasons indexing works is that it has an almost zero expense ratio. A lot of the smart beta funds have expense ratios of half of one percent, three quarter of one percent, so they are high expense. And from my standpoint, this basically eliminates whatever advantage they may have in terms of strategy.” “The second point I want to raise is that all of these factors never work all the time. The low valuation effect works a good part of the time. It has worked most of the time through history, but you could well go through four or five years where it doesn’t not work. Similarly, small companies have given a higher rate of return that the larger companies, over long periods of history. But you could also go through four or five years when large companies do better than small companies. So, as much as these ideas are supported by empirical evidence over very long period of time, they don’t work all the time.” “So, what I usually recommend, and it has worked reasonably well, is not to use just one factor. We can use a number of factors and, hopefully, what happens is when one factor is not working another factor I likely to be working. These are not one factor

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‘Most of the smart beta offering has very high expense ratios’

smart beta funds, but multi-factor smart beta funds. And some have actually done quite well. You get a little higher rate of return, which is a compensation for risk, in my judgement, and it’s not inconsistent with passive.” “So basically getting to your point about smart beta, most of them have been terrible for investors because they are too high costs, they are single beta funds and I don’t recommend them. But of the multi-factor funds, if you can do this at a very low expense ratio, I think it’s fine.” “One last problem that I’d like to mention, with these smart beta funds, is that some of them tend to be tax inefficient. So, what product providers should do is that to have a smart beta offering, with a very low expense ratio, and we couple it with tax-loss harvesting so that it is not tax inefficient. And so yes we do some of that and we think there are circumstances where, particularly if the investor can accept higher risk, it may very well be suitable for them. But only if it’s very low expense and only if it’s coupled with tax-loss harvesting so that it is not tax inefficient.” How do you achieve these low expense ratios? “Through automation. Basically this is the beauty of having everything computerized. You can simply grow. Think of a regular investment advisor who has ten clients and the investment advisor wants to have 20 clients. One person can’t handle it alone so the investment advisor has to hire somebody else, and if they want to grow more, they have to hire a whole staff. The beauty of doing this in an automated fashion is you are infinitely scalable, and that’s how you do it at a very low cost.” Given the current popularity of factor investing and smart beta strategies, many sceptics have warned that excessive bets could lead to the disappearance of premiums. Could factor premiums be arbitraged away, in your view? “Well, there is that possibility. If a given factor becomes too popular, the premium should decline. Actually, some premiums may well have declined somewhat already, and that’s an

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Great Minds

important factor to take into account. Whenever an investment idea becomes overly popular, we cannot, we should not expect that it will continue to have the same beneficial effects as in the past. That being said, my sense is also that, if these really are a compensation for risk, they will not disappear completely. That’s because, over the long run, risk is going to have to be rewarded in some way, with some extra return.” For now, would you worry about a potential overcrowding of these products? “Not yet. But, in that respect, I will draw a parallel with your first question concerning the optimal level of passive investing. Imagine everybody used smart beta approaches, instead of general broad-based passive investing strategies. Well, in that case, I suspect smart beta would certainly not be nearly as beneficial now as it might have been at the very beginning.” How do you view traditional diversification over asset classes, countries or sectors, for example? Should investors also stick to this kind of approach? “Absolutely, absolutely. There’s an expression often used by economists that diversification is the only free lunch that’s available in inv stment markets. And I actually worry a lot that most people do not diversify enough, that people have what’s called a home-country bias. And I think this home-country bias is a mistake too many people make. To give an example, one of the ways that we, at Wealthfront, differ from a lot of other investment managers is that we can have 20% or 25% of a portfolio in emerging markets.” “There’s another statistic that I used to mention to illustrate this home-country bias: there was a time when France accounted for 3% of the world economy and French institutional investors had 97% of their stocks in French companies. That’s simply wrong, and that’s not optimal. So I recommend very broad diversification, not only with stocks but also stocks and bonds. And not just stocks in your country, but stocks from all over the world.”

“Another thing we do is that we tend to stray from straight indexing in the bond market, and look at segments of the market that might be more freely priced and less influenced by big central banks, such as the Fed, the European Central Bank or the Bank of Japan. We seem to be living in an era of financial repression: all over the world, major central banks are keeping interest rates extremely low, particularly on government debt. And we think bond markets are probably not efficiently priced in; they probably don’t give an investor sufficient reward for the risks they assume. As a result, we tend to use corporate bonds somewhat more than government bonds, particularly in the United States. We also use emerging market bonds. All these are still somewhat influenced by the big central banks, but to a much lesser extent.” Sustainably has also become a popular topic among investors. How do you look at sustainability aspects and possible ESG integration? “We don’t do that, but you are quite right, it has become popular. And I think certain aspects of this are troubling. Let’s imagine for a moment that we want to put together a portfolio that would be consistent with truth, beauty and all good things for people. What should we do in that case? Well, you might start by saying: let’s not buy any companies that sell tobacco products, and let’s not buy any companies that mine coal, because that’s the dirtiest fossil fuel.” “So, we would start off with these kinds of considerations and think they seem reasonable enough. But then someone else could come along and say: I don’t want to buy a company that produces alcoholic beverages’. And then we would probably start to wonder: ‘Now, wait a minute, should that be part of sustainability? And do we not own French winemakers as well?’ The problem that I have with sustainability aspects is that, when you get to the point of trying to determine things like ‘solar power is good but oil is bad’, if you push the logic too far, it gets very subjective. And I think that raises some real questions.” Now, a more personal question. After so many years dedicated to improving our understanding of financial markets and edu-

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‘I worry a lot that most people do not diversify enough’

cating investors, what do you see as your biggest professional achievement? “Well, I think that, without question, it would be my book, which really encouraged indexing. You know, a lot of people say to me: ‘Aren’t you discouraged? You have been trying to be an evangelist for indexing for over 40 years now, aren’t you discouraged that only a third of investors are indexed in the United States?’ And the way I usually answer is that I always try to look at the glass being half full, rather than half empty. It’s just amazing. This was very slow to catch on. It was very controversial at the beginning, and I am proudest of the fact that I have had a role in making just pure indexing, passive investing as popular as it is today.” “And I am proud of it because I think indexing has helped people. People have enjoyed happier retirements because of it, because it actually works. So, as far as I am concerned, that is probably the achievement that I feel best about. And, for me, the Wealthfront endeavor is part of it. Because, again, making effective, low-cost investing available to the public makes it easier to save for retirement, makes it more effective and makes for more effective vehicles for saving and investing. I am just extremely happy to be part of the organization, not only because it is successful, but because I feel we are really doing a very good job for our clients. And that is something I am also very proud of.” On a final note, if you could give investors one piece of much needed advice, what would it be? “That one should be very skeptical of anybody who says: ‘I am going to charge you a lot of money but I am going to do a way better job investing for you’. Avoiding that, avoiding the people that come to you and say: ‘I am going to make you a millionaire because you can buy bitcoins and they do nothing but go up’. Avoiding mistakes, steering a steady course, being well-diversified and remembering that the costs really do matter. My feeling is that we’re probably going to be in a low return environment for some years, and costs will be particularly important. Control the things that you can, and one of those things is costs.”

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The research culture is crucial for the success of an asset manager Academic journals have a strong bias towards publishing papers with positive results, which incentivizes researchers to engage in ‘p-hacking’. As a result, the majority of empirical studies in finance are unlikely to hold up in the future, says Campbell Harvey, a professor of finance at Duke University and investment strategy advisor at Man Group, PLC.

Speed read

Research

• The risk of ‘p-hacking’ in research is a threat for investors • There are techniques to improve the quality of research • Asset managers need to foster the right research culture

In recent years, several leading academics, including Campbell Harvey, have been warning about the dangers of ‘p-hacking’ in the academic field of finance. The concept of ‘p-hacking’ refers to the use of many different forms of analysis to uncover patterns in data, until a researcher appears to have found something statistically significant. The reasons behind this phenomenon are quite simple: editors of academic journals want their publications to have the highest possible impact factor, which is based on the number of citations relating to the articles they publish, and studies that support the hypothesis being tested tend to receive more citations. “Authors understand this and want to produce papers that have positive results,” says Campbell Harvey. “It is also more enjoyable to work on research that supports the hypothesis being tested, which is why researchers engage in data dredging to find results that exceed traditional levels of significance.” In his 2017 presidential address1 to the American Finance Association (AFA), he detailed many of the ways that researchers engage in ‘p-hacking’ – trying to achieve the lowest possible p-value, meaning the highest level of significance. Some

examples of the tools found in the p-hacker’s bag of tricks are: selective reporting of results; selective sample size; arbitrary transformation of data; arbitrary winsorization and outlier exclusion rules; and arbitrary selection of statistical tests. According to Campbell Harvey, ‘p-hacking’ is a very serious threat for investors, as it reduces the chance that any result will hold up ‘out-ofsample’. “As a consequence, I estimate that over 50% of all empirical studies in finance are unlikely to hold up in the future,” he says. Hopefully, there are also ways to improve the quality of research. In some of his most recent work, Campbell Harvey has actually put forward different techniques to achieve that goal. These include raising the cut-off for significance or considering both time-series information (factor by factor) and cross-sectional information (looking across many factors), in order to reduce some of the noise that inevitably forms part of realized factor returns.

‘Over 50% of all empirical studies in finance are unlikely to hold up in the future’ Meanwhile, investment management firms should be careful in fostering the right research culture to reduce the number of false positives. For example, suppose two highly qualified researchers, A and B, propose investigating two different potential strategies. A review committee thinks both have high quality ideas and A and B do their research which is also of an equally high quality. But the data supporting A’s strategy fails to hold up, while B’s strategy works well and goes live. It would be a big mistake to reward B and/or punish A. “This could encourage other researchers to engage in p-hacking,” he says. “That’s why the research culture is crucial for the success of an asset management firm.” C. R. Harvey, ‘The Scientific Outlook in Financial Economics’, (https://ssrn.com/ abstract=2893930).

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LAST BUT NOT LEAST

What’s mobile about mobile? Many of us don’t appreciate the complexity or physicality of our mobile communication. Does mobile really mean wireless? No, not really. Actually, only the so-called ‘last mile’ is really wireless; that small part between your mobile phone and the radio antenna. The rest is physical, consisting of lots and lots of fiber. Similarly, data that’s in the ‘cloud’ is not, in fact, abstract or virtual but is physically stored on a server in a data center. To cope with the upcoming tsunami of data and new use cases, this physical infrastructure has to evolve towards 5th generation (5G) technology. For infrastructure operators, this upgrade will significantly improve their return prospects.

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Big data goes mobile: how will our infrastructure cope? Vera Krückel and Folmer Pietersma – Robeco Trends Investing

Given the upcoming tsunami of data, our mobile communication infrastructure will have to evolve towards 5G. For operators of the physical infrastructure required, which consists of antenna towers, data centers and fiber, this upgrade will significantly improve their return prospects.

much everything we do online. An extensive number of components have to seamlessly work together for us to function effectively online: antenna towers; hyper-efficient data centers and last but not least lots and lots of underground fiber or copper miles that connect everything; including our continents through massive subsea cables.

A lot has been written about the digitization of our world. Our total data consumption has increased a stunning 4,000-fold over the last decade - and we are still expecting substantial growth to come. A widely quoted study from Cisco estimates a dazzling average growth rate of 25% per year in total internet traffic until 2020. For mobile data traffic the numbers are even more staggering: Cisco works with a predicted compounded annual growth rate of 50%+ between 2015 and 2020.

Massive investments are required This global communications infrastructure has been built over the course of decades at a cost approaching USD 2 trillion. And clearly, for our infrastructure to keep up with many of the envisioned future applications, further investment will be required. How much that is going to be is not clear yet. But just to give you an idea: Qualcomm calls it the 1000x challenge (…!), Europe has called for EUR 600-700 billion of investments just to catch up with the US and Asia, while Accenture estimates the US needs to spend USD 275 billion in capex investments to make the 5th generation of mobile networks a reality.

Newer applications such as video content streaming, augmented reality or connected cars, use massive amounts of data and will push growth levels even higher. This places substantial demands on the underlying infrastructure that has made and will continue to make all that data traffic possible. Although at first glance it’s the less glamorous part of the equation, the underlying network infrastructure is fascinating, complex, and most of all crucially important to enable pretty

Mobile Traffic (Exabytes per month)

Figure 1 | Explosion in mobile data consumption, by device type 35.0

PCs

30.0

Tablet Other M2M

25.0 20.0 15.0

Smartphone

10.0 5.0 -

Many of us don’t appreciate the vast complexity of the enablers of our digital world, nor the ‘physicality’ of our communication, which we have come to think of as ‘mobile’. Does mobile really mean wireless? No, not really, actually only the so-called ‘last mile’ is really wireless; that small step from your mobile phone to the radio antenna. The rest is physical, consisting of lots and lots of fiber. Similarly, there is nothing abstract or virtual about data that sits in the ‘cloud’; it is actually data that is physically stored on a server in a data center.

2015

2016

2017

2018

2019

2020

Smartphone

M2M

Non smartphone

Tablets

PCs

Other Portable Devices

Millions of connected devices joining the network Not only the amount of data but also the type of communication our infrastructure has to facilitate is changing fundamentally. Think of the Internet of Things (IoT), virtual or augmented reality, smart cities, remote

Source: Cisco, Goldman Sachs

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surgery - you name it. The expectation is that by 2020, 50 billion connected devices will communicate via the network in addition to us humans. All of which will consume and generate data. The infrastructure will have to facilitate all of this and meet a variety of demands: • Latency; connected cars and virtual or augmented reality effectively require zero delay in data transmission or latency • Bandwidth; gaming and video streaming require massive bandwidth (capacity) • Ubiquity; child monitoring or drones in precision agriculture require ubiquity, i.e. zero gaps in their breadth of coverage • Ultra-high reliability; remote surgery will demand consistency and ultra-high reliability • Low battery usage; industrial IoT or other remote devices require low battery usage

heavily in the quality of their networks – once again benefiting infrastructure asset operators.

A redesign is necessary In addition to adding more capacity, the infrastructure will require some redesign. First, much more will have to be done locally to move computing power to the edges of the network. In addition, we need to slice and dice the capabilities of a network and assign only those partitions to an application that it actually requires. Why waste massive capacity on an IoT device that requires only very low bandwidth? That means we need a level of intelligence that can distribute the capabilities of the network in the most optimal way; to the edges where no latency is tolerated or to the (remote) cloud when we need the capacity, but not urgently, to process big data sets.

‘By 2020, 50 billion connected devices will communicate via the network’

To make all of this feasible, our future network needs to be extremely flexible, intelligent and agile. And this is what the 5th generation of mobile networks is meant to bring. We think that independent operators of the enabling infrastructure will benefit significantly from the explosion in data usage. We will need more data centers, more radio antennas and more fiber route connections. Operators will see significant demand and therefore attractive revenue growth opportunities. In addition, considering that they operate a capital intensive infrastructure asset, we expect them to enjoy nice profitability uplifts through economies of scale.

The quest for everything: 5G So what is 5G actually? We don’t know all the technological details yet, but we expect fixed wireless standards to be in place by 2018, while the mobile part will be released in 2019. It will be a long road and while a full-fledged 5G world may not be with us until 2022-2025, infrastructure owners have to start preparing right now. As the industry moves towards 5G, network architects can densify the network with small cells or add new spectrum to increase capacity. Whatever route they take, telecom operators will have to invest

In addition, small cells will be an important tool in increasing the capacity of tomorrow’s infrastructure. However, as they cannot be deployed everywhere, the result will be a very heterogeneous world. We think there will be several layers of infrastructure on top of each other. 5G will be layered on top of 4G, if you like. There will probably even be different variants of infrastructure depending on rural versus urban environments. Also, different use cases will make use of different slices of the infrastructure. The outcome will be a world of communication that is hybrid and heterogeneous and we will have to adapt our communication infrastructure to each specific use case or application. The industry has termed this the Heterogeneous Network or ‘HetNet’. For this, we need flexibility that is enabled through software and a concept called virtualization, which we will explain later on. More importantly, the different components of the infrastructure will also all have to speak to each other. Similarly, network slicing – where a single physical network is subdivided into several virtual networks – will ensure the appropriate network partitions are dedicated to those applications that need just a part of the overall functionality: low-bandwidth but wide-coverage

Figure 2 | 5G Timeline

2016 5G Trials

2017-2019 3GPP Releases

2020 5G finalized

2021-2026 Deployment of 5G Source: Macquarie

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Decentralized data creation with cameras and sensors everywhere

This is not to say there will be no more demand for cloud data centers – quite the contrary, in fact! Big data will continue to demand cloud infrastructure. For some tasks however, mainly those that require low latency, it does not make sense to continuously send data back and forth to the cloud, as this only clogs our network. Instead, we will make increased use of data centers that are located close to us. This means interconnection data centers located close to urban areas or, maybe in time, even micro data centers in the connected device itself. A connected car might very well eventually become a moving data center.

In the past, content was created and stored centrally and then consumed at the outer edges of a network. We would browse a webpage or download a Netflix video from a remote data center onto our mobile devices. This is changing with ever increasing numbers of users uploading YouTube videos, applications such as Facebook Life or Snap Chat - where we keep each other updated with short videos rather than text - or connected cars which will generate massive amounts of data through their sensors and cameras. This more decentralized creation of content will once again place new demands on our infrastructure.

Similarly, radio antennas will move closer to the user and the connected device through the small cells we discussed earlier. Today’s vertical tower structures have a very wide reach but cannot handle the massive amounts of bandwidth or serve very low latency applications. Small cells can overcome this limitation and serve as infill stations where the signal weakens or top up when more capacity is required. With their shorter reach they will have to be deployed in a much denser fashion, though. Luckily they are the size of a shoebox and can be fixed to pretty much everything, such as street lights or bus stops.

Over the last decade, we have gone through a massive centralization phase by moving data to the cloud – which is effectively a massive remote data center. While this is super-efficient and will continue to be so, it will soon be mirrored by a development at the edge of the network in the form of urban or micro data centers; a decentralization phase, where there is a shift closer to the end user. The outer layers of the network will become more intelligent rather than relying on the core network. This is called edge computing.

We see three advantages for operators of tower assets and consider them to be the major potential beneficiaries from reinvestment in network quality: 1. Telecom operators will need to deploy more antennas to add network capacity 2. Tower operators can find new growth venues in small cells 3. Tower operators can earn additional lease revenue as their tower locations are perfectly suitable for micro data centers

applications will be assigned the 4G part of the network, while bandwidth-hungry, latency-intolerant applications such as virtual reality will require 5G. Industrial IoT devices that require low battery usage but very low bandwidth will get a specific narrow band IoT network. In this way, the capabilities offered by the network will be distributed in the most efficient manner possible.

Figure 3 | The core network and its edges

The enablers: C-RAN and SDN We expect hardware, in the form of servers, routers, etc. in the data center, and antenna equipment and base stations in the radio network to become increasingly standardized. When hardware is standardized, it can be aggregated into a pool and its capacity can be combined. There is no longer dedicated but only generic hardware and various types of actions can be performed using it through a software overlay. Thanks to a technology called virtualization this will take place

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in several forms in the network. In its essence, virtualization means that an application, an operating system or data storage, is decoupled or abstracted from the underlying hardware layer. While this brings agility and flexibility, the most important advantage is that it saves on processing capacity. An intelligent software ‘controller’ dynamically allocates tasks to where there is excess capacity and to where that task can be performed most efficiently.

The cost equation becomes much more difficult to solve as we move from a centralized to a decentralized world. At the same time, telecom operators still have little visibility as to whether 5G will open new monetization opportunities for them or not. In the case of virtualization in particular, the economics of network sharing will become ever more convincing, which is why we expect increased use of either third-party network operators or joint venture structures.

‘We see fiber as one of the biggest beneficiaries in the transition to 5G’

The use of our mobile network is very unbalanced; a very small percentage of towers handles a very large percentage of network traffic at any point in time. For example, during the day time, radio antennas in a Central Business District are very busy, while the traffic shifts to residential areas in the evening when everybody starts to stream Netflix.

To better process network traffic, the industry has come up with Cloud-RAN (C-RAN). This technology effectively brings the philosophy of the cloud - centralizing and sharing resources - to the radio access network. Traditionally, we had one base station at each tower, but going forward, especially with small cells, we will aggregate a number of them into a baseband pool (BBU) and use them all together to carry out the processing for a whole range of radio antennas. By doing so, we can dynamically allocate traffic to where we have availability. This can open up significant amounts of capacity and reduce costs, as we only have to provide for average rather than peak capacity. In a similar manner, the intelligence of software allows for efficient use of storage, processing and computing resources. This is termed Software Defined Networking (SDN). The intelligence of the network function dynamically distributes tasks to the most suitable part of the infrastructure depending on their specific requirements. For example, a research institute that has collected vast amounts of data that it wants to perform complex research on, can easily do this in the cloud as latency is not critical. Traffic information that supports connected cars however needs real time responsiveness and is better performed in an edge data center. Dynamically connecting and sharing capacity over the network works only if the different parts of the network can be connected at no latency. This is only possible through fiber connections which enable data transfer at the speed of light. We therefore see fiber as one of the biggest beneficiaries in the transition to 5G.

The economics of infrastructure sharing Complexity will increase in a world that is hybrid and heterogeneous.

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As digital infrastructure represents a significant fixed cost, pure economic considerations have long pointed to the benefits of infrastructure sharing. Outsourcing to a third-party independent operator is a very clear-cut move while a joint venture structure allows for some degree of control over the assets, but is very complicated to manage. However, strategic considerations have frequently led telecom operators to take different routes: when there are quality differences between networks, operators are not willing to share their competitive edge but prefer to keep the infrastructure in-house and use it to try to attract a higher customer base. We think that outsourcing makes a lot of economic sense especially for towers and that this trend will accelerate in regions such as the EU, where 75% of towers are still in the hands of mobile operators. We think the move towards 5G – and the accompanying capital expenditure – might trigger a phase of accelerated outsourcing. Adding an additional tenant to a tower generates incremental revenue while the cost structure remains pretty much the same, implying incremental margins of over 90%. We believe the situation is slightly different for fiber as it will become ever more important in a world that moves towards 5G. We therefore think that at least some carriers will decide to invest in in-house capacity, despite the even greater economies of fiber sharing. Fiber is very expensive to deploy but once under the ground, it is the most efficient mode of transport. There is hardly any efficiency loss and it offers virtually unlimited capacity, making it the perfect asset to be shared. While data centers are already much more frequently third-party operated, the industry is still very fragmented. This is about to change with the wave of consolidation that is about to come. Once the core network is virtualized and a hypervisor decides whether to compute, process and store in the cloud or at the edge, scale will become more important. In addition, it makes sense to have a global footprint and to own both edge and cloud data centers. We think this consolidation move will benefit the data center industry significantly.

Jeroen Blokland

‘All you need are two lines to make the perfect graph’ Interview

A good graph says more than 1000 words. But what actually constitutes a good graph? Portfolio manager Jeroen Blokland on candidates for ‘the graph of the year’, Bunds and bitcoin.

Your twitter account (@jsblokland, 15,000+ followers) occupies a prominent position on the ‘must follow’ lists published by Business Insider and MarketWatch. This is largely thanks to your endless series of graphs. How did you develop this fascination? “I use graphs a lot in my investment research, and I’m always searching for relationships and correlations. You can’t show everything using graphs, but they can help clarify an awful lot. You don’t need sixteen lines, two is the perfect number. Many economists take a stance: ‘the relationship between employment and wages has broken down and this is the reason’ and then debate on it. I don’t like doing that, I want to use a graph to make a succinct and clear statement.” So two lines are perfect? But what are the other ingredients for a really good graph? “A good graph shows a relationship between elements from which you can draw a conclusion with a reasonable degree of certainty. If you plot a graph of the Ifo Business Climate Index against the German economy, you know it will work and you’ll end up with a nice graph. You know that when the Ifo line moves up, growth will generally move higher too. A good graph is a great tool when it comes to making investment decisions. The image shows the relationship; I can explain it and then predict how a market, currency or asset class will move. There is a fantastic graph of interest rates over the last 5000 years – it’s brilliant. But it’s no use to an investor. You need a second line, a factor or an indicator that shows which way interest rates are going to move.” Basing investment decisions on a graph sounds a bit like skating on thin ice. How do you approach this?

“For me, graphs play a fundamental role. Many investors make the mistake of thinking things will be different this time. They tend to think ‘but now we have QE and we’ve never had that before’. Or IT, or artificial intelligence. There is always something that makes us assume that things are not what they used to be. Graphs can help ensure that you make investment decisions while keeping both feet firmly on the ground. A sort of emotional sanity check. Now it’s become clear that the relationship between wages and employment has broken down, all sorts of reports have appeared saying that we need to look at some newfangled employment metric that has just been invented. Although the graph looks great – it’s just backtesting. But are things really different? Why should the original measure no longer be effective? If you look more carefully, it’s clear that the relationship hasn’t broken down, it’s just taking a bit longer. Because more people work part time and because there are different types of jobs.” What is the first graph that you look at in the morning when you switch on your Bloomberg? “For years now the most important graph in our industry has been interest rate movements. I’ve been surprised for a year now about the fact that these are not moving higher, except slightly in the US. Monetary easing is being scaled back and will eventually stop. The German economy is growing at a rate of 2.8% – something that no economist would have dared predict a couple of years ago. But more recently, I have spent a lot of time looking at the bitcoin graph, because it absolutely intrigues me.” This graph is almost a carbon copy of the graph of the tulip mania rally of the 17th century. No way! It might look the same but this is so new and it’s moving so fast and that’s what really fascinates me. Each time I wake up

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‘Funnily enough – I don’t have so much faith in technical analysis’

it can have gained or lost 20% – and we are talking about something that’s worth USD 100 billion. Many people brand bitcoin as a bubble purely on the basis of one line.You can’t really compare tulip mania to a technology either. And – funnily enough – I don’t have all that much faith in technical analysis. Bitcoin fascinates me because of its enormously fast growth while no one is really sure if it’s going to be a success or not. But closer to home, the German 10-year yield that fell below the 0% threshold for a while this year – that really is something special.” So as far as you are concerned that is the mother of all graphs? “Certainly of the last few years, Yes. The mother of all interest rates (in Europe) were negative for a long period. This German Bund graph is the only one that can really challenge bitcoin for

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the title of ‘graph of the year’, and it of course has far more impact. You are not rewarded for putting your money in the safest place in the world – in fact you have to pay for the privilege. This means that all the other options must be extremely risky. Something that’s hard to reconcile with years of rising equity markets. Of course we know it’s the result of central bank policy. But I still really wonder why central bankers have done this, because I can list numerous negative effects it has had and few positive ones. The rich get richer. You get punished for saving and are forced to move higher up the risk curve – and the only people who can afford to do that are the wealthy. The small investors get left behind. They have scrimped and saved for the last few years and can now finally afford to invest. The risk now is, of course, that the party is almost over and once again they’ll be the ones to suffer.”

Column

Jerome Powell: a lesser, but low-risk choice The most important economic decision to be taken so far by President Donald Trump has arguably been the nomination of the next Fed chair. The path of the least resistance would have been to renominate ‘the small lady with the large IQ’, Janet Yellen, for a second term. Presidents typically reappoint incumbent Fed chairs for a second term irrespective of political leanings. Apart from tradition, the roaring stock market would have been an additional argument to renominate Ms. Yellen: never change a winning team! But Mr. Trump decided otherwise. It is tempting to ascribe this to his apparent misogyny, but rumor has it that the intervention by Treasury Secretary Steve Mnuchin was decisive in preventing a Yellen renomination. The main argument was that his preferred alternative, current Fed Board Governor Jerome Powell, is less in favor of strictly regulating the financial industry than Yellen. For the rest, Powell is a kind of Republican Yellen. He has, for example, never dissented from her position on a Fed board vote since his appointment in 2012. This suggests pragmatism. Some Republicans were pressing for a hard money man, like Stanford economist John Taylor, the inventor of the famous Taylor-rule. He has been arguing in favor of higher rates for years. His rule would currently raise the Fed’s benchmark federal funds rate to around

3.5%, well above its recent levels ranging between 1% and 1.25%. Mr. Taylor has also criticized quantitative easing as counterproductive, because in his opinion, driving down longer-term bond yields tends to make lenders less likely to extend credit, which holds back economic growth. Interestingly enough, Mr. Taylor also backs Mr. Trump’s claim that he can raise the annual economic growth in the US to 3% and maintain it at that level. Most Fed officials have been skeptical that economic growth could be raised that high because of structural changes such as an aging population and lower productivity growth. Ms. Yellen has said that consistently maintaining growth rates at 3% would be “quite challenging.” For a disrupter like Mr. Trump, Mr. Taylor would certainly have been the more interesting choice. Instead, he allowed himself be talked into the boring Mr. Powell. That’s completely understandable; of course a populist has no need for a hard money man. Dovish monetary policy and pro-cyclical fiscal policy thanks to partly unfunded tax cuts are going to help Mr. Trump in the November 2018 elections. A lawyer by training, Mr. Powell would be the first Fed chair since Alan Greenspan to lack an economics Ph.D. But Mr. Powell knows his finance. He worked in investment banking and then in George H.W. Bush’s Treasury Department, where he dealt with the crisis surrounding Salomon Brothers, which famously but illegally cornered a Treasury debt auction using phony bids. He made a fortune working in private equity. When he started at the Fed, he basically did not know much about macroeconomics or monetary policy. Compare this to the stellar credentials of Ms. Yellen in these fields. Aside from being a consistent Yellen ally, Mr. Powell has mostly overseen boring, but important matters such as the financial payments system. Mr. Trump’s decision to nominate Mr. Powell, rather than Ms. Yellen, is at first sight surprisingly boring, but upon closer consideration, totally understandable. The question remains: is he really up to the job? Only time will tell.

Léon Cornelissen, Chief Economist

Robeco QUARTERLY • #6 / DECEMBER 2017

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