Robeco Quarterly December 2016 by Robeco

Robeco

Intended for professional investors only

QUARTERLY PEOPLE & PHILOSOPHY ALSO COUNT IN QUANT – 36 OUTLOOK 2017: TIME FOR PLAN B – 7 BEWARE OF RISING INDEX DURATION – 30 LONG READ: DEFINING LIQUID ALTERNATIVES – 32

QUANT investing SUSTAINABILITY investing #2 / December 2016 Robeco QUARTERLY • #1 / SEPTEMBER 2016

‘A higher share of equities increases the expected return, and the contribution to the fiscal budget, but also entails more volatility in the value of the fund and a higher risk of a decline in its long-run value. The majority is of the view that this risk is acceptable.’ The Mork Commission in October 2016 advised the USD 880 billion Norwegian sovereign wealth fund to increase its weighting from 60% to 70%. Still, that didn’t stop the chairman of the commission, Knut Anton Mork, from disagreeing with the majority’s conclusion. Mork instead recommended cutting the stock holdings to 50%.

Robeco QUARTERLY • #2 / DECEMBER 2016

Factor investing versus sector investing: The contest

Despite the rise of factor investing, allocation to sectors remains very popular. But at Robeco, we believe that allocation to the factor premiums implemented in our strategies ensures that they always perform better than strategies that allocate to sectors. Concerns regarding the new Fama-French 5-factor model

The ‘quality’ of low-risk credits

Low Vol in historical perspective: Fund investing since 1774

SUSTAINABILITY investing

Outlook 2017 Time for Plan B: Ten things to set the tone in 2017

Macro economy The debt supercycle also means growing wealth

Trends Going Dutch to optimize DC pension schemes

Research Twisting and turning with taxes

Research Investors should be aware of rising index durations

Long read Defining liquid alternatives

Interview ‘Culture is a crucial factor in quant investing’

Column Brexit becomes more complicated by the day

Voting is more powerful than meets the eye 22 While rubber-stamping company resolutions is fairly routine, dissent also occurs during shareholders’ meetings and does have an effect. New research shows that even the smallest levels of objections can still rattle a board sufficiently to change something. Working towards a sustainable palm oil industry

UN Sustainable Development Goals: An opportunity for investors

Macondo boosts risk management in deepwater drilling

Robeco QUARTERLY • #2 / DECEMBER 2016

And more…

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CONTENTS

Climate change

Global warming: A systemic risk Climate change will have an impact on politics, macroeconomics and financial markets that may show up before the real effects of global warming materialize, Chief Economist Léon Cornelissen warns in our latest five-year outlook, titled ‘It’s always darkest just before dawn’. “The scientific consensus is that global warming will become worse, before it hopefully becomes better,” says Cornelissen. “One reason for optimism is the fact that heightened global concerns surrounding this phenomenon have now resulted in the ambitious COP21 Paris Agreement.” Cornelissen says climate change could on one level be described as one of mankind’s greatest market failures which the world is only just coming to terms with. This is manifesting itself in extreme weather events: “Global warming also implies global ‘weirding’. This not only means droughts like those recently experienced in Australia, where

Presidential returns S&P 500 after 100 days in the Office 1 Roosevelt +86% 2 Johnson +12% 3 Kennedy +9% 4 Obama +8% 5 Bush sr +8% 6 Truman +4% 7 Nixon +2% 8 Clinton +2% 9 Reagan +1% 10 Carter -4% 11 Eisenhower -6% 12 Bush jr -7% 13 Ford -11% Blue – Democratic, Orange – Republican

meteorologists had to search for new colors for their weather maps, but also wildfires in California and elsewhere.” “But it could also mean – somewhat paradoxically – more severe winters as a consequence of a seasonal change in the path of the so-called ‘jet stream’, or a southerly bend in the Gulf Stream which is currently responsible for the mild sea climate in northwest Europe. Climate change will therefore have an impact on politics, macroeconomics and on financial

markets.” So what will global warming mean for the expected returns on asset classes? “The most significant physical impacts of climate change will become evident in the second half of this century,” says Cornelissen. “But the consequences for forward-looking asset markets could become apparent far earlier. When future expectations in terms of climate change are adjusted, markets and prices will reflect this, possibly long before the physical changes of global warming make themselves felt.”

Investment paradox The paradox of low-risk investing is at the heart of some of Robeco’s most successful strategies. For the novice, it might seem counterintuitive to expect lower returns from riskier assets. However, over the past four decades, numerous academic studies across many stock markets have shown that safer, less volatile securities tend to outperform riskier and more volatile ones over long periods of time. To explain this well-documented anomaly to a broader audience, Pim van Vliet, founder and fund manager of Robeco’s Conservative Equity funds, teamed up with Jan de Koning, client portfolio manager for quant equity strategies, to write ‘High Returns from Low Risk’, a book packed with practical insights into low-risk investment. It will be available in bookstores in December 2016.

Robeco QUARTERLY • #2 / DECEMBER 2016

Emerging markets

Dead-end street After two decades of strong economic growth, emerging Europe has lost momentum. Robeco Emerging Markets Equities is currently not invested in Central and Eastern Europe because of the unstable economic policy in the region, say Dimitri Chatzoudis and WimHein Pals. When Poland, Hungary and the Czech Republic became members of the European Union in 2004, it created a steady investment climate for companies from Western Europe and elsewhere. During the 2008-2009 crisis, Poland was actually the only country in the European Union to avoid recession. But things changed after the crisis. Foreign investments in Central and Eastern Europe dried up and the exports from East to West dwindled. Buoyed up by high

We believe in a prudent approach As we approach the end of the year, we can safely say that uneventful is not a word that applies to 2016. The main culprits, of course, were the British referendum and the US elections. In both cases the outcome defied all the polls and expert predictions, and thus took financial markets by surprise. This reaffirmed the limitations we face when predicting the future in general or the outcome of specific major events. The most interesting aspect of both the Brexit referendum and the US election is probably that they were both close calls. A 48-52 outcome, as was the case with Brexit, in absolute numbers is not that different from a 52-48 result. With the US elections the difference was even smaller: 47.8% versus 46.9% of all votes (or to be more specific: 62,825,754 versus 61,486,735 votes), and in favor of Clinton too. The impact however was huge because in both cases voters faced a binary ‘bet’: the winner takes all. As investors we have learned not to bet on a specific outcome, but to prepare our portfolios for all scenarios. In general, however, our industry and the media spend way too much time and energy on predicting the unknown, especially at this time of the year. Forecasts for the 12 months ahead can be useful, funny or thought-provoking (and, yes, we jump on the bandwagon too), but it usually makes more sense to take a more long-term view. That is the reason why we put so much time and effort into our annual five-year Expected Returns publication. And why, when looking at the past, we also dig deep.

income from raw materials, Russia initially looked like a potential new market. But this too came to an end in 2014, as oil prices collapsed. Meanwhile, the political wind changed direction in Poland and Hungary, with the rise of Eurosceptic and populist ideas. These two countries are no longer progressive and stable, and their investment climate has worsened.

No matter how important current events seem to be, Brexits and US elections are just ripples on the surface from a longer term perspective. In this Robeco Quarterly we look at the history of mutual funds since 1774, which shows that in the early days it all revolved around prudence – a virtue many investors have lost sight of along the way. We also look at the long-term future of Quant investing, where we believe this prudent approach will enable us to stay ahead of the pack. Wishing you all the best for 2017,

Peter Ferket, Head of Investments

Robeco QUARTERLY • #2 / DECEMBER 2016

Lower yields mean greater risk Consumer trends

Central banks have been dominating bond markets, or all markets for that matter, for years now. As a result of their massive bond-buying programs, yields have fallen to historically low levels. And this means increased risk, because even the faintest glimpse of normalization will probably propel interest rates significantly higher. But it’s not quite that simple. If this rise in interest rates happens, it will hit bond prices harder than in the past.

Strong brands, strong performance Strong brands are a ticket to strong performance, enabling the companies possessing them to outperform other stocks. That has been the experience of household name products that have withstood the test of time, say Robeco trends specialists Jack Neele and Steef Bergakker in their latest white paper on the issue. “In a world of exploding product choice, consumers increasingly need to cut through the noise to make informed purchasing decisions,” they say. “Brands can help. They facilitate information processing and reduce the risk of making the wrong decision. Strong brands have historically outperformed the broader equity market and are likely to continue to do so.” Neele and Bergakker say the ability to utilize premium pricing is what makes an effective brand a strong earner,

backed by a large addressable market. But ultimately, it’s more about a mindset than market share, they argue. “Research has revealed that most people in most buying situations make purchase decisions intuitively; that is, they rely on their mental auto-pilot to make quick, effortless and associative decisions that require very little energy,” they say. “Brands can become part of people’s mental auto-pilot if they succeed in becoming embedded in memory structures that are triggered to fire in certain situations. They need to trigger the right mental cues at the right time in the right place.” And catchy slogans certainly activate these mental cues, they say. “That is why we can still remember many of the advertising slogans of our youth. Mindshare is long-lasting and extremely powerful.”

The reason? As yields have fallen, duration has risen. In the case of European government bonds, duration has increased by roughly two years since 2011. This implies that bond prices will drop an additional 2% for every 1% rise in bond yields. So this steady increase in duration makes bond investors, particularly passive investors, much more vulnerable to rising bond yields than they were a couple of years ago. Something to keep in mind.

Jeroen Blokland Senior Portfolio Manager

Robeco QUARTERLY • #2 / DECEMBER 2016

Time for Plan B: Ten things to set the tone in 2017 Outlook 2017

Most people agree that 2016 was a year of upheavals, from Brexit to Trump and an alarmingly high number of celebrity deaths. So will 2017 be any more stable for investors?

In its annual outlook for the coming year, Robeco Investment Solutions has forecast what is likely to dominate the agenda. Here are ten of the top picks chosen by Chief Investment Officer Lukas Daalder (pictured), Chief Economist Léon Cornelissen and team strategist Peter van der Welle.

1 | Bring on Plan B Monetary policy has entered a phase of diminishing returns, and is no longer able to kick-start the economy on its own. Presidentelect Trump has already said he will push for fiscal stimulus, replacing the current over-reliance on monetary policy. With even the ECB now insisting that governments should not rely on the central bank to keep bailing them out, sentiment on this subject has shifted. Given the current low growth expectations, there is considerably more scope for surprises on the upside, and this could lead to a much-needed rekindling of investment as a growth engine.

2 | Tight spot may be the right spot The US economy has finally reached full employment and wage growth has steadily improved. This can drive personal consumption and facilitate a rebound in investment. Overall, Robeco Investment Solutions expects US growth to exceed the level forecast for 2016. So, will this lead to a much more aggressive policy from the Federal Reserve? Fed Chair Janet Yellen has said she considers wage growth between 3% and 4% as healthy, and that this is a necessary condition for a gradual tightening of monetary policy. As a majority of the Fed decision makers will probably continue to err on the side of caution, two modest rate hikes at the most are likely during 2017.

3 | P is for populism The populist and nationalist forces that fueled the Brexit and

Robeco QUARTERLY • #2 / DECEMBER 2016

Trump victories may well be repeated in a heavy political agenda for 2017, with presidential elections in France in the spring and general elections in Germany in the autumn. France poses the greatest risk as far-right National Front leader Marine Le Pen seems likely to reach the second round of the presidential elections; if she wins, this would unleash a crisis in the EU. The most logical response to this trend is for mainstream politicians to try to regain popularity with the broader electorate by introducing policies such as an increase in the minimum wage, more progressive tax regulations and fewer austerity measures. This is partly why the growth outlook for 2017 as a whole is not as negative as some might think.

4 | Japan’s box of tricks Faced with QE that was going nowhere, the Bank of Japan spectacularly moved the goalposts in 2016 with the introduction of Yield Curve Targeting, setting a lower rate of zero for the 10-year government bond yield. But it is hard to see how this will make a difference. Monetary policy alone is not enough – the government also needs to step in. The extent to which Prime Minister Abe does so will be an important issue in 2017. Japan’s track record on fiscal spending has unfortunately not been very convincing to date, but raising the minimum wage or increasing pay-outs are some of the options available to Abe.

5 | The Chinese debt threat The explosion in Chinese debt levels may become a real global worry in 2017, as centrally directed growth targets have taken precedence over sensible investment policy, which has led to overcapacity in, for example, manufacturing and housing. A prudent policy would be initiate debt write-downs and reduce over-capacity. However, this would mean China abandoning

Outlook 2017

its medium-term growth target of 6.5% – which is unlikely to happen. Instead, China is set to kick the can down the road for a little longer.

modest drop in profit margins is likely, while sales volumes are expected to improve, pushing overall corporate earnings growth back into positive territory in 2017.

6 | Trading places

8 | Emerging from recession

As global trade is cooling, and may fall further under a Trump presidency, the best medicine to revive it should be a cyclical pick-up in economic activity. But even if global economic growth improves in 2017 as expected, the increase in global trade could still be underwhelming. But let’s not get too pessimistic here. Emerging markets are still far behind the technological frontier of developed markets, and global trade remains a powerful catalyst for them to catch up. (See ‘Expected Returns 2017-2021' for the long-term view).

Emerging markets overturned five years of underperformance to buck the trend in 2016, yet they still trade at a significant discount to their developed market peers. There will probably be a pause in the current rally at some point, after which the focus will shift towards fundamentals. So there is reason to remain positive on the asset class. Brazil and Russia are coming out of recession, while India and Indonesia have implemented reforms and will likely experience healthy growth rates. A further catch-up in productivity will keep earnings growth attractive compared to that of developed markets.

7 | Equities are all about valuations Earnings per share growth for the US stock market has been declining since 2015, but the fears of an overdue recession that gripped the market in 2016 proved unwarranted. Experience shows that expansion phases do not die of old age. Given expectations for continued wage growth, on balance a more

For professional investors

9 | Yields are set to rise As a result of QE, many government bonds now have negative yields, meaning investors actually pay governments for the privilege of lending them money. Some investors are braced for a long-awaited ‘correction’ in bond markets. Much, if not all depends on central bank policy, which rests in turn on the return of inflation. If headline inflation does start to rise in Europe, speculation may soon arise as to when the ECB will initiate tapering. Rising European yields would therefore be curbed by any ECB intervention. The biggest uncertainty is the US; if Trump succeeds in implementing a reflationary package, pushing debt levels higher, US Treasuries look vulnerable. 2017

Time for Plan B OUTLOOK

10 | Sterling sliding The British pound fell about 18% on the Brexit referendum result, reflecting the increased risk to the economy of leaving the Single Market. Continuing uncertainty over the exit process will dampen foreign investment in the UK. Given the UK’s large current account deficit, it is clear that this lower level of foreign investment will continue to keep pressure on sterling. A more direct impact is expected to come from higher inflation as sterling’s fall makes imports more expensive. And as domestic demand falls, it is clear that the UK economy will show markedly lower growth in 2017.

Go to http://www.robeco.com/en/professionals/ insights/outlook-2017/index.jsp to read our full outlook for 2017

Robeco QUARTERLY • #2 / DECEMBER 2016

QUANTinvesting

Factor or sector? Despite the rising popularity of factor investing over the past decade, many still strongly advocate allocation to sectors. Even some academics. For example, a recent paper suggests that when short selling is not permitted, sector allocation provides better diversification opportunities in tough equity markets. But what is the theoretical foundation that justifies systematically favoring some sectors over others? Also, which factors were actually taken into account in this study and how did this affect the outcome? At Robeco, we believe that allocation to all the well-established factor premiums implemented in our strategies – which include value, momentum, low volatility and the recently added quality – ensures that they always perform better than strategies that allocate to sectors, regardless of the optimization objective.

Robeco QUARTERLY • #2 / DECEMBER 2016

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Factor investing versus sector investing: The contest A recent paper suggests that, if short selling is not permitted, sector allocation does as well or even better than factor allocation. However, these results are crucially dependent on the factors considered, which in this case do not include Low Risk. Explicit allocation to all the well-established factor premiums as implemented by Robeco, always performs better than allocation to sectors, regardless of the optimization objective, say Simon Lansdorp and Milan Vidojevic.

Factor investing uses a rules-based approach to isolate assets with certain characteristics that are expected to deliver superior risk-adjusted returns. Examples are stocks that are inexpensive relative to their fundamentals, stocks with strong recent performance, low-risk stocks, or high-quality stocks. Strategic allocation to such factors has been shown to provide diversification benefits and improve risk-adjusted returns compared to the more traditional portfolio management approaches that explicitly allocate to countries and sectors.

approach only when evaluated using certain performance metrics, such as attaining the highest return, while sector investing beats factor investing when other performance metrics, such as diversification, are used as the relevant evaluation criteria. For example, the paper claims that sector investing has the potential to offer greater downside protection than factor investing as strategies based on certain sector allocations are exposed to lower absolute risk levels than the best possible factor allocation.

Interestingly, a 2016 working paper by Marie Brière and Ariane Szafarz, ‘FactorBased v. Industry-Based Allocation: The Contest’, provides results of a comparison between factor-based and sector-based investing. The authors conclude that neither of the two approaches is the overall clear winner if short selling is forbidden. In their study, Brière and Szafarz consider the size, value, momentum and quality factors, and ten sectors, as classified by Kenneth French. And while they acknowledge that factor investing is superior to sector investing when short selling is permitted, they also find that sector investing does as well as or even better than factor investing in the long-only context.

We oppose the idea that sector investing can add as much, or even more value than factor investing, even in the longonly context. First, there is no theoretical

Performance metrics matter More specifically, the authors conclude that factor investing is the superior

foundation that would justify favoring certain sectors over others. While some have historically outperformed others, there is no reason to expect that past patterns will persist. Factor investing, on the other hand, is based on a vast amount of academic evidence that shows the existence of several factor premiums and, most importantly, provides reasons to expect these factors to continue to earn a premium in the future. Numerous academic papers also show that factorbased strategies have added value in portfolios in practice.

Introducing Low Risk Second, regardless of differences in the theoretical basis, we argue that the empirical findings of Brière and Szafarz crucially depend on their selection of factors, and that conclusions turn in favor of factor investing if a different group of factors is selected. At Robeco, we believe in a set of four key factor premiums that, in addition to value, momentum, and quality, also includes the low-risk factor.

Figure 1 | Efficient frontiers

Total return

20%

15%

10% 10% Factors

15% Sectors

Risk (volatility)

20%

25%

Factors ex-Low Risk

Source: Webpage of Kenneth French and Robeco: time period July 1963 to December 2015

Robeco QUARTERLY • #2 / DECEMBER 2016

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The reason why Brière and Szafarz find that sector allocation has more potential to provide downside protection could well be because they do not include the low-risk factor in their selection. Consequently, in their setting, the sector investing approach can be tilted to defensive sectors like utilities, while the factor investing approach is restrained in the extent to which it can allocate to the defensive segment of the market. We have run our own horse race between factor investing and sector investing, but this time have also included a low-risk factor in the contest. We find that factor investing is superior to sector investing no matter what metric is used for performance evaluation (see graph). Moreover, the factor portfolios used in this analysis are based on very generic factor definitions. So using more sophisticated factor strategies is likely to give even better results, making the case for factor investing even more compelling.

‘There is no theoretical foundation that would justify favoring certain sectors over others’

Concerns regarding the new Fama-French 5-factor model Nobel prize laureate Eugene Fama (pictured) and fellow researcher Kenneth French have revamped their famous 3-factor model by adding two new factors to analyze stock returns. On top of the classic Market Risk, Size and Value factors, they also look at Profitability and Investment. This 5-factor model is a major step forward but it also raises many questions, say David Blitz, Matthias Hanauer, Milan Vidojevic and Pim van Vliet.

Back in 1993, Fama and French argued that the size and value factors capture a dimension of systematic risk that is not captured by market beta in the Capital Asset Pricing Model (CAPM). They proposed extending the CAPM, which resulted in the 3-factor model. The size effect is where small cap stocks earn higher returns than those with a large market cap. The value effect is the superior performance of stocks with a low price-to-book ratio compared to those

Robeco QUARTERLY • #2 / DECEMBER 2016

with a high price to book. Over the past two decades, this 3-factor model has been very influential. It has become common practice in the asset pricing literature to look at both 1-factor and 3-factor alphas. However, many such studies also suggested that the 3-factor model is incomplete and that more factors are needed to accurately describe the crosssection of stock returns. Inspired by this mounting evidence that three factors were not enough, in 2015, Fama and French decided to add two additional factors to

their 3-factor model, namely profitability (stocks of companies with a high operating profitability perform better) and investment (stocks of companies with high total asset growth have below average returns). Both new factors are concrete examples of what are popularly known as quality factors. This 5-factor model is likely to become the new standard in asset pricing studies, which significantly raises the bar for new anomalies. However, it still fails to address

QUANT INVESTING

important questions left unanswered by the 3-factor model and raises a number of new concerns.

Missing Low Volatility and Momentum The first issue is that, just like its predecessor, the 5-factor model retains the CAPM relationship between risk and return, which implies that, all other things being equal, a higher market beta should result in a higher expected return. This

the 3-factor model, the 5-factor model remains unable to explain the momentum premium, and continues to ignore it. Yet, because momentum is too pervasive and important to ignore, most studies also look at 4-factor alphas, based on the 3-factor model augmented with the momentum factor. For the same reason, many researchers will probably feel the need to add the momentum factor to this new 5-factor model, resulting in a 6-factor variant.

‘This new model is unlikely to put an end to empirical asset pricing discussions’ assumption refutes the existence of a low beta or low-volatility premium, despite a wide body of literature showing otherwise. On this specific matter, Fama and French have argued that the low-beta anomaly is fully accounted for in their 5-factor model. But their conclusion seems premature, since they fail to provide direct evidence that a higher market beta exposure is rewarded with higher returns. A second concern is that, similar to

Robustness issues

The robustness of the two new factors is also an issue. It is particularly surprising that the investment factor is defined as asset growth, which Fama and French themselves deemed a ‘less robust’ phenomenon, back in 2008. More specifically, the 5-factor model fails to explain a number of variables that are closely related to the two newly selected ones. Another robustness concern is that it is still unclear whether the two new factors were effective before 1963 or evident in other asset classes, while for other factors such as value and momentum this is known to be the case. Another concern is the economic rationale behind the

new model. Fama and French initially justified the addition of the size and value factors by arguing that these could be seen as priced risk factors, implying that they might capture the risk of financial distress. Since then, however, studies have shown that the direct relationship between distress risk and return is actually negative. This is consistent with the existence of a low-risk premium. In the case of profitability and investment, Fama and French do not even attempt to explain that these are plausible risk factors. Instead, their rationale for including these factors is that they should imply expected returns, which they derive from a rewritten dividend discount model. But it remains unclear if the higher expected returns for firms with high profitability or low investment, all else being constant, are due to higher (distress) risk or just a case of mispricing.

Ongoing debate If Fama and French’s goal was to simply construct a model that fits the data without having to rationalize the chosen factors, their 5-factor model does a pretty good job. But this was not their intention. This new model is therefore unlikely to put an end to empirical asset pricing discussions or lead to consensus. While the traditional size and value factors are still being questioned – the size premium seems to have diminished somewhat since it was first documented in the early 1980s – this new 5-factor model is already being challenged by competing alternative models. We expect many studies to appear in the years ahead that document anomalies with significant 3-, 4-, 5-, and 6-factor alphas, in the same way that many studies have documented asset pricing anomalies with significant 3- and 4-factor alphas over the last two decades. In the end, the 5-factor model may well turn out to raise more questions than it answers.

Robeco QUARTERLY • #2 / DECEMBER 2016

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The ‘quality’ of low-risk credits Low Risk, Value, Momentum and Size are the most well-known factors in the academic literature. A more recent addition is Quality. But this is a less clearly-defined concept. In credit markets, it can be seen as an extension of Low Risk. All Robeco’s credit factor models have used Quality since their inception, say Patrick Houweling, Jeroen van Zundert, Frederik Muskens and Mark Whirdy.

the risk view and the behavioral view. They concluded that a risk-based explanation is unlikely, because a quality portfolio has lower volatility than the market and tends to outperform in market downturns.

Recently, several index providers have launched quality equity indices, including S&P, MSCI and FTSE. Although these indices each have their own set of quality variables, they all incorporate profitability and risk measures. The breadth of these academic studies and the range of market indices indicate that quality is a rather ambiguous concept, which may encompass various themes. At Robeco, we define high-quality companies as firms with high profitability, high-quality earnings, and conservative behavior.

Therefore, a behavioral explanation is more likely: although investors are willing to pay up for the stocks and bonds of high-quality firms, the market underprices these securities relative to low-quality firms. Bouchaud et al. (2016) argue that “investors systematically underweight the information contained in quality-like signals; they are too focused on other indicators such as earnings per share […]”.

Although Warren Buffett is known as the ultimate value investor, a 2013 study (Frazzini, Kabiller & Pedersen) showed that his superior returns can in fact be explained by the fact that he invests in

‘Quality is a rather ambiguous concept, which may encompass various themes’ stocks that are not only cheaper (value factor), but also safer and of higher quality (low-risk and quality factors). The definition of quality in this study is comprised of over 20 variables, grouped into four themes: profitability, growth, safety and payout. Other academic studies have investigated specific quality variables, such as earnings quality (measured by accruals), profitability (measured by gross profits) and investments (measured by asset growth or equity growth).

A Quality portfolio has lower volatility One may wonder why a quality portfolio generates a premium over the market. After all, who doesn’t like profitable, cash flow-generating, well-managed companies? Academic researchers investigated two possible explanations:

To illustrate the links between quality and low risk, we evaluated the quality factor in the period 1994-2015 in the USD investment grade and USD high yield corporate bond markets. In each month, we computed a score for each firm on each quality theme (profitability, earnings quality, conservativism) and averaged them to get a firm’s overall quality score. Then we created five equally populated corporate bond portfolios based on this score: Q1 contained the bonds in the top 20% (the highest quality firms), Q2 the next 20%, and so on, up to Q5 which

Figure 1 | Risk-return plot of Quality quintile portfolios for USD investment grade and USD high yield 4.0%

1.0% Q2

3.0%

0.6%

excess return

0.8%

0.4% 0.2%

2.5% 2.0% 1.5% 1.0% 0.5%

0.0% -0.2% 0%

Q2 Q1

3.5%

excess return volatility

0.0%

Q5 6%

-0.5% 0%

Q5 2%

10%

excess return volatility

12%

14%

Source: Robeco, Barclays, FactSet. Sample period January 1994-December 2015.

Robeco QUARTERLY • #2 / DECEMBER 2016

QUANT INVESTING Figure 2 | Sharpe ratios of the market and top quintile Quality, Low Risk, Value, Momentum, and Size portfolios for USD investment grade and USD high yield 0.6

0.4

0.5 0.3 0.4 0.3

0.2

0.2 0.1 0.1 0.0

Market

Quality Low Risk Value Momentum Size

0.0

Market

Quality

Low Risk

Value

Momentum Size

Source: Robeco, Barclays, FactSet. Sample period January 1994-December 2015.

contained the bottom 20% (the lowestquality firms). It should be noted that this does not mean that, for example, Q5 will always contain lossmaking firms. This will vary over time with the business cycle. We used a holding period of 12 months. The returns and volatilities of each quintile portfolio are shown in Figure 1. We found that high-quality firms (Q1) have higher returns and lower volatility than low-quality firms (Q5). As a result, the high-quality portfolio has a much higher Sharpe ratio than the low-quality portfolio. Moreover, the five quintile portfolios displayed a constant increase in risk and a near-constant decline in return. This empirical evidence clearly shows that the quality factor is useful in a factor investing framework, both in investment grade and in high yield credits.

Quality compares well with other factors Next, we compared quality with other proven factors – low risk, value, momentum and size – and found that all factors generated higher Sharpe ratios than the market. Moreover, the Sharpe ratio of the quality factor is of similar magnitude to the Sharpe ratio of the other factors, as Figure 2 shows. For investors, safety is often seen as an attribute of quality, but safety is also important in terms of risk. Even without using overlapping variables in the definitions,

‘Even after controlling for the low-risk element of Quality, it still generates alpha’ it is intuitively obvious that quality is similar to low risk. For example, quality dislikes loss-making firms and it is not hard to imagine that unprofitable firms are also riskier. Quality investing also favors firms that are conservatively managed, such as those that prefer to pay off their debt rather than aggressively invest. Deleveraging clearly reduces default risk.

statistically significant alphas, and the outperformance of both factors is negatively correlated with the market, because their beta is negative. So both quality and low risk typically outperform in a bear market, and underperform in a bull market. The similarities between the quality and low-risk factors also become obvious when regressing their outperformance versus each other. The betas are not equal to 1 which means the factors are not identical, but they are around 0.6 and are statistically highly significant. Moreover, the alphas are still sizeable: 0.21% for investment grade and 0.55% for high yield. So, even after controlling for the low-risk element of the quality factor, it still generates alpha. This demonstrates that quality has added value beyond this low-risk element, even if this is statistically weaker than the added value both factors offer over the credit market risk premium.

Strong empirical evidence for this intuitive similarity between quality and low risk can be found when analyzing the quality characteristics of low-risk sorted portfolios shown in Figure 3. The low-risk portfolio (Q1) is invested in companies which are more profitable and generate more cash flow while the high-risk portfolio (Q5) contains firms that are less profitable and generate less cash flow. More evidence on the similarity between quality and low risk can also be found by analyzing returns.

Use of Quality and Low Risk in Robeco’s factor strategies

As we show in Figure 1, the lower the ranking on the quality factor, the larger the realized return volatility. Hence, the quality of a firm is predictive of the future volatility of its bonds. Both factors generate

Because quality and low-risk factors are both quantitatively and qualitatively similar, we combine them in a single basket in our factor models. So far, we have called this basket ‘low risk’, even though it also contains quality variables.

Robeco QUARTERLY • #2 / DECEMBER 2016

QUANT INVESTING Figure 3 | Average profitability and cash flow for low-risk sorted portfolios for USD investment grade and USD high yield markets 35%

20%

30%

15%

25%

10%

20%

15%

10%

-5%

-10%

-15% Q1 IG

Q5 IG

Source: Robeco, Barclays, FactSet. Sample period January 1994-December 2015.

For example, leverage has been part of our low-risk factor since the inception of our factor strategies. And in recent years, we have added other variables such as profitability. All our quantitative multi-factor ranking models contain the combined low-risk/quality basket. The Robeco Conservative Credits strategy is tilted towards the low-risk/quality factor

and uses value, momentum and size as supporting factors. The Robeco MultiFactor Credits strategy offers balanced exposure to all factors. Both strategies are driven primarily by quantitative models, with a fundamental overlay to take into account the non-quantifiable risks. The Robeco High Yield Bonds fund, on the other hand, is a predominantly

fundamentally managed portfolio, in which we apply a multi-factor model to the bonds of listed small and mid-cap companies. In all applications the use of quality variables, in addition to pure lowrisk variables, helps to tilt the portfolios towards safer, more profitable, and more conservatively managed companies.

Low Vol in historical perspective: Fund investing since 1774 History shows that good investment ideas do not guarantee commercial success. In a recent white paper, Jan Sytze Mosselaar and Pim van Vliet, portfolio managers of Robeco’s Conservative Equities funds, looked back at over 200 years of mutual fund investing. Their conclusion? Performance remains highly dependent on timing, but capital protection, high income and low turnover have all also contributed to long-term wealth accumulation in the past.

The first ever mutual fund was launched by Abraham van Ketwich in 1774 in what was the global financial center of the 18th century: Amsterdam (pictured). Van Ketwich owned one of the many brokerage offices in the city, and came up with the idea of offering a diversified fund of bonds that would mitigate the investment risk for small investors. He named his fund Eendragt Maakt Magt

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(unity makes strength). It would consist of several share classes and would invest in ten different categories of securities, 50 in total, which were all listed in the prospectus. The categories included government bonds from Russia, Sweden and Denmark, as well as bonds securitizing Danish and Spanish toll revenues, but the fund focused mainly on Caribbean plantation loans, the predecessors of mortgage-backed securities. Dutch government bonds were not included,

as their perceived low risk was felt not to require diversification. Equity investments were deemed to be too risky and were excluded from the investment universe. The fund wasn’t supposed to trade much – something which was safeguarded by a strict division between the investment manager and the broker, Van Ketwich, who handled the trades. The starting point was to equally weight the investments to ensure the benefits of diversification. The fund would pay an annual dividend of 4%, and would be terminated after 25 years. In the following years, two other funds were introduced. But neither of these vehicles were a big

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well. A typical closed-end trust in the UK in the 19th century invested in around 500 to 1,000 companies, and was actively managed by professional money managers.

unsuccessful. These developments were all supported by the increase in computational power, which also enabled the rapid rise of evidence-based investing from the late 1990s. The simplest rulesbased funds just tracked market indices and offered diversification at very low cost. However, academics also started to acknowledge that market indices are not efficient. Based on these insights, new rules-based funds started to target factors such as low volatility, value and momentum, to achieve a better risk-return profile.

‘Van Ketwich was too early and the funds suffered serious headwinds’

success. Van Ketwich was too early and the funds suffered serious headwinds. In 1780, the Fourth Anglo-Dutch War broke. Investors’ sentiment deteriorated and the Caribbean plantation loans suffered as colonial goods could not be shipped back to Europe. In 1795, the situation worsened as the Dutch Republic went to war with France. As a result, the Dutch Caribbean colonies were confiscated by the British. The Dutch economic hegemony was now over, and London took over from Amsterdam as the financial center of the world.

The UK and the US take the lead One of the first investment funds outside the Dutch Republic was the Foreign & Colonial Trust, which was launched in 1868. The trust grew into F&C Asset Management and is nowadays part of BMO Global Asset Management. Another investment trust that still exists, is the Scottish American Investment Company.

On the other side of the Atlantic, in Boston, the still existing Massachusetts Investors Trust (MIT) started in 1924 – five years before the start of the Robeco fund in Rotterdam – offering an open-end low-cost investment vehicle that would give small investors the chance to have a diversified portfolio, similar to Van Ketwich’s idea. After the Great Depression of the 1930s, the four oldest mutual funds – the MIT Fund, the Investors Incorporated Fund, State Street and Wellington – were run by experienced fund managers who invested conservatively as the depression era was still fresh in their minds. Their goal was to give their investors a prudent, mutual fund with a focus on controlling risks. For example, in its prospectus, active manager Wellington, founded in 1928, stated that its investment objective was: “to pay reasonable dividends, to secure profits without undue speculation, and to conserve principal”. The modern mutual funds as we know them today started to appear during the swinging sixties. Then, not only did the industry grow rapidly, the investment focus also shifted from conservatism to outperformance with the rise of ‘star managers’. Influential capital-market models were developed by academics, leading to the rise of market-weighted indices which became common benchmarks. Meanwhile, early attempts to build a low-beta fund in the 1970s remained

‘The crisis of 2008 was a blessing in disguise for low-volatility investing’ This trust initially invested in railroad bonds, but later expanded its business into shares and bonds in other sectors as

Low-risk investing back in fashion Three important trends have heavily impacted the industry over the past decade: the breakthrough of indextracking funds; the rise of quantitative funds; and the increase in low-risk funds. This last investment philosophy became particularly relevant after the successive stock market shocks of the 2000s and brings us back to the beginning of fund investing. As a matter of fact, the crisis of 2008 was a blessing in disguise for low-volatility investing. It was a sound reminder that risk needs to be managed if investors want to achieve high long-term returns. Not all that much has changed since the days of Abraham van Ketwich. Historically, investors have always had two often conflicting aims – to achieve capital growth and maintain capital protection. Though his timing was unfortunate, which shows that patience and a bit of luck are also important factors, Van Ketwich’s idea of a prudent and diversified investment vehicle for the small investor to mitigate risk was brilliant. In an industry obsessed with short-term relative performance and high turnover, it is crucial to preserve, promote and live these age-old investment virtues.

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The debt supercycle also means growing wealth Debt gets a bad rap, evoking images of human figures bound in chains… but is it really that bad? It’s actually a lot more complex, says asset allocator and debt investor Lukas Daalder.

Speed read

Research

• One person’s debt is another person’s asset • Not all debt is equal, and not all issuers are the same • China, US credits and government deficits remain flashpoints

The amount of debt in the world seems to be rising faster than the economic growth needed to sustain it, creating the concept of a ‘debt supercycle’ that has no end in sight. However, debt is also a very useful tool: most of mankind’s greatest advances have been funded by it, and modern investment would be impossible without it. “What most people seem to forget is that wherever there is a debtor, there is also a creditor: one person’s debt is another person’s asset,” says Daalder, Chief Investment Officer of Robeco Investment Solutions and a co-author of ‘Expected Returns 2017-2021’. “Providing that the debt can be repaid, this could also be described as a ‘wealth supercycle’, though this is a phrase you never hear being used. Would a massive increase in wealth be feasible, without this leading to higher debt?”

In defense of debt…

increased level of wealth and savings in society, and reducing it would have negative consequences, for example on the money available to pay pensions;

Daalder cites five reasons to be cheerful about debt: • Borrowing allows people to invest for the future, be it in business ideas, housing or big ticket items like cars. if used wisely, wealth can transform the prospects of individuals, businesses and even whole economies; • Where there is a debtor, there is also a creditor: mortgage debt is an asset for banks, while government bonds are held by pension funds. Instead of talking about a ‘debt supercycle’, we could also be talking about a ‘wealth supercycle’; • Debt is a logical consequence of the

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• Not all debt is equal: there is a big difference between debt for short-term consumption, such as credit cards used for shopping, and debt linked to long-term investments or an underlying asset, such as a mortgage to buy a house; • Not all countries are the same: emerging markets rely more on debt because their equity markets are not yet mature, but the fact that it can be converted into equity in the years to come reduces the threat of debt accumulation.

‘Mortgage debt is an asset for banks, while government bonds are held by pension funds’

“Debt, as it turns out, is not as black and white as it is sometimes made out to be,” says Daalder, whose multi-asset fund invests in both government and corporate

Research bonds. “However, we’re not simply saying that we should welcome an ever increasing pile of debt; although it can be seen as a net zero for the economy as a whole (debt = wealth), there are still reasons why too high a level of debt leads to trouble in the end.”

‘So who’s buying all this deficit-funding debt? Enter the central banks…’

Three pressure points Daalder says the three main potential pressure points are the escalating levels of Chinese debt, the potential for US corporate debt to turn sour – particularly if US interest rates rise, as expected – and the ‘elephant in the room’ of debt issued to fund Western government deficits. “In China, private debt had risen from below 120% in 2008 to an unprecedented 205% by 2015, mostly driven by a near stellar increase in corporate debt,” he says. “The good news though is that China is a centrally managed economy with a very high savings rate, and a current nominal growth rate of 8%. The bad news is that this growth may have been boosted by the huge rise in debt. Much will depend on the policy pursued by the Chinese authorities.”

US also has lots of cash He says the more worrying prospect is the US; unlike China, its debt is spread around the globe and a debt default cycle could certainly have adverse consequences for the broader financial

markets. The figures are also astronomical: annual US bond issuance doubled to USD 1.5 trillion between 2008 and 2015, a figure higher than the Netherlands' annual GDP. “Which brings us to the elephant in the room: governments. They acted as the lender of last resort during the economic collapse of 2007-2009, which led to high deficits across the board. In a four-year period, debt as a percentage of GDP rose by 30% for the advanced economies on aggregate, after which it stabilized at around the 100% of GDP level.” So who’s buying all this deficit-funding debt? Enter the central banks, which are still in the midst of extensive quantitative easing programs, and by the end of 2016 will have mopped up USD 7 trillion in government bonds. “And thanks to negative interest rates in some countries, governments can actually get ‘paid’ to borrow right now. This does not exactly sound like a classic debt cycle that is about to reach tipping point,” Daalder says.

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Going Dutch to optimize DC pension schemes The world is watching with interest as the Netherlands switches from DB to DC pension schemes. Robeco's research reveals that schemes offering a variable pension benefit and collective risk sharing are clearly better for members than those that do not, say Tom Steenkamp, Head of Investment Research, and Jacqueline Lommen, Executive Director European Pensions.

Speed read

Pensions

• Combining personal pension accounts with collective risk sharing • The savings and risk cover portions will be unbundled • Only two investment funds are used for life-cycle investing

The eyes of the world are now focused on the Netherlands’ ‘pension polder’. Economic and social developments are forcing the government, employers and employees, who have a long history with defined benefit (DB) pension schemes, to make the leap to defined contribution (DC) schemes. This brings them a step closer to a future-proof pension system.

have long been commonplace and the US and UK have extensive experience with variable and flexible pension benefits. Fortunately, the Netherlands can profit from the lessons learned by other countries and, thanks to its own wealth of pension experience, perfect them to the benefit of all. In keeping with Dutch tradition, the Netherlands is doing this through ‘poldering’: a process where the government, employers and unions meet to hammer out a compromise. The solution combines parts of DB and DC to get the best of both worlds, by including personal pension accounts but preserving collective risk sharing. The idea is to take the progressive step of unbundling the savings and risk cover portions of a pension scheme. Guarantees would also be completely eliminated. What form will this take?

Collective risk sharing Pension funds with DB schemes the world over struggle with chronic underfunding and lack the solvency to honor the guarantees they provide to members. Low interest rates and increasing life expectancy are to blame. Moreover, accounting standards such as IFRS and USGAAP are making it impossible for employers to keep increasingly higher pension costs and the associated commitments on the balance sheet. In addition, the way in which pension is accrued and benefits are paid out must be made more flexible to accommodate the changing needs of the labor market and society at large. It’s a difficult step for social partners to take. But they must do it, as switching to DC schemes will offer pension funds and employers a lasting solution to their underfunding and accounting obligations. However, it does mean that members will bear the brunt of the pension risks (mortality, longevity, disability and investment risks). Which solution would adequately protect members while gaining enough support from the employers and unions? And how can the DB entitlements already accrued (the past services) be transferred to a DC scheme?

Unbundling savings and risk cover To address these issues, the Netherlands is also looking beyond its borders. In Asia, Australia and South America, DC schemes

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In the risk sharing portion, all the member’s biometric risks will still be hedged and shared collectively, even if the member has a personal pension account. The remarkable part is that neither the pension fund nor the employer will continue bearing these risks. Instead, the members do so collectively. Unlike in many other countries, benefits must be life-long and lump sum payments are not allowed. An innovative structure was devised for the longevity risk in the benefits phase. If the macro longevity increases (i.e. overall life expectancy rises), all members’ benefits decrease. The benefits are also adjusted in response to the micro longevity (i.e. if more or fewer members die than accounted for in the prognoses). However, when members die, the resulting mortality profits (the remaining balances in their pension accounts) must be distributed to the remaining members of the collective scheme. Any shocks that occur may also be spread over time to limit pension benefit fluctuations.

Two-fund investment model The savings portion of each member’s pension plan is kept in a personal pension account. The members bear their own investment risk. The pension assets are invested according to the life-cycle model. In that model, young members have higher

Pensions

DC with variable benefit and collective risk sharing Decrease vested rights and benefits Smart DC

DB without sponsor guarantee (Dutch CDC)

Individual DC

Conditional indexation DB Final pay DB

Defined Contribution scheme

Defined Benefit scheme

‘The expected benefit can be 20% higher than in the case of guaranteed benefits’

risk investment profiles in order to maximize returns. As the member ages and approaches retirement or enters the benefits phase, the investment risk is reduced. This is a tried-and-tested concept which is widely known internationally. However, what makes the Dutch solution so innovative is it uses only two investment funds for life-cycle investing: a return portfolio and a matching or protection portfolio. Both are funds of funds and are actively managed. The advantage of this approach is that all of the asset manager’s expertise and know-how in asset allocation and risk management are available to individual members because they are contained in those two funds. Using just two large institutional investment funds means that it is cost-efficient, workable and easy for members to understand. Moreover, it facilitates the transition from DB to DC schemes as the return-matching investment concept is already used in DB schemes. Another innovation is the application of the human capital theory in the life-cycle investment policy. By also taking human capital, a member’s future earning capacity, into account, the financial capital can be put into riskier investments offering the potential for higher returns. In most countries, the asset allocation for young members starts with an investment of 70-80% in equities,

which is rapidly reduced in favor of bonds. The Dutch put 100% into high-risk assets and hold these for longer.

Pension benefits 20% higher

To support this in practice, the Dutch government recently passed a law that no longer requires mandatory benefit guarantees and makes variable benefits possible in DC schemes. The advantage is that members can invest in return-focused assets for a longer period of time and as such expect a higher pension. Robeco Investment Research has calculated the expected amounts and fluctuations in fixed and variable benefits and concluded that DC pension members are clearly better off with variable benefits. The expected benefit can be 20% higher than in the case of guaranteed benefits. The combination of a variable benefit and sharing risks collectively also greatly reduces the fluctuations and downside risk compared to ordinary DC solutions. With their collectivity-based pension system and EUR 1.7 billion in pension assets, the Dutch have a wealth of experience in pension fund management and collective risk sharing. Having struck just the right balance with its new DC scheme, the Dutch DC solutions might well be copied in other countries in the years to come.

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SUSTAINABILITY investing

Voting does make an impact Investors often think that voting against contentious company policies makes no difference because ‘everyone goes with the flow’. Not so. While rubber-stamping company resolutions from strategy to directors’ salaries is often fairly routine, dissent does occur – and it does have an effect. New research shows that even the smallest levels of objections can still rattle a board sufficiently to change something, even when this does appear evident at first. A Dutch professor is attempting to directly link voting patterns to end-results, and has reached some startling conclusions. His work has been borne out by experience on the ground by Robeco’s engagement specialists, proving that active ownership has moved from an ideal to a demand.

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Voting is more powerful than meets the eye Voting is a more powerful investor tool than meets the eye, as even small levels of dissent can lead to major changes further down the road, says a leading researcher on the subject.

“Even a tiny percentage of 4% dissent can be a signal for the firm to start engagement, and for managers to care more about that engagement,” says Hans van Oosterhout, Professor of Corporate Governance and Responsibility at the Rotterdam School of Management of Erasmus University. "If you look at the chain of events, from behind-the-scenes discussions to actual voting, the bottom line is that investor activity can make a difference, particularly when it’s focused upon strategic issues. Up until recently, we all thought that voting doesn’t matter, but we have recently come to understand that it is one of the most potentially effective

started to use new research methods to capture the effects of voting, and that really shows interesting new insights.”

and powerful mechanisms of public engagement.” Van Oosterhout’s work attempts to make a quantifiable connection between shareholder voting and the end-result. “Much has changed over the last decade or so, since especially institutional investors have started taking their voting rights seriously,” he says. “We have also

‘Voting does have an influence, even when there is more than 90% approval’

North Korean parliaments “If you take a casual look, shareholders always seem to vote with management, and on average approval rates are extremely high, with more than 90% voting in favor for most proposals,” he says. “In my own studies, the average rate of dissent is about 4% on all proposals combined, so the conclusion that shareholder meetings are like a North Korean parliament is certainly understandable.” “But in recent research, we’ve seen that voting does have an influence, even when there is more than 90% approval. The little amount of dissent that is there can be a sign that might prompt management to do something about the issue. Sometimes this leads to CEO or board turnover, abolishing poison pills or other takeover defenses, or even to less value-destroying mergers and fewer but more profitable acquisitions.” The results of Van Oosterhout’s academic research are also borne out by experience on the ground, says Michiel van Esch, an engagement specialist with Robeco’s Governance & Active Ownership team, which uses voting to try to change contentious company policies. "We have seen an increase in shareholders taking their voting rights seriously," he says. "We also see increased appetite from our clients, as more and more of them now ask detailed questions about

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SUSTAINABILITY INVESTING

how we have exercised their voting rights, while asking for our rationale on certain voting decisions and the nature of our policies. Increasingly, clients even have their own policies or principles, and they expect us to fulfil them. Shareholder dissent can lead to changes, but its success depends on the process around it.”

Indirect action “It’s true that there are very few agenda items that actually get voted down, but we often find that some sort of reaction still occurs, and often indirectly," he adds. "We recently had a company where 30% of shareholders voted against a proposal that tried to push formal decision making on capital management to the board only, where they didn’t need to go to an AGM to get their dividend approved. It

‘They consider voting outcomes to be part of a political process’ didn’t seem very controversial. But after the meeting, the company sent letters to its shareholders saying that it looked to them that shareholders had a problem with their capital management, and they wanted to meet to talk about it. All of a sudden, even though the actual voting result didn’t lead to changes, it led to a process where they started talking to their shareholders about the need to change things.” Van Esch says it’s also interesting to see agenda items that are canceled ahead of a vote. “If management gets a

sense that something controversial might not pass, it can cancel it – which is also a result for us at that point.”

Votes of no confidence? Van Oosterhout says sometimes companies view shareholder dissent as ‘votes of no confidence’ that are dealt with politically rather than financially. “Even proposals that may have nothing to do with economics could make managers more responsive, because they consider voting outcomes to be part of a political process; they don’t ignore the vote,” he says. “We’re only beginning to unravel how this works. We can see the outcomes, but not yet the causal mechanisms. The consequences are there; we just have to join the dots.”

Working towards a sustainable palm oil industry Palm oil is faced with a range of sustainability risks, including human rights violations, deforestation and poor labor standards. Engagement specialist Peter van der Werf is in talks with several large companies to help them improve their sustainability, and thus their financial performance.

Palm oil yields more oil per hectare of land than any other crop and is therefore more profitable. It accounts for almost 30% of the edible oil market. In recent years, production and demand have increased tremendously. Indonesia and Malaysia together account for 85% to 90% of global palm oil production.

What’s the issue with palm oil? So what’s the problem? “There are quite some environmental and social issues in this industry. When companies are associated with these, this can damage their reputation and, ultimately, their

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share price. They may even undermine the industry’s growth model,” says Van der Werf. “This makes this issue relevant for investors.” The main risks are deforestation, fire and haze, and human rights violations. “On average an area the size of 300 football fields of rainforest is cleared each hour to make way for palm oil production. This is bad in itself, as it threatens the rich biodiversity in these forests, including the habitat of the orangutan. But on top of this, the removal of forests releases carbon into the atmosphere, speeding up global warming.” Another phenomenon that is

quite common, especially in Indonesia, is fire and haze. Peatland is often cleared by burning vegetation and, once started, fires can burn three to four meters underground, continuing for months or even years. “In 2015, haze was declared an emergency in a number of provinces, causing more than half a million cases of acute respiratory illness,” Van der Werf explains. Finally, when huge areas of forests are cleared, local communities are displaced without consent. “Land grabbing was common in the case of palm oil plantations,” says Van der Werf. “In

SUSTAINABILITY INVESTING

the past the palm oil industry has been linked to major human rights violations, including child labor and poor working conditions.”

'Environmental and social risks may undermine the industry's growth model'

A direct impact on investments When these environmental and social risks are not managed properly, they may result in financial and reputational risk for investors. For example, violation of regulations could lead to the suspension of a plantation’s certification status, resulting in the loss of its certification premium. Similarly, conflicts with local communities and laborers could lead to industrial stoppages and operating losses. Van der Werf selected a range of companies such as traders, processors, food producers and retailers which are involved in various stages of the palm oil value chain. “We believe together these companies can influence various parts of

the chain to deliver more sustainable palm oil,” says Van der Werf.

SMART objectives Van der Werf started the engagement in 2014 and is now midway through it. When does he deem an engagement successful? “We always come up with measurable objectives at the start of the engagement,” Van der Werf explains. “In this case, we have five goals. First, we want companies to respect indigenous peoples’ rights and abide by local and international laws. Second, we want to understand how companies enforce better labor conditions at their suppliers. Third, we encourage companies to make commitments to

control deforestation and peat land conversion. They can also play a key role in asking farmers to adopt better agricultural practices like crop rotation, efficient water use and better fertilizers.” “Our fourth goal is to encourage involvement in joint initiatives to upgrade minimum wages to living wages,” he continues. “Our fifth and final objective is to empower small farmers who are living under or close to the poverty line. Our engagement with the companies focuses on how they can participate in various programs and help improve smallholder capacity.“

Despite good progress, there’s still a long way to go Over the last few years, Van der Werf has seen the largest traders and processors develop sustainable palm oil policies.

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“Traceability is becoming increasingly important,” he says. “Companies that cannot trace their way back to the source of their products may increasingly find that access to market is closed to them or that they have less favorable pricing terms. Buyers like Carrefour are actively encouraging their palm oil suppliers to work with higher standards for sustainable palm oil.” According to Van der Werf, Nestlé now sources 50% of its palm oil from smallholders, and for Wilmar this is 40%. Olam has committed to an ambitious plan to develop 30,000 hectares for smallholder palm oil production in Gabon. By the end of September 2015, ADM had achieved around 92% traceability back to the mill. Golden Agri Resources (GAR) has mapped its supply chain to mill level and aims for full 14

’Companies that cannot trace back to the source may increasingly find the market closed to them‘ 0% traceability by end 2017. Bunge is also working on a system to ensure complete transparency in the palm oil supply chain. “We do value these traceability advancements,” says Van der Werf, “but we will continue to ask for further traceability back to the fields, which is an even more daunting task.”

Ensuring real change on the ground

start of the value chain and most exposed to the risks on the ground, we urge them to ensure that no more land is cleared or peat is drained and that food security is addressed by adopting better agricultural practices. Ensuring land rights are being respected is also important if companies are to retain their license to operate.” Despite the important progress made, there is still a long way to go. “We continue to engage to ensure real change on the ground for smallholders, communities and workers while securing Indonesia’s greatest natural treasure – its rainforests and peatlands,” Van der Werf concludes.

Van der Werf will continue to engage with the largest growers. “As they are at the

UN Sustainable Development Goals: An opportunity for investors The UN has released its Sustainable Development Goals and called on the private sector to become more involved. Asset managers can also benefit from the investment opportunities that arise, say Engagement Specialist Matthias Narr and Active Ownership Specialist Bas Knol.

In the autumn of 2015, the Sustainable Development Goals (SDGs) were released by the United Nations as a successor to the Millennium Developing Goals (MDGs), which expired in 2015. The ‘Agenda for Sustainable Development’ has been adopted by 193 countries, which together agreed to contribute to the realization of 17 SDGs by 2030. The 17 goals reflect a set of universal priorities ranging from the availability of water and sanitation for all, to food security, gender equality and to ensuring access to affordable and sustainable energy. The MDGs, adopted in 2000, achieved good results on improving

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education levels and health, reducing hunger and alleviating poverty. As they approached their expiration date in September 2015, the UN developed new goals for the next 15 years, including more ambitious targets and new social and environmental challenges.

An appeal to the private sector The SDGs substantially differ from the MDGs in that they call on the public AND the private sector to cooperate with the signatory governments to tackle the most serious issues facing both people and planet. UNCTAD has estimated a yearly financial shortfall of USD 2.5 trillion in SDG

investments. This means that governments alone cannot financially achieve these SDGs. The private sector can back many SDGs directly, especially those that are infrastructure related, by investing in power generation, renewable energy, transport, water and sanitation projects. It can also contribute to more abstract concepts such as sustainable economic growth and sustainable production and consumption. Other SDGs such as climate change adaptation, education and the promotion of peaceful societies are more systemic in nature, and thus more

SUSTAINABILITY INVESTING

difficult to operationalize for the private sector. These goals are more likely to be addressed by the public sector. According to a recent PwC study, SDGs 8 (Decent Work and Economic Growth), 13 (Climate Action) and 9 (Innovation and Infrastructure) are the most practicable goals for the private sector to tackle. Those goals represent opportunities for companies to make an economic profit from solving social or environmental problems.

How can asset managers contribute to the SDGs? Robeco contributes to the SDGs by integrating Environmental, Social and Governance (ESG) factors into the investment decision-making process of various investment strategies. In addition, Robeco encourages companies to take action on the SDGs through a constructive dialogue with its investee companies and by voting at over 4,000 shareholder meetings.

’Business models that integrate ESG factors lead to innovation and operational efficiencies’ The SDGs can act as a business opportunity for companies as well. Those that align their business strategies with the SDGs will be more likely to anticipate future regulatory and market-related developments. This helps them avoid the risk of losing their license to operate or the high costs of adjusting to structural changes too late. Prahalad et al.1 and Porter et al.2 conducted empirical studies which demonstrated that business models that integrate ESG factors lead to innovation, process improvements, operational efficiencies and have many other positive spill-over effects, that are likely

to have a positive impact on financial performance. In turn, lagging sustainability performance may translate into supply chain issues, low employee productivity and litigation costs. Thus, the nonintegration of SDGs could also represent a financial risk.

Engagement on the goals Robeco’s Governance & Active Ownership team encourages companies to take action on the SDGs through a constructive dialogue (engagement). As an example, in the engagement theme ‘Environmental Challenges in the European Electric Utilities Sector’, electric utilities are encouraged to implement proactive and ambitious environmental strategies. Irrespective of their historical energy mix, they are stimulated to focus on decarbonization: moving from coal to gas to renewables and using meaningful internal carbon prices in their planning. Not only

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does this produce environmental benefits, it also makes their business strategy more viable in the long term. In this engagement theme, we contribute to the realization of SDG 7 (Renewable Energy). During our engagement activities so far, we have already seen substantial changes in the sector. Two German utilities, for example, have drastically adjusted their business models in order to focus on renewable energy. The ‘Social Issues in the Food & Agri Supply Chain’ engagement theme is an example of how we encourage companies in the food industry to build smallholder

’The financial industry can direct capital towards sectors that contribute to the SDGs’ capacity. We urge them to support the development of the communities in which they operate by providing job skills training and education on agricultural techniques. This contributes to the achievement of SDG 1 (No Poverty) and SDG 2 (No Hunger). Through our ‘Board Quality’ engagement theme we contribute to SDG 5

(Gender Equality). In these engagement programs we ask companies to create wellbalanced boards of directors in terms of gender, age and skills.

The 17 UN Sustainable Development Goals have relevant investment implications. The financial industry, with its ability to direct capital towards sectors that contribute to the SDGs, has a special role to play.

1. Prahalad et al., Serving the World’s Poor Profitability, 2002 & Prahalad et al., Why Sustainability Is Now the Key Driver of Innovation, 2009 2. Porter et al., Creating Shared Value, 2011

Macondo boosts risk management in deepwater drilling After the Macondo oil spill in 2010, Engagement Specialist Sylvia van Waveren started engaging with ten companies in the deepwater drilling industry. The objective was to gain an insight into the risks and investment opportunities, and encourage best practices.

In 2010, the BP-operated Gulf of Mexico deepwater drilling platform Deepwater Horizon caught fire following the Macondo well blowout, killing 11 employees and causing an estimated 4.9 million barrels of oil to spill into the sea. Since this major incident, it has become increasingly important for investors to know whether their investee companies are managing the financial, environmental and social risks linked to deepwater drilling effectively. At Robeco, we have engaged with ten companies active in deepwater drilling, these are PTT EP, Statoil, Total, Tullow, Chevron, Petrobras, ConocoPhillips, Repsol, Anadarko, and CNOOC. Our goal was to be able to identify the companies

Robeco QUARTERLY • #2 / DECEMBER 2016

that were most advanced in deepwater operations management and risk control, as well as the laggards. We visited BP’s Monitoring Center in Houston to witness the way BP manages the well risks, trains its people and prepares response efforts to handle disasters. By taking BP as an industry example, a company that had learned its lessons well, we were better able to ask other deepwater drilling companies the right questions.

Sense of urgency As investors we are happy to see that, after three years of engagement, the companies now disclose a lot of information. For example, many companies publish a list of where the deepwater assets are located, as well as the challenges at each site and how

these are being addressed. Companies also disclose vital information on safety systems. This enables us to better assess the risks per company. We also see a clear trend of cooperation between companies and the development of globally accepted recommendations for emergency response and good operating practices. In general, we are positively surprised by the substantial improvements the sector has made in a relatively short period of time. Apparently the Macondo incident really gave the sector a sense of urgency to focus on these issues.

Twisting and turning with taxes “There is increased segregation between the location where actual business activities and investment take place and the location where profits are reported for tax purposes.” (OECD)

Speed read

Opinion

• Many companies have aggressive tax policies • Investors need to look at tax sensitivity of their portfolios • A global uniform tax rate is still wishful thinking

Booking profits in countries with business-friendly tax regimes appears to have become common practice. Of course, the EUR 14 billion penalty that the European Commission imposed on Apple in back taxes is the most striking example in this case. Maybe it’s not one of the most virtuous companies in the world, but it is certainly not the only one that parks profits and cash in countries with a favorable tax climate. Although their specific case has attracted a lot of attention, this is actually a much more widespread phenomenon. Recent research in the US by the Citizens for Tax Justice (CTJ) shows that 367 of the 500 companies in the Fortune 500 have one or several subsidiaries in tax havens. For instance, Apple booked nearly USD 215 billion dollars of its earnings abroad, resulting in the company paying USD 65.5 billion less tax. Facebook only pays EUR 3.5 million in tax on profits on a turnover of nearly EUR 5 billion. As fund manager of the global equity fund Robeco NV, Mark Glazener closely monitors these developments. Such tax saving strategies can drive up a multinational's bottom line results considerably, but also entail risks which you have to take into account as a fund manager. "In the US, we see that profit margins are being eroded and earnings growth is leveling off. Cash is mainly being used to fund share-buyback programs, something that also inflates the earnings per share. However, the low tax burden of many companies has become a topic of discussion. If ordinary citizens have to pay their tax bills, why can companies get away with such a low tax payments? It could well be the case that tax burdens are currently at their lowest levels." Glazener acknowledges that this is certainly not a new theme. "Coca-Cola was refused permission to establish a production site in Vietnam in 2012

because the company hardly paid any taxes. Later on, Starbucks was the victim of a public boycott because the company was accused of tax avoidance in Europe. The company then announced that it would ‘voluntarily pay some tax’. These are just two examples that show that public (and political) opinion can turn against companies with an aggressive tax policy. And these are the warning signs that you must signal in your fundamental analysis. "As an investor, you look at the direct and indirect risks of each position in your portfolio. A change in a country's tax regime falls in the first category: the direct risks. As do expensive or nonstrategic acquisitions. Certainly recently, tax advantages appear to be the main driver behind billion-dollar takeovers." Glazener cites the reverse takeover of Pfizer by the Irish Allergan as a typical example of a deal that is mainly advantageous because a large share of the company's profits will fall under the Irish tax system. "Profits realized by US companies abroad are taxed again in the US when the cash is repatriated. Many companies consider this undesirable and choose to keep this cash outside the US. The problem is it doesn’t earn anything there. But there is an alternative. You can also do something more profitable with this cash, something that also increases its value by 35%: transfer it to a bank in the US." In following this path, Pfizer is not an isolated case. "The same considerations certainly also played a role in Microsoft's decision to take over Nokia's mobile phone division. The majority of US companies are playing a tax game."

Indirect risks Nevertheless, the 'Apple case' makes it clear that increasing profits by means of such tax strategies can backfire on the companies that do it. A profit-enhancing factor can suddenly turn out to be a risk factor. And then there are the indirect risks too, which consist of reputation risk or the negative impact that the situation can have on a host country, for example in a continent such as Africa. Certainly in times of social or public unrest and when income inequality fuels the dissatisfaction and resentment in many countries, corporate tax policy is something that can quickly be targeted and criticized. Public opinion can turn against a company and, as we have seen in the past, this can have a big impact. "This theme does not have an equal impact on each sector," says Glazener. This

‘It is difficult to assess the impact of changing tax regulations’

Robeco QUARTERLY • #2 / DECEMBER 2016

is also apparent from a Sustainable Corporate Taxation report published by Robeco SAM in 2014. In the utilities, telecom, energy and banking sectors, taxes are paid correctly. "But in sectors such as healthcare, technology and commercial services, the tax burden is a lot lower because it is easier to allow profits to be booked in favorable tax regimes. Patents are transitory, power stations are permanent," Glazener explains. Glazener: "As an investor, you look at the tax sensitivity of the positions in your portfolio; but, it is difficult to assess the impact of changing tax regulations. So you work with scenarios. In Apple's case, although it’s a large sum of money in absolute terms, the impact on profitability is of course ultimately a lot smaller due to the company's huge market cap." The question is how will other European countries with a lower tax burden respond to this? Will they also start billing companies for back taxes? "This is a difficult process due to agreements that companies have made with the local tax authorities," Glazener explains, who does believe that tax regimes could come under pressure in the longer term.

exist for the time being. "It is a small country with a good financial infrastructure. But the pressure is increasing." And about the ethical issue: "The tax conduct of companies is completely logical, from a financial point of view. Tax optimization is positive for shareholders, as long as 'fair taxes' are paid. More aggressive forms of tax burden reduction are not tenable in the long term and are ultimately harmful." Glazener shares this point of view with former British prime minister David Cameron, who also raised this issue during the World Economic Forum in Davos (2013): “Some forms of avoidance have become so aggressive that I think it is right to say these raise ethical issues, and it’s time to call for more responsibility and for governments to act accordingly.”

‘You can always find a small island with a more accommodating tax regime’

Swiss route Relocating to countries with a lower tax burden is not just something US companies do. European multinationals are also opting to follow this path. The 'Swiss route' is particularly popular among multinationals. "A company like Ahold pays its taxes properly in the Netherlands. However, on its US revenue, which accounts for 70% of its profits, it pays taxes via the Swiss route. US oil service companies such as Schlumberger and Halliburton are doing exactly the same thing." The question is whether this Swiss route is tenable and whether this strategy is ethical from an ESG perspective. Glazener believes that the Swiss route will continue to

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PO Boxes

"As a portfolio manager, you look at these issues and try to get a clear picture of this in order to see whether there are any warning signs. We have higher price targets for companies where there is no threat with regard to the payment of taxes. It is part of estimating the financial risks. This means that it is more important than ever to examine a company's tax policy," says Glazener. "Even if it is not yet possible to quantify these risks in analyses. In general, you will have nothing to fear from responsible tax paying companies. Nor will companies with an aggressive tax policy necessarily be subject to an underweight position in our portfolio; but we do take higher risks into account. As long as there is no global harmonized tax regime, this issue will continue to play a role for investors, as the Panama Papers proved this year. A global uniform tax rate would be the solution, but this seems to be wishful thinking. "You will still always be able to find a small island with a more accommodating tax regime," Glazener believes. And you can fit a whole lot of PO boxes on such an island.

Investors beware rising index duration Global bond yields are still at historically low levels, triggering an increased supply of long-dated bonds. As a result, durations of fixed income indices are moving up rapidly. This is a potentially toxic combination according to portfolio managers Kommer van Trigt and Olaf Penninga. If bond yields rise, as they did right after the outcome of the US election, index-focused or passive fixed income investors will incur significant losses. fixed income products is moving higher, while compensation for that risk is falling rapidly.

Speed read

Research

• Benchmark durations have risen significantly over the years • Historically low yields have boosted supply of long-dated bonds • A flexible and benchmark unconstrained approach is required

Not a plea to ‘sell everything’

Over the last 30 years the duration of a widely used global government bond index has almost doubled from 4.3 years to 7.9 years (by end October 2016). This effect gathered pace in the past three years. Robeco research shows that the bulk of this increase in duration, almost 80%, relates to a change in the issuance pattern by debt agencies. Historically low yield levels have triggered a strong rise in the issuance of long-dated bonds, pushing up the average maturity of outstanding debt. Governments, for example, are locking in cheap funding, which reduces their refinancing risks. Spain, Italy and Belgium have issued bonds with maturities as long as 50 years and Japan is said to be considering doing the same, while Ireland has even privately placed a 100-year bond.

This is not a plea to sell all fixed income exposure. In the short run, yield movements tend to be more important for overall returns than the actual yield levels themselves. The first half of 2016 is a good example of this mechanism at work. Although yield levels were already low at the start of the year, returns over the first half were good because bond prices moved up as yields moved to even lower levels.

‘A potentially toxic combination is in the making’ What our analysis really underpins is the need for a flexible and benchmark unconstrained approach. It also highlights how important it is to specifically manage the interest rate sensitivity one wants to have in a bond portfolio. An active stance towards duration management can prevent losses in periods when bond yields rise, while still leaving open the possibility to benefit from falling yields.

The average duration of corporate bonds is also on the rise although the increase is less pronounced than for government bonds. However, due to low yields, Figure 1 | Duration and maturity of the J.P. Morgan GBI Global index European companies in particular have started to issue 10 longer-dated debt, while the ECB’s unprecedented monetary stimulus measures have also pushed 9 down corporate bond yields. Faced with a growing 8 stock of low or negative-yielding corporate debt, credit investors have been forced into longer-dated 7 bonds that still offer the prospect of positive returns. 6 Corporates are very willing to satisfy that demand.

5 4 Jan-86 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16

From a borrower’s perspective, this all makes perfect sense. But what about investors? For investors that tend to follow or even mimic fixed income indices, there’s a potentially toxic combination in the making. Just as yield levels have fallen to unprecedentedly low levels, the durations of most fixed indices are rising fast. In other words, interest rate risk in index-related

Duration

Maturity

Source: Robeco, JP Morgan

Robeco QUARTERLY • #1 / DECEMBER 2016

LAST BUT NOT LEAST

When returns run dry Liquid alternative funds are receiving more attention as investors look for returns outside the mainstream asset classes. The problem is, many aren’t that liquid, and many aren’t that alternative. Separating the wheat from the chaff has literally become a defining moment for two Robeco quant researchers. Alexander de Roode and Thijs Markwat have written a white paper which debunks many of the claims surrounding this favored hedge fund-style strategy. While the subject could be viewed as complex, it essentially boils down to two simple adjectives. Liquid: can you easily get into and out of the assets being used? Alternative: are you really buying things other than standard equities or bonds? If not, you may not be getting value for money.

Robeco QUARTERLY • #2 / DECEMBER 2016

Defining liquid alternatives Alexander de Roode and Thijs Markwat – Robeco Quantitative Research In a landscape of low yields, lower expected returns and fewer diversification opportunities, liquid alternatives are receiving more attention from investors. We define the criteria for true liquid alternatives, and we examine whether they really give exposure to alternative sources of return and diversification. Not all liquid alternative funds live up to their name.

by hedge funds should, according to our definition, aim to deliver a distinct source of return. Since the choice of investment vehicle affects the possible types of alternative strategies that can be implemented, investors need to evaluate whether liquid alternative investment strategies can truly offer portfolio diversification.

Investors’ portfolios can benefit from diversification by adding assets that are uncorrelated with mainstream asset classes. Alternatives are a diverse category of assets that are often regarded as a different source of returns. These investments range from commodities to more illiquid investments such as private equity, but also include trend strategies in the form of Commodity Trading Advisors (CTAs). Given the current market environment, investors are intensifying their search for alternatives that can deliver solid returns and offer true diversification in their portfolios. Interest in the alternative investment universe is therefore increasing, leading to questions about the potential benefits of such allocations. To clarify the definition of the alternative investment universe, we start by distinguishing between alternative strategies and alternative asset classes. In our definition, alternative strategies are characterized by their aim to deliver portfolio diversification through exposure to alternative risk premiums, something which static exposure to asset classes cannot achieve. Investments in alternative asset classes give the investor static exposure to nontraditional assets alone. If an investment strategy substantially loads on traditional risk premiums, then it does not fit the definition of ‘alternative’. Hence, it should not be considered an alternative strategy. Due to the active way they invest, hedge funds are probably the best-known vehicles offering exposure to alternative strategies. However, not all hedge funds have been able to provide portfolio diversification, and most charge substantial fees while remaining secretive about their investment strategies. A new type of investment vehicle has recently emerged that aims to offer exposure to alternative sources of return, and with low cost and high transparency. These funds are called ‘liquid alternatives’ and could broadly be described as hedge funds within a mutual fund framework. Liquid alternatives such as the strategies used

Alternative investment universe The alternative investment universe offers a diverse range of investment opportunities. The term ‘alternatives’ is typically used to denote investments that are different from equities and bonds. Therefore, this class of assets has a broad investment scope, with largely varying return characteristics. To identify groups of alternatives, we split the alternative investment space into alternative asset classes and alternative strategies. The first of these comprises separate asset classes such as private equity, direct real estate and commodities. Funds in this subcategory offer exposure to the risk premiums of non-traditional assets. Not all of these investments can be fully considered to represent exposure to alternative risk premiums. Many of these alternative asset classes have a high correlation with equity markets, making them less effective in terms of portfolio diversification. An example of such an asset class is a commodity index. Over the last decade such indices have failed to offer diversification to investors as they remained correlated to mainstream assets such as equities. The other subcategory of alternatives consists of alternative strategies. Most funds in this subcategory apply very broad investment strategies Investment vehicle characteristics Traditional mutual funds Liquid alternatives Hedge funds Transparency

High

Low

Liquidity

Daily

At best monthly

Lock-up period No

Often around 1 year

Fees

Low

Moderate

High

Leverage

Usually not

Moderate

High

UCITS

Yes

Most

Source: Robeco Investment Research

Robeco QUARTERLY • #2 / DECEMBER 2016

such as global macro, equity market neutral and managed futures. These strategies may also entail investments in alternative asset classes. To continue the commodity example, an investment strategy that takes active timing positions in individual commodities will fall under the subcategory of alternative strategies. Conversely, alternative strategies can also consist of investment strategies that are only applied to the traditional asset classes of equities and bonds. In that case their alternative character comes from the strategy alone and not from the underlying investments. An example of this is a trend strategy applied to equity and bond markets. We believe that in order to be considered ‘alternative’, a strategy should capture another source of return than that offered by investments in traditional asset classes. As only then are alternative strategies beneficial for an investor’s portfolio.

strategies have been introduced in the form of mutual funds and Exchange Traded Funds (ETFs).2 These vehicles also allow a larger group of investors to access alternative risk premiums. By providing daily liquidity through investing in highly liquid securities, these funds can offer a reduced lock-up period. Most also meet investor requirements for a higher level of transparency. This allows investors to improve their portfolio construction, as they have access to more information about the fund’s strategies. Some ETFs offer exposure to a single alternative risk premium, allowing the investor to select his own portfolio exposure.

‘True liquid alternatives deliver diversification by exposure to alternative risk premiums’

Investment vehicles in alternative strategies Exposure to the alternative investment universe is obtained through an investment vehicle. The choice of vehicle can influence the underlying exposure. The hedge fund industry is lightly regulated and is the traditional method of gaining exposure to all sorts of alternatives strategies. While some funds have delivered diversification, even in the financial crisis, others have shown a large correlation with traditional risk premiums.1 Hence, they often fail to offer a true source of differentiated returns. Since almost all hedge funds are quite opaque about their investment strategies to protect their competitive edge, investors cannot easily analyze the exposures of the hedge fund strategies in their portfolio. Combined with the longer lock-up periods – the amount of time they have to hold these investments – this makes it more difficult to be able to allocate to these alternatives.

Many of these funds are also UCITS compliant, offering reliability and transparency to investors. Liquid alternatives do not necessarily need to be UCITS compliant in order to be transparent and provide liquidity. Some alternative strategies that meet these requirements may not be fully compliant with UCITS regulations. One example is alternative strategies that are applied to individual commodities. While such strategies involve highly liquid instruments, UCITS funds do not offer opportunities to invest in individual commodities. To implement such alternative strategies, mandates may be offered to institutional investors. These mandates may offer additional exposure to assets outside the UCITS formats, yet still remain liquid and transparent. However, this does not imply that every hedge fund strategy could be turned into a liquid alternative variant. Some are more suited to mutual fund frameworks than others. Managed futures funds for instance are probably the most suitable, as they involve frequent trading on futures markets. Other hedge fund strategies, such as merger arbitrage and distressed debt, are much less suitable for a mutual fund format, as they can require long holding periods. Hedge fund strategies that trade in illiquid OTC derivatives are by definition not appropriate for a liquid alternative framework.

To overcome the hurdles of liquidity and opacity, alternative An important component in hedge fund strategies is leverage. This can help to amplify spread differences between assets allowing them to be effectively incorporated in a portfolio. Without leverage, these differences may be too small to profit from. However, by applying leverage, the return characteristics can become a more important factor in the portfolio and balance out other risk exposures. The use of instruments such as leverage, short selling and the use of derivatives is one of the differences between hedge funds and liquid alternatives.

Three criteria for liquid alternatives

Liquid alternatives

Alternative risk premiums

Transparency

Source: Robeco Investment Research

Robeco QUARTERLY • #2 / DECEMBER 2016

Liquidity

Even for hedge fund strategies that do fit into a mutual fund framework, adjustments usually need to be made. Some might

examples of illiquid investments are direct real estate, infrastructure and private equity. These investments give investors access to the so-called ‘illiquidity premium’.4 Whether investments in such asset classes are appropriate depends on an investor’s willingness and ability to accept a longer investment horizon and a lock-up period. Investors able to invest under such constraints can gain exposure to the illiquidity premium. However, as these strategies can only be implemented by relatively few investors due to their strong constraints, we do not consider them to fall into the category of ‘liquid alternatives’.

be suitable from a technical point of view in a more liquid format, but regulatory differences between hedge and mutual funds could be a practical impediment. These could, for instance, relate to the amount of exposure or leverage that can legally be used in an investment strategy.

Criteria for true liquid alternatives We identify three important criteria for the evaluation of liquid alternatives in a portfolio. In short, the strategies underlying liquid alternatives should give exposure to alternative risk premiums, and be liquid and transparent. The risk premium of an asset class is the expected compensation for the risk of investing in it. Traditional risk premiums for asset classes are the equity risk premium and the bond term premium. By applying a buy-and-hold strategy in the equity or bond market, investors can access the corresponding risk premiums. We can further categorize the asset class risk premiums in different markets. For example, the equity risk premium in the US is different to that in Japan, as US equity markets have behaved differently from those in Japan markets over the years. Since the returns of different markets are becoming more correlated over time, there is now less difference in the risk premiums between markets within an individual asset class. This tendency means there are less opportunities to diversify equity risk or bond risk.3

Identifying alternative investment styles Alternative risk premiums complement those of the two main asset classes: bonds and equities. Many alternative funds implicitly load on these two premiums, while promoting themselves as offering alternative sources of return. A more diversified portfolio can be accomplished by having exposure to different return drivers. A portfolio that already has a large exposure to the two main risk premiums will not be much improved by adding further exposure.

‘The impact of liquid alternatives styles on the investor’s portfolio can be quite different’

One important component of obtaining liquid alternatives for investors is to enable access to risk premiums other than traditional ones. Exposure to these alternative risk premiums can only be obtained through more complex strategies. Strategies to capture alternative risk premiums can be categorized as either timing and cross-sectional strategies. In timing strategies, the aim is to take long positions in upward markets and short positions in downward markets. In cross-sectional (long/short) strategies, on the other hand, spreads between asset classes can be exploited while having limited market exposure. Using these strategies can deliver substantially different return characteristics to those of the market, adding diversification to an investor’s portfolio. The second characteristic is transparency. We believe this is an important feature in evaluating whether funds can be defined as liquid alternatives. Transparency allows investors to analyze whether the investment strategies’ exposure is suitable for their portfolio. It also helps them determine the optimal level of exposure in their portfolio. A third component of liquid alternatives is the liquidity itself. Alternative strategies can provide access to illiquid assets. Common

To evaluate which categories can add value in a portfolio context, we calculate the correlation of the various alternative investment styles. We find that most have a high correlation, indicating that the diversification benefits of including such strategies are weak over longer periods. Consequently, these investment styles do not fall within our definition of an alternative strategy. Also, in a liquid format these funds would not contribute to improvements in the investor’s portfolio. We also find two categories that potentially could deliver diversification to a balanced portfolio. Global macro and managed futures returns have had a low correlation to equities over a longer time period, delivering a different source of returns to equity

Investment vehicle characteristics Style

Description

Arbitrage/Relative value

Contrarian strategies

Global macro

Strategies based on macroeconomic environment

Managed futures

Strategies based on market trends

Non-traditional bond

Total return strategies in fixed income markets

Market neutral

Investments using a market neutral exposure

Multi-strategy

Multiple investment strategies (fund-of-funds strategies)

Volatility

Based on changes in the market volatility

Source: Robeco Investment Research

Robeco QUARTERLY • #2 / DECEMBER 2016

markets. Two other strategies have also had a similar correlation to global macro, namely equity market neutral and event-driven risk arbitrage, but both display a higher correlation with bonds over a similar horizon. Therefore, with their different return characteristics to those of the typical constituents making up investor portfolios, global macro and managed futures offer potential liquid portfolio diversification. Another observation is that the diversification potential of alternative strategies has declined since the financial crisis of 2008. Various categories had a much lower correlation before the crisis than they have had since. Alternative strategies with a higher correlation before the crisis have continued to have high correlations after it. This increased correlation is particularly evident in the bond correlations for these strategies. Consequently, their potential diversification impact on a portfolio is lower.

of quantitative strategies, investment strategy simulations can help investors to evaluate the effects of the strategy on their portfolio. The combined effect of the uniqueness of certain strategies and the large dispersion in returns makes manager selection a key part of the process of selecting liquid alternatives.

Liquid alternatives: the verdict Liquid alternatives can be attractive for investors, and it is worth investigating their potential benefits for portfolios. Liquid alternatives can give investors exposure to alternative investment strategies in an efficient way. These strategies have become more transparent and liquid than traditional alternatives. We believe they can benefit investors’ portfolios as they enable them to access additional sources of risk premiums. Therefore, portfolios may be more stable and less influenced by market regimes.

‘Liquid alternatives can create more balanced investment portfolios’

Selecting liquid alternatives Funds within the liquid alternative universe pursue a large variety of strategies. So their impact on investors’ portfolios may vary considerably. In selecting a liquid alternative, the effect on the portfolio is the key evaluation criterion. Identifying whether an alternative investment strategy behaves differently from traditional market exposure is the first step. Next, the investor should verify whether this particular style of liquid alternative adds value to the portfolio and can improve diversification. Since liquid alternatives aim to deliver diversification to the portfolio, the investor needs to evaluate the effect of liquid alternatives on the portfolio and not on a standalone basis. The first method an investor can use to verify whether a style adds value to a portfolio is to look at liquid alternative indices. These benchmarks can help determine how much exposure to liquid alternatives is needed to ensure optimal allocation, although the return characteristics can be quite significant, even within the subcategories of investment strategies. Therefore, the investor should not expect a benchmark to be able to fully represent holdings in liquid alternatives. Individual returns of funds may substantially differ from benchmarks. While some indices might be investable, it is often impossible to use this method to allocate to a large group of liquid alternatives. Another hurdle for investing in liquid alternatives is the large dispersion of returns in this universe. Indices of liquid alternatives are constructed by averaging the return characteristics of a subcategory of funds. As a result, the index may have lower volatility, resulting in different return characteristics to those of the individual funds. Therefore, to successfully allocate to liquid alternatives, the actual investment strategy of the fund needs to be analyzed in the light of the investor’s portfolio. Using live fund track records, or in the case

Robeco QUARTERLY • #2 / DECEMBER 2016

An important dimension in allocating to liquid alternatives is the manager selection process. Since the liquid alternative space is quite a broad investment universe, offering a range of different exposures, investors need to carefully analyze the impact of individual fund strategies on their portfolios. To summarize, liquid alternatives provide a relatively new opportunity for investors to engage in hedge fund-like investments. This exposure can help to create more balanced portfolios. The actual selection of alternative strategies will depend on investors’ characteristics and preferences. We conclude that liquid alternatives can be beneficial for investors’ portfolios.

1. For more details on our analysis on hedge funds, we refer to our white paper ‘The added value of hedge funds in a pension portfolio.’ 2. Some ETFs replicate exposure to certain hedge fund styles, others offer long-short exposures in equity markets. In the rest of the paper we refer only to mutual funds. 3. William N. Goetzmann & Lingfeng Li & K. Geert Rouwenhorst, 2005. ‘Long-Term Global Market Correlations’, Journal of Business, University of Chicago Press, vol. 78(1), pages 1-38. 4. For more information about the illiquidity premium, we refer to our white paper on ‘The ins and outs of investing in illiquid assets’.

Pim van Vliet

‘Culture is a crucial factor in quant investing’ Quant investing is becoming more widely accepted. But such developments are always accompanied by growing pains. We talked to Pim van Vliet, head of Conservative Equities, about the opportunities and pitfalls and why culture and philosophy are so important.

Has quant investing finally reached maturity? “I think we can safely say that quant investing is now on the brink of adulthood. In addition to active funds, consultants are also starting to rate quant products. But there is still a lot of naivety about. The current enthusiasm for quantitative factor investing could evaporate overnight if something goes wrong. These are signs that the market is not yet fully mature. There are, for example, quant products still being sold on the basis of the flimsiest backtests, while investors forget that there is a big difference between ‘paper performance’ and real ‘dollar performance’.” “If the people who offer quant products and those who buy them are not sufficiently critical, problems can arise. Every asset management company that wants to grow is now betting on quant. But there is more to it than just recruiting a couple of rocket scientists and putting a backtest in the market. A real-life track record and a solid reputation will become increasingly important in the years to come as the demand for quant products increases and the market grows.” So is there more to it than robust and proven models? How important is it to have the right people and philosophy? “It’s crucial. In the future, people will focus more and more on the culture and philosophy that characterize the asset manager. The philosophy behind the strategies – pursued by the people behind the models – is what makes the difference. Of course every quant-driven product has an appealing backtest, but without the right culture, paper profits remain just that. Our quantitative investment philosophy is supported by three pillars: a strategy is evidence-based, prudent and based on economic principles. The

first is pretty obvious, and even though our database goes back 90 years, which is further than most, it’s the second and third pillars that set us apart from the rest.” “The biggest risk for quants is data mining – overfitting models as a result of limited data. In our experience the most ‘fitted’ and complex models often have the worst performance in practice. Implementation and execution are hugely important. Every asset manager or index provider can knock up a factor product. But those parties that lead the field in quant, have more experienced people who have already been through different cycles, including challenging years like 1999, 2007 and 2009.” “Now the market is growing quickly there’s a lot of chaff amongst the wheat. It is more important for clients to be able to assess the differences between various parties. This is why it is a good thing that independent consultants now also look at quant seriously. Investors must maintain a healthy dose of skepticism and not let themselves be dazzled by a good story. In order to evaluate a product (and its seller) on its merits, you need to look at their performance over a complete cycle. Now there are only a few quant funds that have a ten-year track record. And almost all the smart beta indices are even more recent and therefore not fully proven.” Is Quant investing at Robeco less ‘quant’ than we might be inclined to think it is? “Quant is not a machine that you plug data into and where returns come rolling out if you turn the handle. It is a ‘people thing’. You won’t achieve success by simply attractively packaging an algorithm and selling that. Robeco's quantitative factor investing is closer to fundamental investing than people tend to

Robeco QUARTERLY • #2 / DECEMBER 2016

‘Quant is not a machine you plug data into and where returns come rolling out’

think. Yes, we are highly systematic in our work, but at the same time we also try to incorporate the strengths of fundamental investing: know your portfolio, keep it simple, put yourself in the client's shoes, don't trade too much.”

“There is an increasing awareness that, as is also the case with fundamental funds, there is a great deal of diversity in quant. There are CTAs and high-frequency quant funds, but also defensive products with low turnover. The Conservative Equities range is our quant label, but the philosophy and turnover of these funds are more similar to, for example, other Robeco equity funds, than the products offered by other quant investors.” What role can quant fulfill in a portfolio? “Conservative Equities is all about stable returns and a high dividend. That is clear enough for many investors; we don't need to get into the mechanics of it. They can include this strategy as an alternative to a high-dividend fund. One important distinction between us and other income products is the proven reduction in the level of risk. This strategy also enables you to achieve a more stable coverage ratio, and is also an appropriate addition to a life-cycle mix. In traditional life-cycle funds you start off with a high weight in equities that is gradually reduced over time in favor of bonds. Conservative Equities enables you to maintain a position in equities for longer.”

Robeco QUARTERLY • #2 / DECEMBER 2016

Column

Brexit becomes more complicated by the day From time to time the German Federal Constitutional Court (FCC) gives rulings on issues related to the never-ending euro crisis. One example is its ruling on the legality of the ECB’s Outright Monetary Transaction program. It firstly tried to tempt the European Court of Justice (ECJ) into putting severe limits on its use, while suggesting that the ECJ was a lower court with merely an advisory role. But the ECJ resisted, declaring that monetary policy is something to be left to the experts, and refusing to limit the scope within which they can act. The FCC had to swallow its pride, and important constitutional matters (such as what is the highest court, for instance) were left open. Fun and games among the professionals! It was not the first time. The FCC had previously refused to throw Europe into a major crisis by skillfully navigating some choppy water, and as a result, investors have learned not to take constitutional risks too seriously. It is quite understandable that non-elected judges do their utmost to avoid being drawn into the political arena. It therefore came a bit as a surprise when the High Court in the UK issued a crystal clear ruling stating that it is not up to the government to invoke Article 50 of the Lisbon Treaty (the legal path to leaving the

EU) but that parliament must first give its approval. If the government appeals and the Supreme Court sustains the ruling of the High Court in December, this will throw Prime Minister Theresa May’s plans to invoke Article 50 by March next year into disarray. There is unlikely to be a majority vote against Brexit in the current UK parliament as its members will not want to give the impression that they are going against the will of the people (even given the narrow Brexit majority of 51.9%). However, it is highly likely parliament will demand assurances from the government to avoid a ‘hard’ Brexit – something which would allow continued access to the internal market rather than making immigration control the priority. The latter was, however, something that May stated to be her priority at the last Conservative Party Conference. This process may well delay the invocation of Article 50. An alternative for the government is snap elections, for example, immediately after they lose the aforementioned appeal to the Supreme Court. This must be a tempting thought, given the current disarray within the Labour Party and the uninspiring leadership of the Liberal Democrats. Moreover, it would give May a mandate. But an election is not without risk and it could be argued that in essence it would constitute a second referendum on Brexit, something the Prime Minister has already ruled out. The British pound reacted enthusiastically to the apparent falling odds of a speedy ‘hard’ Brexit. Could Brexit even still be derailed altogether at this stage? It still doesn’t seem likely, but it can’t be ruled out either. Before the June 2016 referendum some cynics remarked: if the Brexit camp wins (a big ‘if’ at the time), for the first five years, the UK will try to get out and for the next five they’ll try to get back in again. With the benefit of hindsight, it seems there is some truth in the first part of this statement. But extended uncertainty will, of course, take its toll economically. And these costs could weaken the case for Brexit after all. Fascinating!

Léon Cornelissen, Chief Economist

Robeco QUARTERLY • #2 / DECEMBER 2016

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Robeco QUARTERLY • #2 / DECEMBER 2016

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