Robeco
QUARTERLY Intended for professional investors only
ENHANCED INDEXING Staying ahead of the pack
QUANT investing SUSTAINABILITY investing #10 / December 2018
‘An advantage of rules-based investing is that you don’t act on noise, you keep calm in volatile periods and don’t fall for one of the many behavioral pitfalls’ Jan Sytze Mosselaar, portfolio manager Conservative Equities
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Robeco QUARTERLY • #10 / DECEMBER 2018
And MORE
QUANT investing
CONTENTS
OUTLOOK Our 2019 outlook: Turbulence ahead
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OPINION The name’s Bond… Corporate Bond
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RESEARCH Stranded assets? Oil cannot be written off just yet Positioning for a shift towards value stocks
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GREAT MINDS – BERTRAND BADRÉ ‘We’re on the cusp of a very positive transformation’
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LONG READ eSports – the next generation of gaming monetization
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INTERVIEW Wilma de Groot – ‘We have a much better proposition than passive’
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COLUMN Merkeldämmerung
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10 | Thought smart beta indices had unlimited capacity?
11 | The strategic case for EM factor investing 13 | Multi-Factor Bonds: an alternative to passive 15 | Crash testing the FamaFrench factor model in EM
SUSTAINABILITY investing
Bertrand Badré – page 28
22 | Three trends behind thematic environmental investing 23 | Sustainability and the role of finance
25 | Investing in the UN Sustainable Development Goals 27 | Climate change growth could be worth USD 26 trillion
Robeco QUARTERLY • #10 / DECEMBER 2018
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There’s an ever-increasing need for educational materials which can help advisors to understand themes. To meet this need Robeco recently launched the Robeco Essentials of sustainability investing. The need for education is growing, and by launching this online platform, Robeco shares its knowledge and expertise on key topics, to enable financial professionals to further improve their skills and help their clients achieve their investment goals. The platform will eventually consists of several educational modules, focused on specific key themes for investment professionals. The first module that is available is centered on one of Robeco’s key strengths, sustainability Investing, and aims to help professional investors such as private bankers to understand and explain sustainability to their end-clients. This module comprises nine building blocks that can be accessed for selfstudy purposes. Each module includes educational content presented in the form of animated videos, charts, case studies and a summary. After completing a module, a test is available. For investment professionals it is also possible to accrue hours towards Continuous Professional Development (CPD) accreditation. The online educational modules are available in local languages in Spain, Italy, France, the UK, Germany, Switzerland, Belgium and the Netherlands. Masja Zandbergen, Head of ESG integration at Robeco: “Sustainability Investing is here to stay and will continue to grow. We do, however, see that there’s still a lot of room for improvement when it comes to the level of knowledge on this
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topic. In order to provide well-informed advice, or make the right decisions, sufficient knowledge is instrumental, particularly when it comes to sustainability investing. It’s in our DNA, and we see it as our duty to share our passion and
expertise with those who have yet to fully embrace it.” In early 2019, a second module, on the Essentials of factor investing, will be launched.
One Belt One Road – it’s not a China-only thing Infographic
Sustainability
The essentials of sustainability investing
The Belt and Road Initiative is a Chinese development strategy, geographically structured along five land corridors, and the maritime silk road.
One Belt One Road – it’s not a China-only thing The Belt and Road Initiative is a Chinese development strategy, geographically structured along five land corridors, and the maritime silk road.
Already invested in projects
USD 900 billion
For comparison:
USD 4-8 trillion
USD 120 billion
Estimated total investment
Marshall plan (calculated to today’s value)
Silk road economic belt Maritime silk road initiative
86 countries and international organizations joined the initiative ©Robeco, Sources: Fitch, Deloitte, CBBC
Source: Robeco, TechStartups.com
Robeco QUARTERLY • #10 / DECEMBER 2018
Wealth and well-being
Will 2019 mark the long-awaited revival of so-called value stocks? Value stocks have lost a staggering 35% against growth stocks in bull markets since 2009. Due to this long period of lagging returns, the relative performance of value versus growth stocks now seems completely out of balance. First, a similar performance in around 2000 heralded a rotation out of growth stocks into value stocks. This rotation also took place in a macroeconomic environment that, knowing what we know now, we can typify
You need to have a good reason to create a new mission statement. And we do.
Editorial
Equities
Value for money
“To enable our clients to achieve their financial and sustainability goals by providing superior investment returns and solutions.” This is the new mission statement that Robeco and RobecoSAM have shared since October. The new part is “and sustainability”. We have joined forces with RobecoSAM to help our clients achieve their goals – in terms of both wealth and well-being. These two objectives are inextricably linked in this day and age. For some clients, the emphasis is of course still on the financial aspect – we are still investors first and foremost – but there is a growing realization that sustainability has an important role to play in that process. A new mission statement for an asset manager that celebrates its 90th anniversary in 2019 doesn’t just come out of nowhere. Sustainability is the next big thing in our industry. Almost every asset manager is flying the sustainability flag these days. The question, however, is how they put this into practice and to what extent sustainability really is in their DNA – or whether it is just a thin veneer of marketing speak.
as ‘late cycle’ – a phase we also seem to have reached now. Second, the price-earnings ratio of the MSCI Value Index is currently 21% below that of the MSCI World Index, which represents an above-average discount level. While value stocks should be cheap now, based on other valuation criteria such as dividend, price-cash flow ratio and book value, they look even more attractive compared to their historical average discount. With both valuation and the phase of the economic cycle in mind, a return of value stocks seems very likely.
Robeco QUARTERLY • #10 / DECEMBER 2018
Sustainability is nothing new for our Swiss-based sister company RobecoSAM, as they have been fully focused on it since their incorporation in 1995. Robeco launched its first sustainable fund in 1999 and fully embraced sustainability in 2010. Things have picked up speed since then. We were the first asset manager with a coherent policy on ESG integration and in recent years we have developed from being a pioneer to a leading asset manager in sustainability. Befitting that status is a look under the hood of our sustainability strategy, which we did this summer in ‘The Big Book of SI’. The addition of sustainability to the mission statement is therefore no more than confirmation of the developments over the past ten years. The asset managers that will make a difference on this front – a front that will only gain in importance in the future – are those for whom sustainability is more than just a marketing pitch. Asset managers have to show that what they do really has an impact: that they walk the talk.
Peter Ferket, Head of Investments
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US consumer confidence recently hit an 18year high. This sharp increase hasn’t really come as a surprise. A number of factors are contributing to the phenomenon. One of the most important is the labor market, where unemployment has fallen to 3.7% – the lowest level since 1969. In the last couple of months job creation has also been accompanied by faster wage growth. Wages grew by more than 3% in September for the first time in over ten years. At least as important is the fact that, with inflation at 2.3%, real wages are now increasing as well.
Lessons from our 2018 ‘Super Quant’ internship Research
Column
Confident consumer
In its effort to keep offering topnotch investment strategies, each year Robeco’s quantitative research department runs several research projects with our ‘Super Quant’ interns, under the supervision of our experienced researchers. For Robeco, these internships represent a unique opportunity to hire students from some of the best universities in finance and econometrics, and to either drill deeper into our existing intellectual property or explore new areas of research. For example, one of our projects investigated whether variables derived from the text in annual and quarterly reports to the SEC may provide useful information for equity and credit investors. In total, we analyzed 353,173 filings, which amounted to 20 million pages and five billion words. We looked at several variables, such as text length, readability and sentiment.
The processing time was close to eight hours. Our study showed that text analysis can be used to automate and speed up the reading process, and that text variables are informative for a firm’s future equity and credit performance, mostly concerning volatility. Another project analyzed the use of macroeconomic data to predict equity, bond and currency returns. In particular, it looked at so-called ‘surprise’ indices produced by brokers. For many macroeconomic statistics, economists are polled ahead of publication. The ‘surprise’ is the difference between the predicted and the actual outcome. One feature of these indices is that they are not flat, but rise and fall over time. This implies that surveys go through overly pessimistic and overly optimistic periods, which in turn, can be used to predict equity and bond returns.
But are there no risks? Of course there are. A rapid rise in interest rates could put a damper on the pace of consumer spending, especially if the housing market were to collapse. But the foundations of the US housing market are still strong. No, the risk lies elsewhere. Companies have accumulated much more debt than consumers and an escalation of the trade war between China and the US could really dampen sentiment.
Jeroen Blokland Senior Portfolio Manager
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Sustainability
RobecoSAM’s Country Sustainability Ranking The Country Sustainability Ranking Update from November 2018 shows Sweden as sole leader, followed by its neighbor Denmark and then
Switzerland, which was again the only country that managed to crack the Scandinavian phalanx at the top by ranking third.
Dimension & Total Sustainability Scores Sweden Denmark Switzerland Finland Norway Canada Netherlands New Zealand Ireland Australia
0.0
1.0
Environmental
2.0
3.0
Social
Governance
4.0
5.0
6.0
7.0
8.0
Robeco QUARTERLY • #10 / DECEMBER 2018
Our 2019 outlook: Turbulence ahead Markets are likely to have two faces next year, as the bright economic picture clashes with political headwinds and rising rates. That’s the principal takeaway in the outlook for 2019 by Robeco Investment Solutions (RIS), predicting a mixed bag of outcomes for the main asset classes of equities, government bonds and credits.
Speed read
Outlook
• Markets expected to show two faces in 2019 • Riskier assets may have a head start • For bond investors it will remain hard to find decent returns
“We expect to see sustained, above-trend growth in developed economies and somewhat stronger growth in emerging countries in 2019,” the team says in its outlook entitled ‘Turbulence ahead’. This sounds like good news for the financial markets. As growth remains strong, we could see above-average growth in earnings and so far there is no indication of extensive monetary tightening occurring.” “However, next year we expect the markets to have two faces. The bright economic picture is expected to be overshadowed by concerns that this long bull market will soon end; think rising interest rates, protectionism, Italy and Brexit. Investors would be
Robeco QUARTERLY • #10 / DECEMBER 2018
well-advised to prepare for these concerns becoming reality.”
US economy risks overheating The team predicts that the US economy will continue its steady growth path in 2019, though the chance of overheating has risen. “For the time being, the risk of a recession remains low; it's the risks to growth that are high,” RIS says. “Trade tensions between the US and China are likely to persist, though without any significant escalation.” For the 28-nation European Union – which will become 27 when the UK leaves in March 2019 – growth is seen mirroring that of 2018, and, as such, remaining above trend. “The only negative risk factor will be a thing of the past after 29 March 2019, when the UK is scheduled to leave the EU, but we expect to see a transition deal that will ensure little actually changes for the time being,” the outlook predicts. “The budget plan of Italy's new populist government is a second risk factor that is still looming over the market, as it violates prior
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Outlook
budget agreements with the EU. Nevertheless, we believe that Italy will eventually back down – just because it's in their best interests.” “Meanwhile, the European Central Bank (ECB) is likely to implement an initial, modest interest rate hike just before its President Mario Draghi steps down, allowing his successor to take office in 2020 with a deposit rate of 0.0%. In the meantime, inflation is showing a gradual rising trend, moving nicely towards ECB targets.”
Japan and China march on In Japan, growth is also expected to match what was seen in 2018, with the economy steered by the ’capable hands’ of Prime Minister Shinzo Abe and Bank of Japan Governor Haruhiko Kuroda. Chinese policy will be aimed at maintaining a relatively high growth rate of above 6.0%, although the country will probably have no other choice than to accept a lower figure in 2019, the team believes.
benefits from a more defensive equity portfolio, that doesn't mean we are overly positive about US equities. After nearly a decade of above-average returns, US equities are overvalued, not least compared to equities in other regions. We expect the tables to turn, generating new opportunities in 2019.” “The widening growth differential between emerging and developed markets is a reassuring sign for emerging markets. The fact that emerging market equities fell considerably this year will definitely help, too. For European equities, which have also come down a lot, subsiding concerns over Brexit and the Italian budget in particular could support an upturn.”
Poor returns seen for bonds For bonds, it will remain hard to find decent returns in 2019, the team predicts. “We are now in a later stage of the economic cycle: historically, this hasn't been the best time to invest in corporate and high yield bonds,” RIS warns.
‘We would not be surprised if the financial markets had two faces in 2019’
“Thanks to sustained growth in China and in developed markets, 2019 looks fairly good for emerging markets,” RIS says. “We expect the growth differential between emerging and developed markets to widen, opening the door for investors with a somewhat bigger risk appetite to generate higher returns.”
Two faces for markets For markets, this all means a mixed bag. “We would not be surprised if the financial markets had two faces in 2019,” the team says. “Initially, riskier asset classes, primarily equities, could do well. Growth remains strong, the growth in earnings is above average and there is no indication of extensive monetary tightening anywhere in the world.” “The trade war between the US and China is still an important factor, but the markets seem to have priced in the prospect of a protracted conflict without any significant escalation. Assuming that the US economy does overheat, equity prices will probably move even higher before things really start to heat up. However, as the year progresses, it will make sense to prepare, to some degree, for harder times.”
Look for defensive equities Under these circumstances, RIS believes that it is a good idea to focus more on equities with a more defensive profile. “In addition to low-risk equities, we think equities with a low valuation, high quality and/or high dividend fall into this category,” the team says. “But despite our expectation that investors will reap long-term
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“Interest rates are rising, while spreads have narrowed significantly. Central banks’ vast bond-buying programs have pushed both yields and spreads to artificially low levels. And there's not much of a buffer for even the slightest bit of normalization.”
“For high yield bonds, this is compounded by the fact that when the perceived risk of recession increases, it is accompanied by an expected rise in the number of defaults. That's why the outlook for this asset class is not particularly rosy.”
More positive on EM and Treasuries “We don't expect a lot from European government bonds in the coming year, either. The ECB won’t start gradually raising shortterm rates to 0% until next autumn, so there is limited room for a rise in long-dated bond yields.” “We're more positive about emerging market government bonds. Due to the huge depreciation of emerging currencies, this class is undervalued, while the yields are much higher than in developed markets.” “US Treasuries will be the bright spot in this class − maybe not right away, as the Fed will continue hiking and the risk of overheating won't immediately be reflected in the yields. But with 10-year yields above 3%, and likely to rise further, US Treasuries are an interesting class to consider in preparation for harder times ahead for risky investments at a later stage in 2019.”
Robeco QUARTERLY • #10 / DECEMBER 2018
QUANTinvesting
The capacity factor Could popular smart beta strategies already be facing capacity issues? Even though some product providers may be tempted to downplay this threat, we argue investors should indeed take it very seriously. Because smart beta indices concentrate their trades on just a handful of rebalancing dates each year, their capacity is, in fact, quite limited. However, because the implementation shortfall that goes along with tracking smart beta indices tends to translate into a lower return of these indices due to index arbitrage, and not into an underperformance of passive managers or ETFs, investors may simply not realize it. Here’s a wake-up call.
Robeco QUARTERLY • #10 / DECEMBER 2018
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Thought smart beta indices had unlimited capacity? Think again! Following smart beta indices is a popular way to implement factor investing. But as money pours into these strategies, capacity issues cast doubt on their ability to keep their promises, warn David Blitz and Thom Marchesini, from our quantitative research team.
When implementing a strategy, investors and asset managers will inevitably be faced with a number of practical hurdles. These hurdles include elements such as direct and indirect transaction costs, constraints regarding the number of trades that can be executed within a certain period for a given security, or simply the management of investment in- and outflows. As assets under management (AuM) grow, these hurdles only tend to get bigger and can end up having a considerable impact on performance. This is what determines the capacity of an investment strategy or an investment style: the point where additional inflows start weighing on the overall performance of a strategy or style. The growing popularity of smart beta
products has led many experts to wonder whether capacity issues might arise sooner or later. A recent study1 by one of the largest providers of smart beta products attempted to answer this question. It concluded that smart beta indices have a huge, almost unlimited, capacity. At Robeco, however, we challenge this assertion.
Unfeasible smart beta trades Indeed, because smart beta indices concentrate all their trades on just a handful of rebalancing dates each year, we argue these simply become unfeasible at the AuM levels suggested in the study. Most trades would be ten to 100 times the typical daily volume of the stocks in question. Investors placing buy or sell orders of this size would probably trigger circuit breakers put in place by stock exchanges.
Table 1 | Simulated performances for minimum volatility strategies Return
Volatility
Turnover
MSCI (actual)
14.66%
9.87%
19.98%
Simulated (gradual)
14.78%
9.91%
20.01%
MSCI (actual)
11.34%
9.77%
20.97%
Simulated (gradual)
11.47%
9.80%
20.97%
MSCI (actual)
12.49%
7.85%
19.84%
Simulated (gradual)
12.74%
7.89%
19.83%
MSCI (actual)
6.45%
10.79%
19.80%
Simulated (gradual)
7.54%
10.97%
19.84%
USA
EAFE
Global
Emerging markets
Source: Robeco
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In the case of the well-known MSCI USA Minimum Volatility Index, for example, our calculations show that at a mere USD 10 billion AuM, trades already start to be made at levels exceeding 100% of the average daily transaction volume (ADV). At around 100 billion AuM, about half of the trades are over 100% ADV and we already see a few above 1,000% ADV. At this level, we also start to get positions that are bigger than 10% of the total market capitalization of certain companies. As a result, we estimate the capacity of smart beta strategies that replicate this particular index to be somewhere in the USD 10 to 100 billion range. This is 10 to 100 times lower than the USD 1 trillion order of magnitude suggested in the study mentioned above. And since the US stock market is the largest and most liquid equity market in the world, this estimate looks like a best-case scenario. In other words, for other markets the capacity of smart beta indices is most likely even lower. Meanwhile, the study does not consider trade feasibility and only looks at the estimated transaction costs of trades. Using a proprietary model, the authors give examples suggesting that the transaction cost estimates for common trade sizes are similar to those found using other transaction cost models, such as some of those used in the academic literature and even our own proprietary model. But these models are calibrated for conventional trade sizes, which are typically in the range of 0% to 20% of the average daily transaction volume of a stock. Assuming that the predictions of these kinds of models can
Robeco QUARTERLY • #10 / DECEMBER 2018
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be extrapolated to trades bigger than ten to 100 times the typical daily volume of a stock clearly seems far-fetched. If the capacity of smart beta indices is really so limited, why do passive managers and ETFs seem to have little trouble replicating the performance of these indices? The answer is that the implementation shortfall that comes with tracking smart beta indices tends to translate into these indices delivering lower returns, and not into passive managers or ETFs underperforming. This is because index providers announce index changes in advance of the actual rebalancing, supposedly to facilitate the index replication process for passive managers and ETFs. However, research shows that there are significant price distortions in the period between the announcement and rebalance dates, the result being that stocks entering the index do so at inflated prices, while stocks leaving the index do so at depressed prices.
Many papers have documented this phenomenon for broad market indices, and our own research shows that the MSCI Minimum Volatility indices also suffer from this. Back in 2016, Robeco’s Joop Huij and Georgy Kyosev estimated the hidden drag on performance for this specific index at 16 basis points per annum. This is quite substantial given that the amount of money in the funds tracking these indices was still relatively low over the sample period considered.
Flexible active factor investing We also argue that properly designed active factor strategies can provide the high capacity that investors are looking for. The reason is because while smart beta indices concentrate their trades on a few rebalancing dates, active factor strategies can trade gradually, making full use of the liquidity that is offered by the market. In a simulation example, we rebalanced MSCI Minimum Volatility indices gradually by delaying trades. We found
no loss in performance but a spectacular improvement in trade feasibility. This holds true not just for MSCI Minimum Volatility indices, but also for other smart beta indices such as MSCI Quality and MSCI Value-weighted indices. Table 1 compares the key statistics that were assessed for the gradually rebalanced indices and the regular MSCI Minimum Volatility indices. The turnover of the two approaches was practically the same, because they involved the same trades. The only difference was the timing of those trades. Volatility was also very similar. Finally, returns appeared to be slightly better for the gradually rebalanced strategies. As a whole, these results imply that gradual rebalancing is not harmful for the performance of the MSCI Minimum Volatility indices. 1 R. Ratcliffe, P. Miranda and A. Ang, 2017, ‘Capacity of Smart Beta Strategies from a Transaction Cost Perspective’, The Journal of Index Investing.
The strategic case for emerging markets factor investing Factor premiums can be found in stock markets across the world, including emerging markets. But does factor allocation in emerging markets really add value to a global equity portfolio in practice? Well, according to Wilma de Groot and Weili Zhou, from Robeco’s quant equity team, the short answer is yes.
In a recent Robeco research note, we investigated whether allocating part of an investor’s portfolio to emerging markets equities adds value to a global equity portfolio. Using market data over the period from January 1988 to December 2017, we analyzed whether investors should allocate to emerging stocks and how they should go about it.
Robeco QUARTERLY • #10 / DECEMBER 2018
More specifically, we considered two main options. The first is based on a passive allocation that replicates the MSCI Emerging Markets Total Return Index. The second involves allocation to the wellknown value and momentum factors, within the MSCI Emerging Markets Total Return Index investment universe, using a ranking approach, as well as relatively simple factor
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Table 1 | Factor premiums in emerging and developed markets Market
V+M
Value
Momentum
11.4%
16.7%
16.5%
16.6%
Emerging markets Total return Excess return Volatility Sharpe ratio
8.0%
13.3%
13.1%
13.1%
22.6%
22.3%
22.2%
23.8%
0.36
0.59
0.59
0.55
Downside risk
17.1%
15.5%
15.5%
16.6%
Maximum drawdown
-64.4%
-60.2%
-62.5%
-64.3%
8.0%
11.8%
12.1%
11.4%
Developed markets Total return Excess return Volatility Sharpe ratio
4.8%
8.5%
8.8%
8.0%
14.6%
14.8%
15.8%
14.4%
0.33
0.57
0.56
0.56
Downside risk
10.8%
11.6%
12.2%
11.4%
Maximum drawdown
-54.7%
-57.8%
-61.6%
-54.4%
Source: Robeco
definitions and portfolio construction rules (investing in the top 33% of the most attractive stocks from a factor perspective, with monthly rebalancing).
Factors add more value than passive We found that, historically, allocating part of an investor’s portfolio to passive emerging markets equities increased the portfolio’s risk-adjusted return. However,
the gains of allocating to emerging markets are far greater when value and momentum factors are taken into account in the stock selection process. The benefits of allocating to factors in emerging markets can be significant, even when factor investing is already implemented in the developed markets part of the portfolio. Table 1 shows the return characteristics of market and factor portfolios in both
emerging and developed markets, over period from January 1988 to December 2017. The results for the multi-factor quant portfolio (V+M) consists of a 50/50 allocation to value (V) and momentum (M). This portfolio exhibits a significantly better risk-adjusted performance than a passive emerging markets portfolio. Specifically, the return of this portfolio was over 5% higher than the passive market portfolio with a similar volatility. The downside risk and maximum drawdown were also somewhat lower for the factor portfolio than the market. The Sharpe ratio was around 65% higher than for the market index: 0.59 compared to 0.36 for the market index. The returns shown do not take account of management fees and transaction costs, which could have a large impact on performance. In our analysis, we also considered more sophisticated portfolio construction rules that do not entail the immediate sale of stocks that become less attractive in terms of factor exposure. Instead, every quarter, only stocks that are no longer among the top 50% are sold. These stocks are then replaced by the most attractive stocks at that time that are not yet included in the portfolio. Our calculations showed that compared to a more static approach, this dynamic approach leads to both lower turnover and higher returns.
Costs don’t alter our conclusions Based on prudent assumptions, we also looked at the impact of transaction costs and management fees on performance. More specifically, we assumed trading costs of 30 basis points for developed markets stocks and 50 basis points for emerging markets stocks. We also assumed annualized management fees of 10 basis points for passive developed markets, and 20 basis points for passive emerging
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Robeco QUARTERLY • #10 / DECEMBER 2018
QUANT INVESTING QUANT INVESTING
markets. An additional 10 basis points per annum mark-up was included for the factor portfolios. Our conclusion is that even once these costs have been taken into account, allocating to emerging markets factor premiums still adds substantial value. Finally, we analyzed the performance of the different investment strategies over two equal sub-periods: from January 1988 until the end of 2002 and from 2003 until December 2017. The results in both sample periods were in line with the findings for the overall sample. Allocating to emerging
markets improved the Sharpe ratio of the portfolio in both sub-periods, and allocating to the value and momentum factors further improved the Sharpe ratios. As a result, we advise investors to allocate part of their portfolio to factor premiums in emerging equity markets, especially given that the factor definitions used in our study are relatively simple. We argue that efficient factor investing strategies using enhanced factor definitions, as well as smart rules for stock selection and portfolio construction, can achieve even
better investment results, while lowering both risks and costs. Robeco has been successfully running factor-based portfolios in emerging markets for over ten years now. Since its launch in 2008, our QI Emerging Markets Active Equities strategy has proven its ability to consistently and significantly outperform the MSCI Emerging Markets Index, both in up and down markets, delivering positive excess returns in eight out of nine full calendar years.
Multi-Factor Bonds: an alternative to passive fixed income A growing number of investors are implementing their fixed income strategies through passive Exchange Traded funds (ETFs). But these products are far from ideal. For investors looking for a smarter solution, factor investing offers an alternative, say Robeco’s Olaf Penninga, Martin Martens and Patrick Houweling.
portfolio positions are predictable and easy to explain. Derivatives are used, but only to a limited extent.
Strong empirical foundations One of the main pitfalls of classic passive bond strategies is that they inevitably lag the reference index, once costs and practical implementation hurdles are taken into account. However, it is possible to design factor-based investment strategies that generate stable and attractive alpha without taking on additional risk compared to passive strategies. Robeco’s Multi-Factor Bonds strategy is designed to achieve exactly that. It benefits from explicit exposures to a number of proven factors, while maintaining a market-like risk profile, similar to that of a popular broad bond index, the Bloomberg Barclays Global Aggregate Index. As a result, the
Robeco QUARTERLY • #10 / DECEMBER 2018
Academic research shows that factor premiums exist beyond equity markets and that factor investing also works with fixed income, including credits and government bonds. Our own research confirms this and the Robeco Multi-Factor Bonds strategy is one of the very first factor investing solutions for aggregate fixed income that offers balanced exposure to five proven factors. Figures 1 and 2 show the historical performance of these different factors, in both credit and government bond markets.
‘Our Multi-Factor Bonds strategy is one of the very first factor investing solutions for aggregate fixed income’ strategy is able to deliver stable relative performance, while maintaining a neutral position in terms of duration, currencies and other risk measures. In this sense, our multi-factor bond solution represents a smart alternative to passive fixed income ETFs. Moreover, the rules-based and systematic nature of this global bond strategy leads to a high degree of transparency: all trades and
Our simulations of the strategy’s performance over the period from January 2001 to September 2018 show that the strategy is able to deliver attractive
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QUANT INVESTING
Figure 1 | Historical performance of factors in credits
Figure 2 | Historical performance of factors in government bonds
3,0%
3,6% Value
Value
3,4%
2,5%
Momentum
Size
1,5%
Excess return
Credit return
3,2% 2,0%
Low Risk/Quality
1,0%
Market
0,0%
2,6% Market Low Risk
2,2% 0%
2% 4% Credit return volatility
Source: Robeco, Bloomberg. USD Investment Grade, January 1994 through December 2017. Decile portfolios constructed using Robeco factor definitions. Credit returns measured over durationmatched government bonds. This chart is for illustrative purposes and does not represent the performance of any specific Robeco investment strategy. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
alpha with a low tracking error. During that period, the strategy would have delivered an annualized outperformance of 1.0%, on average, over the Bloomberg Barclays Global Aggregate index, with little volatility regardless of the specific market environment. Our simulations show a Sharpe ratio and an information ratio both of which are just above 1.0. The simulated ex-post tracking error is 0.8%, consistent with our aim to design a strategy with an indexlike risk profile. In light of the current low-yield environment, adding an average outperformance of nearly 1.0% to a significant improvement over the return profile of a global bond portfolio.
Building a risk-neutral portfolio with optimal factor exposures Our approach to building multi-factor bond portfolios is to start by determining the allocation to credits and government bonds such that they offer a similar risk-return profile to that of the broader Bloomberg Barclays Global Aggregate index. Building a risk-neutral portfolio of credits and government bonds is the starting point
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2,8%
2,4%
0,5%
Momentum
3,0%
6%
2,0%
2,80%
3,30% Return volatility
3,80%
Source: Robeco, Bloomberg. February 1986 through February 2018. This chart is for illustrative purposes only and does not represent the performance of any specific Robeco investment strategy. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
for optimizing the factor exposures in both segments of the portfolio. Then, we apply our proprietary multi-factor selection model to select credit bonds that offer the best exposures to the low-risk, quality, value, momentum and size factors. This credit selection model has been successfully applied in live factor investing credit portfolios since 2012 and is based on extensive in-house research. We use enhanced factor definitions and apply prudent implementation. With our enhanced factor definitions, we capture factor premiums in a more robust way than with standard academic definitions, by combining multiple sources of information. For example, our proprietary quantitative models take accounting data and equity market information into consideration to define corporate bond factors.
on country/maturity combinations. Moreover, we ensure factors do not clash with each other, by applying a multi-factor framework. More specifically, we require a bond to score well on multiple factors and therefore avoid expensive low-risk bonds with poor momentum, for example. Next, we systematically screen bonds of various maturities across the most liquid developed government bond markets to identify those that score best in terms of the value, momentum and low-risk factors. The resulting portfolio is well-diversified across corporate bonds, agencies, and Treasuries and is managed in a highly systematic way to achieve optimal exposures to the desired factors.
We also apply top-down risk constraints to avoid concentration risks in the portfolio. In corporate bonds, for example, we apply limits to sector exposures, while in government bonds we place restrictions
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Crash testing the Fama-French factor model in emerging stock markets Factor investing works in emerging stock markets, as well as in developed markets. But factor definitions matter greatly. From this perspective, even the now well-established fivefactor model, proposed in 2015 by Nobel-prize winner, Eugene Fama, and fellow researcher, Kenneth French, still leaves room for improvement. When alternative factor definitions are tested in emerging markets, the evidence clearly demonstrates that they are more robust, says Matthias Hanauer, from our quantitative research team.
‘The superior performance of the new emerging market factor model is not driven by any particular region’
Within just a few years, the Fama-French five-factor model1 has become a standard model in the academic literature on asset pricing. Yet out-ofsample tests on the model in the emerging markets investment universe remain scarce. In a recent paper,2 Robeco’s Matthias Hanauer and fellow researcher Jochim Lauterbach, from the Technische Universität München, addressed this issue. Using monthly stock returns for a total of 28 emerging market countries over the period from July 1995 to June 2016, they examined the predictive power of an extensive set of factors, including value, size, profitability, investment and momentum variables.
Stronger emerging market variables However, the two researchers also found that the exact factor definitions used
by Fama and French are less robust than alternative factor definitions and that a momentum factor should be added to the model.4 As a result, they argue that the factor definitions of the Fama-French five-factor model are not ideal for emerging markets and propose a different set of variables they dubbed the “strongest emerging market variables”. More specifically, they find that the anomalous returns associated with cash flow-to-price, gross profitability, composite equity issuance, and momentum are pervasive, as they are found in the calculation of both equal- and valueweighted returns, as well as cross-sectional regressions. Based on these findings, they proposed a new emerging markets factor model and derived out-of-sample return
In so doing, they were able to confirm the key results of Fama and French’s research on their five-factor model in developed markets. In other words, they found that the value, profitability, and investment factors (of which the combination of the latter two is often referred to as ‘quality’) can also be documented in emerging markets. Moreover, in contrast to conclusions deriving from financial theory, but in line with previous findings,3 they did not find a positive relationship between risk and return.
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forecasts with it, based on current firm characteristics. The forecasts based on the alternative factor definitions are superior to those derived with the five-factor model for both types of returns and crosssectional regressions. Furthermore, these conclusions hold true not just for theoretical long-short portfolios, but also when taking common practical investment hurdles, such as short-selling constraints, transaction costs, and investments limited to large stocks into account. Under these conditions, the revised factor model proves to deliver a higher Sharpe ratio than valueand equal-weighted strategies as well as the minimum volatility and an optimized portfolio based on return forecasts derived from the five-factor model. Another important finding is that the superior performance of the new emerging market factor model is not driven by any particular region. In fact, while the Fama-French five-factor model proves unable to forecast significant long-
short returns or a CAPM alpha in Central and Latin America, the emerging market factor model is found to be efficient – or at least more efficient than the five-factor model – in all the different regions considered in the study. These include not only Central and Latin America but also Europe, the Middle East and Africa, as well as Asia.
of view, the debate over which variables serve as the best proxies for measuring these factors remains.5 In fact, in a paper6 published in 2017 in the Journal of Financial Economics, Fama and French acknowledged that future research might further refine the definition of factors in asset pricing models, including their own five-factor model.
The ongoing factor-definition debate
Back in 2008, Fama and French already indicated that as a variable, asset growth is not sufficiently robust. Meanwhile, in a more recent paper7 comparing different factor models, Kewei Hou, Haitao Mo, Chen Xue and Lu Zhang, from the US National Bureau of Economic Research (NBER), demonstrated that the five-factor model cannot explain the composite equity issuance anomaly.
Ultimately, this study raises the question of how factors ought to be defined, not just in emerging markets but also in developed markets. The results presented by Hanauer and Lauterbach provide strong evidence to support the idea that the factor definitions of the five-factor model may not be optimal not only for emerging markets, but also for developed markets, including the US market. Although the value, profitability and investment factors are now commonly accepted in the research community, both from an academic and a practical point
Also, in the same spirit, studies by Cliff Asness and Andrea Frazzini,8 on the one hand, and by Francisco Barillas and Jay Shanken,9 on the other, have documented that value variables should preferably be measured with the latest market capitalization when used in combination with momentum. A few years earlier, Kewei Hou, Andrew Karolyi and BongChan Kho10 had already argued that cash flow-to-price is at least as important as the book-to-market ratio in describing global stock returns. 1 Fama, E. F., French, K. R., 2015. ‘A five-factor asset pricing model’. Journal of Financial Economics 116, 1 – 22. 2 Hanauer. M. X., Lauterbach J., 2018. ‘The cross-section of emerging market stock returns’. Emerging Markets Review, forthcoming. Working Paper (August 2018) available at SSRN. 3 Blitz, D. C., van Vliet, P., 2007. ‘The volatility effect: Lower risk without lower return’. Journal of Portfolio Management 34, 102–113. 4 These findings are in line with our concerns about the fivefactor model. 5 See also our research on the quality factor: https://www. robeco.com/en/insights/2016/07/defining-the-quality-factor. html 6 Fama, E. F., French, K. R., 2017. ‘International tests of a five-factor asset pricing model’. Journal of Financial Economics 123, 441–463. 7 Hou, K., Xue, C., Zhang, L., 2014. ‘A comparison of new factor models’. NBER Working Paper No. 20682. 8 Asness, C. S., Frazzini, A., 2013. ‘The devil in HML’s details’. Journal of Portfolio Management 39, 49–68. 9 Barillas, F., Shanken, J., 2018. ‘Comparing asset pricing models’. Journal of Finance 73, 715–754. 10 Hou, K., Karolyi, G. A., Kho, B.-C., 2011. ‘What factors drive global stock returns?’ Review of Financial Studies 24, 2527–2574.
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The name’s Bond... Corporate Bond What should and should not be included in strategic asset allocation is a hotly debated topic. But should an asset class be rejected entirely… on the grounds that it is basically a combination of two others? Quantitative researcher Laurens Swinkels makes the case for the corporate bond.
Speed read • Credits said to be a combination of equities and government bonds • Corporate bonds offer diversification benefits for portfolios • Investors can also strategically harvest factor premiums
For high yield, the interest rate return contributes 2.50% and the credit spread 2.71%. The contribution of the interest rate component for high yield is smaller than it is for investment grade, due to the combination of the shorter interest rate duration of high yield bonds, and the structural decrease in interest rates over the sample period.
Opinion
Replication is weak When institutional investors perform long-term asset liability management studies, their strategic asset allocation is typically not linked to the macroeconomic cycle, asset class valuations or sentiment. In September 2017, a Norwegian sovereign wealth fund advised the country’s government to exclude corporate bonds from the fund’s strategic asset allocation. It wasn’t because the fund’s asset allocator thought that corporate bonds – also known as credits – were too risky, underperforming or generally unpalatable. The main argument was that their returns are merely a combination of the returns on government bonds and equities, making the entire corporate bond asset class redundant. Here, we discuss why corporate bonds should be included. Let’s start by decomposing the returns of investment grade and high yield corporate bonds into the risk-free rate, the interest rate return and the credit spread return. We can then compare the credit spread returns to the returns on government bonds and equities. The results are shown in Table 1. The risk-free rate contributes 2.96% to the average total return for the 1988-2018 sample period. For investment grade bonds, the interest rate return contributes 3.25 % and the credit spread 0.60%.
These figures suggest that the credit spread return is not sufficiently different from zero to warrant a separate allocation to credits. However, we can run another test to see what would happen if they were indeed then replaced with equities or government bonds. Here, we look at the equity premium relative to the one-month riskfree rate, shown as RMRF beta in Table 2, and the total returns of US Treasuries minus the one-month risk-free rate, known as TERM beta.
Table 1: Return of US investment grade and US high yield total returns and its components: risk-free rate, Treasury returns and excess returns over Treasuries, where the Treasury bonds are duration-matched to the corporate bonds. The t-statistic relates to the statistical significance of the average return. August 1988-June 2018. Investment grade
High yield
Average
6.80
8.17
Volatility
Panel A: Total return 5.17%
8.47%
Sharpe ratio
0.74
0.62
t-statistic
4.07
3.37
Average
2.96
2.96
Volatility
0.72%
0.72%
Panel B: Risk-free rate
Panel C: Treasury return vs. risk-free rate Average
3.25
2.50
Volatility
4.88%
4.25%
Sharpe ratio
0.67
0.59
t-statistic
3.64
3.21
Panel D: Excess return vs. Treasuries Average
0.60
2.71
Volatility
3.80%
9.22%
Sharpe ratio
0.16
0.29
t-statistic
0.86
1.61
Source: Bloomberg Index Services, Kenneth French, Robeco
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Opinion
Table 2: Regression results of credit spread returns on RMRF and TERM for US investment grade and US high yield. t-statistics between parentheses. August 1988-June 2018. Investment grade Annualized alpha
0.20
2.23
(0.34)
(1.78)
RMRF beta
0.13
0.35
(11.1)
(14.1)
TERM beta R2
High yield
-0.23
-0.82
(-5.9)
(-10.0)
33.0%
48.4%
Source: Bloomberg Index Services, Kenneth French, Robeco
Figure 1 shows that at the end of 2017, corporate bonds made up close to 20% of the invested global market portfolio, while listed equities has a weight of just over 40%. Excluding an asset class that is half the size of listed equity markets increases diversification risks relative to the market portfolio that can not necessarily be compensated for elsewhere.
Harvesting factor premiums
‘Excluding corporate bonds reduces diversification benefits that are not compensated by higher returns’
This gives a regression (R2) of 33.0% for investment grade bonds, and 48.4% for high yield bonds, meaning that two-thirds or one half of the returns for each asset class respectively cannot be attributed to dumping credits, but are due to other market factors which change. Put simply, the replication here is weak; removing corporate bonds from a portfolio and replacing them with equities and government bonds results in different month-to-month return fluctuations.
Diversification benefits Then there are the diversification benefits to consider. A ‘market portfolio’ containing equities, government bonds and credits in varying proportions is one of the most broadly diversified. According to the Capital Asset Pricing Model, the market is the only risk factor that should price all other assets. Therefore, a fund that deviates from the market portfolio contains risk that can be diversified away, and should not therefore contain a risk premium.
There is an additional reason why allocating to corporate bonds can be beneficial for investors – the presence of factor premiums. In corporate bond markets, the evidence suggests that the factors of size, low risk, value and momentum all apply in some degree, making harvesting factor premiums possible.
The size factor is based on research that shows the stocks and bonds of smaller firms tend to outperform those of larger companies. Low-risk bonds have been proven to have better risk-adjusted returns than high-risk bonds, while value investing studies have shown that stocks and bonds that are undervalued tend to outperform the market, while overvalued securities tend to underperform. Finally, the momentum factor follows the principle that companies that have recently performed well tend to continue to perform well, and vice versa.
Bonds therefore offer advantages
So, should corporate bonds remain part of strategic asset allocation? Yes. Replication with other assets – while possible – is weak, while excluding corporate bonds reduces diversification benefits that are Figure 1 | The global invested multi-asset market portfolio in December 2017 not compensated by higher returns. And Equities - 41.8% allocating to corporate bonds may harvest Government bonds - 24.6% factor premiums that are unrelated to factor Investment grade credits - 17.0% premiums in equities. Real estate - 5.8%
Private equity - 4.0% Emerging debt - 2.9% Inflation-linked bonds - 2.3% High yield bonds - 1.6% Source: https://personal.eur.nl/lswinkels/
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Therefore, an investor who believes that diversification is important, or that factor premiums exist, should conclude that corporate bonds should be part of a strategic asset allocation.
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Stranded assets? Oil cannot be written off just yet Fossil fuel assets that will become ‘stranded’ due to the Paris Agreement have become a long-term threat to the sustainability of energy companies. But they do not currently threaten the prosperity of oil companies, which still have a role to play in portfolios, says Robeco Chief Economist Léon Cornelissen. Spending on fossil fuel explorations by oil majors has already fallen sharply since 2014, as illustrated in Figure 1.
Speed read
Research
• Paris Agreement will create trillions of dollars of unburnable fuels • Big Oil is transitioning to a low-carbon future but moving slowly • Oil price hasn’t reacted, and it’s not yet time to avoid this sector
The issue arises due to the commitment by the 195 countries who have signed up to the accord to limit global warming to 2 degrees Celsius above pre-industrial levels by 2100. This means that up to 80% of the world’s fossil fuel reserves cannot be burned, causing trillions of dollars’ worth of stranded coal, oil and gas.
Estimates of what can be burned and what needs to be left in the ground vary substantially, though according to the International Energy Authority, practically all of the oil majors’ so-called 2P (proven and probable) reserves can be extracted. In that case, it is the so-called 3P reserves (proven, probable and possible) in excess of the 2P reserves that run a big risk of becoming stranded. This latter share represents only a couple of percentage points of the total value of oil majors, so the potential for it to become stranded could be considered a tail risk for oil companies as a
With oil and gas reserves possibly remaining unused due to the ongoing energy transition towards renewables, investors are faced with a tough question: is it time to sell these carbon intense holdings or would that be premature? And are fears of incurring substantial losses due to an unavoidable write-down of useless stranded assets overdone?
Low-carbon future In 2017, Big Oil started to position itself for a low-carbon future, with the European majors leading the way. Uncertainty will remain, as there is no roadmap for the energy transition, and no clear view as to how long it will take, or what the winning technologies will be. One clearly identifiable trend is Big Oil’s increased investment in carbon-free energy. The oil giants reckon that oil supply will peak around 2020 and then fall 20% by 2030, fueled by the need to reduce production to meet the climate target of 2°C. To achieve this, part of the supply will be substituted by alternative sources such as solar and wind energy.
‘One clearly identifiable trend is Big Oil’s increased investment in carbon-free energy’
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Figure 1 | The trend in worldwide capital expenditures in oil and gas has been broken
In USD dollars (millions)
1,000,000
Oil price hasn’t reacted Meanwhile, the oil price has not yet reacted to the prospect of much of it becoming unusable. With oil on its way out, the price is expected to go down over the longer term. But a lack of investment (e.g. in oil sands or in the Arctic) could eventually give rise to shortages, thus pushing up oil prices. So far, price behavior does not seem to be based on the transition to a low-carbon economy.
100,000
10,000 87
90
95
00
05
Source: Datastream
whole. As the demand for oil continues to grow over the next five years, particularly from emerging markets, the transition to a lowcarbon economy could easily be well underway later rather than sooner. Estimates as to when oil demand will peak have shifted and now vary from 2023 to 2070.
Supply side problems (in Nigeria and Venezuela, for instance), and the OPEC cartel’s successful rationing policies are the key factors influencing shorter-term price movements. The upside for oil prices is limited somewhat by the US shale revolution, as higher prices increase supply, illustrating the adage that the best remedy for higher prices is higher prices.
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Against the backdrop of increasing global demand, this creates a dilemma for investors. Is it time to dispose of carbon holdings? Or is it too soon? And are fears of incurring substantial losses due to an unavoidable write-down of useless stranded assets overdone? At some point, the oil price has to drop significantly. Even Saudi Arabia has recently announced a plan to become carbon-neutral within a couple of decades.
Oil and the index Oil also remains an important part of stock market indices, despite the ongoing preference for the FAANG internet stocks. Exxon Mobile, the largest of the oil majors, remains in the MSCI World Index’s top ten holdings, while the energy sector accounts for more than 6% of the MSCI World Index. As movements in oil prices are essentially unpredictable in the shorter term, and so far seem largely unaffected by the global transition to a non-carbon economy, investments in the energy sector still make sense.
‘With oil on its way out, the price is expected to go down over the longer term’ 20
Disregarding the sector would be inadvisable, as it offers interesting opportunities for active investors to add value. Over the last decade, the energy sector has added a unique risk to equity portfolios. Going forward we expect this to remain the case. Investors stand to benefit from the added portfolio diversification.
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SUSTAINABILITY investing
Saving the planet is trendy If there is one theme that tops the sustainability agenda it is the battle against climate change. But that’s not the only trend driving thematic environmental investing; in fact there are three. It starts with millennials, who are more environmentally conscious than previous generations, and will soon start calling the shots when it comes to investing sustainably, using an inherited wealth transfer in the trillions. Certainly they won’t be stuck for opportunities in investing in the digital revolution that has accompanied their lives since the mid-1980s. Meanwhile, increasing regulation is making it harder for companies and investors to ignore the unstoppable rise of sustainability itself, as our lead story explains.
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Three trends behind thematic environmental investing Three structural trends are driving investment that benefits the environment, says thematic investor Rainer Baumann. Demographic changes in society combined with greater regulation and digitalization are driving sustainability investing onwards, allowing the creation of thematic funds that can capitalize on long-term structural shifts.
It is being led by the gradual dying out of the post-war generation known as the baby boomers, who are now in their 60s and 70s, and their replacement with the generation of millennials born since the mid-1980s who have a far greater interest in sustainability than their parents or grandparents. And they will have plenty of money to invest: these millennials are set to inherit up to USD 59 trillion between now and 2060, creating the largest intergenerational wealth transfer in history, according to the Center on Wealth and Philanthropy at Boston College. “The first major trend is the replacement of baby boomers with millennials who are
huge transformation of many traditional business models. That might be scary for certain traditional industries, but this change and transformation is also a huge opportunity for new businesses.”
becoming more and more influential in taking investment decisions,” says Baumann, Head of Investment Management at RobecoSAM.
Different attitude “We know from various studies that millennials will take a completely different attitude towards investment, as they also do in terms of how they behave and how they consume. They have a higher sense
The new auto industry Baumann says the automotive industry is a good example of how all three trends apply, as consumers demand more environmentally friendly cars, while regulation progressively tightens emissions standards and innovation makes cars more efficient.
‘Perhaps the most interesting trend is the fast acceleration of innovation, particularly in digitalization’ of responsibility, and will also take environmental issues more into consideration than previous generations. So, changing consumer habits is definitely one driving force.” “The second trend is regulation – we see encouraging signs that it is moving in the right direction, and is driving more concrete rules that is supporting the wider adoption of environmental, social and governance factors (ESG) in investment and society.” “But perhaps the most interesting trend is the fast acceleration of innovation, particularly in digitalization – we see a
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“And that in a nutshell is currently what makes thematic investing so exciting – this combination of a huge technological shift with tightening regulation and changing consumer habits.”
“One sector that is going through a fundamental shift is the automotive industry, and the electrification of that sector; I guess we’ll see more innovation there in the next few years than we’ve seen over the past 30-40 years,” he told a recent Responsible Investor conference. “We now have one million cars being sold this year that are either electric or hybrid, and we expect these numbers to grow to 8-9 million by 2020. And then it really kicks in by 2030-2040, when we will reach the point where more electric cars will be sold than those with traditional combustion engines.” “So, there is a transformational shift that
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SUSTAINABILITY INVESTING
has created a completely new market for investment. That is something that at RobecoSAM we currently look very closely at; we look at how we can benefit from that by building portfolios that invest in the new value chain that is starting to come up.” “Besides the car makers, there is of course a huge industry in the car supply chain, which is changing from the traditional industry to new applications in things such as car lighting systems. The next big step will be in radar technology that is essential in distance or speed monitoring. This ultimately is the technology that will allow cars to drive themselves.”
Oil is yesterday’s news Meanwhile, the higher oil price seen in recent months makes petrol-driven cars more expensive run – aiding the sustainability cause – but that dynamic is becoming irrelevant, Baumann says.
‘What will become increasingly important will not be the oil price, but the electricity price’ “A rising oil price is always an indication of a strong economic growth, but generally I would say we are becoming more and more independent of the oil price, so it really doesn’t matter that much anymore,” he says. “In the mobility area, for example, we are moving from combustion engines to electric vehicles, and we have seen development in building technologies where we’re moving away from fossil fuel systems to electricity-based systems.” “What will become increasingly important will not be the oil price, but the electricity
price. There we see the price remaining relatively low and stable, because we have an increasing supply of electricity from clean and alternative sources, and that keeps this transition ongoing.”
Baumann says investors should also not forget how the most basic or traditional of industries can still become attractive thematic investments from their innovation potential. “We have a thematic investment strategy in the water space; this is considered to be a mature theme, but there is a lot of innovation going on, particularly in emerging markets, which gives our portfolios a lot of investment opportunities, and as a result, great returns,” he says.
Sustainability and the role of finance Sustainability is usually defined as meeting today’s needs without compromising the ability of future generations to meet theirs. The financial industry can play an increasing role in trying to achieve this.
That was the opening scene-setter for Robeco’s Big Book of SI, and it all begins on an historical note. The term ‘Tragedy of the Commons’ was coined by 19th century British economist William Foster Lloyd to describe a hypothetical situation involving the overgrazing of common land in medieval Britain. It is a metaphor for the degradation and eventual depletion of shared resources.
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The dilemma at its heart relates to the link between self-interest and open access, where individuals put selfinterest above the common good. And it is a classic example of coordination failure, which could be resolved by dividing the resources into individual parcels, or through the introduction of a government-enforced quota system. This lies at the heart of many of the sustainability issues we encounter today. A recent example involves CO2 emissions
from the global shipping industry. Due to the principle of freedom of the open sea, shipping companies had escaped regulations to reduce greenhouse gas emissions that according to the Economist magazine were higher than the whole of Germany.
Setting targets or caps This changed in April 2018 when the International Maritime Organization set binding targets to bring the industry in line with the ambitions of the Paris Agreement. These include cutting greenhouse gas emissions by at least 50% by 2050 (compared with
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SUSTAINABILITY INVESTING
2008 levels). International collaboration has proven to be key in resolving this coordination problem. Aviation, an industry not directly included in the UN climate agreement, also has a plan in place to reduce emissions. It has set out three goals: a global average fuel efficiency improvement of 2% per year up to 2050; carbon-neutral growth from 2020 onwards; and a 50% absolute reduction in carbon emissions by 2050 (compared with 2005 levels). As an alternative to regulation, governments could choose to put a price on carbon to
‘Targeted investment can be instrumental in the redeployment of capital to sustainable activities’ solve the coordination problem – for instance, via a cap and permit system, or by means of a simple levy. While this is already happening to a limited extent, an estimated 85% of global emissions are currently not covered by such measures.
Massive population growth Related to the tragedy of the commons is the fact that the world’s population is expected to approach 10 billion by 2050. Despite ongoing innovation and productivity increases, future generations will face increasing resource scarcity and challenges linked to climate change – not just environmental consequences, but also social effects such as climate migration. These developments strongly indicate the need for a more circular economy, based on much lower rates of natural resource extraction and use, in contrast to today’s largely traditional linear economy. According to the OECD, the amount of materials extracted from natural resources and consumed worldwide has doubled since 1980 and is ten times higher than in 1900. The rapid industrialization of emerging economies and continued high levels of consumption in developed countries are responsible for this trend. Therefore, the challenge for businesses and economies is to grow in a way that can be facilitated by the Earth’s natural resources in the long term without depleting them. Circularity can play a key role in countering the negative effects of the current over-consumption crisis.
Finance can play a key role For the role that finance can play, targeted investment can be instrumental in the redeployment of capital to sustainable activities. A key role of financial markets is the efficient allocation of resources to the most financially viable companies, not just in the present, but even more critically, in the future.
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SUSTAINABILITY INVESTING
Financial materiality is the critical link at the intersection of sustainability and business performance. More specifically, investors should focus on identifying the most important intangible factors (sustainability factors) that relate to companies’ ability to create long-term value. For instance, lowering energy consumption in manufacturing processes results in significant cost-saving opportunities and has a direct impact on a company’s bottom line. Going a bit deeper, financial materiality is defined as any intangible factor that can have an impact on a company’s
‘Financial materiality is the critical link at the intersection of sustainability and business performance’ core business values. These are the critical competencies that produce growth, profitability, capital efficiency and risk exposure. In addition, financial materiality includes other economic, social and environmental factors such as a company’s ability to innovate,
attract and retain talent, or anticipate regulatory changes. These matter to investors because they can have significant impacts on a company’s competitive position and long-term financial performance. Over a century after the Tragedy of the Commons first outlined what sustainability was in medieval terms, that is essentially how SI is viewed today.
Investing in the UN Sustainable Development Goals Investing in the United Nations Sustainable Development Goals (SDGs) can be challenging, but it is now possible to verify corporate contributions to them, using a three-step framework developed jointly by Robeco and RobecoSAM.
Three-step process This framework offers a scoring methodology that evaluates a specific company’s ability to meet the 17 SDGs, or whether its products or activities detract from them. This then enables the construction of a bespoke credits strategy that can be shown to make a positive contribution.
“We’ve created a three-step process to assess the impact that companies are having on achieving the Sustainable Development Goals," Jan Willem de Moor, manager of the RobecoSAM Global SDG Credits fund, told the Responsible Investor 2018 conference. “In the first step we look at what the
The SDGs range from eradicating world hunger and reducing global warming, to improving health care, technological access and educational standards in emerging markets. Launched in 2015, they have been adopted by 193 countries, with a challenge to businesses – including asset managers – around the world to help meet them all by 2030.
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companies are producing, or what services they are offering, and how does that contribute to a specific SDG. For example, for SDG3 (good health and well-being), it would make sense to look at pharmaceutical companies, or those making medical devices, or offering health care insurance, as these companies could contribute to that specific SDG.” “Taking SDG 11 (sustainable cities and communities), we would focus on home builders, the producers of building materials, and also car producers, because if you’re making a lot of electric vehicles, this is helping to achieve the goal of sustainable cities.”
‘We’ve created a threestep process to assess the impact that companies are having on achieving the SDGs’
“SDG 10 (reduced inequalities) is a typical example of where it’s difficult to find companies whose products contribute
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Figure 1 | The 17 SDGs
Source: UN directly to this SDG. This is where the second step of the process is used to focus on how companies are producing their goods. Are they, for instance, emphasizing gender equality in their human resources, creating a good governance structure, or putting a lot of emphasis on reducing their greenhouse gas emissions?”
“Lastly in step 3, we focus on controversies. The first two steps are more process orientated, while in the third step we look at whether a company has done something like generated an oil spill for example, has been caught up in bribery and fraudulent activity, or has been mis-selling its products. We then assess whether this was a oneoff event, and whether the company is addressing its problems or not.”
Scoring system The outcome of this threestep process is quantified in the SDG rating framework. This uses a proprietary scoring system developed by RobecoSAM in which scores are assigned from +3 for those companies making the best contributions, to -3 for those making the worst.
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Detractors would include companies suspected of using child labor, causing excessive pollution, or selling over-priced products for quick profits in emerging markets, and such activity would be reflected in negative scores. “We find that about 60% of companies in our investment universe do make a positive contribution to the SDGs,” de Moor says. “We use these outcomes as a screening process and a first step into creating a credit portfolio that would ultimately have a positive impact on the SDGs.” “This is really new, and is different to the way we used to do things. Our dedicated sustainability products always used to have a best in class approach – which is something we still offer – but the SDGs have more of a sector focus. It’s been driven by client demand for more impactcreated products, as clients don’t want to invest in certain companies.”
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SUSTAINABILITY INVESTING
Climate change growth could be worth USD 26 trillion Investing to limit climate change could add USD 26 trillion to the global economy, according to a study by the Global Commission on the Economy and Climate.
The report says the money can be generated in five key economic systems: energy, cities, food and land use, water and industry. It has analyzed the revenuegenerating potential of a number of areas such as renewable energy and the introduction of carbon pricing, combined with the savings from avoiding the damage caused by global warming. The Commission is an initiative set up by seven coastal countries – Colombia, Ethiopia, Indonesia, Norway, South Korea, Sweden and the UK – and is chaired by the former president of Mexico. Its flagship project is the New Climate Economy, a think tank which aims to provide independent advice on how countries can achieve economic growth while dealing with the risks posed by global warming. The 2018 report identifies and quantifies areas in which tackling climate change can actually raise and save money, based on detailed studies. It believes that more than 65 million new low-carbon jobs can be created by 2030, equivalent to the current population of the UK. Some USD 2.8 trillion could be raised from the introduction of carbon pricing – a much-discussed system that is currently only in force in selected part of the world – a sum equivalent to the current GDP of India. Finally, the world could avoid trillions in weather-related losses; 2017 cost USD 320 billion in storm damage alone. Hurricanes
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are getting fiercer; Puerto Rico still has not recovered from the 2018 hurricane that devastated the island. Widespread flooding from storms and rising sea levels is becoming more common, and wildfires such as the devastation seen in California is wrecking entire communities.
Time is running out And the world is seen as running out of time to limit global warming under the Paris Agreement to 1.5 degrees Celsius by 2100. In October, a report by the United Nations Intergovernmental Panel on Climate Change warned that this target would probably be reached by 2030, and that global warming of 3 degrees by the end of this century was more likely.
as a business opportunity rather than some sort of inconvenience is seen by many as the way forward. “It is becoming more and more clear that investment in sustainable infrastructure is the growth story of the future,” says Robeco Chief Economist Léon Cornelissen. “Public investment is important, especially in developing countries, but the role of private investment is non-negligible, especially in advanced economies.” “As infrastructure currently represents only a small percentage in the portfolio of institutional investors, there is ample scope for expansion. Infrastructure could offer long-term, stable cash flows and act as an attractive diversifier in investment portfolios.”
Treating the fight against global warming
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Bertrand Badré
‘We’re on the cusp of a very positive transformation’ Great Minds
Bertrand Badré is a former managing director of the World Bank and the founder of Blue like an Orange Sustainable Capital, a company that invests in sustainable projects in emerging countries. We talked with him about the challenges of sustainable development, the role the private sector can play and the main ideas developed in the book he recently authored on this topic.
The main thesis of your book is that finance can serve the ‘common good’. Could you explain what you mean by ‘common good’ and how it relates to concepts such as sustainability investing and ESG? “For me, it boils down to the fundamentals of economics. I don’t like the segregation between real economy and financial economy. We have an economy that forms a whole, in which finance is the tool par excellence for managing a number of things, including time and space.” “The problem is when finance becomes its own end; when making money with money becomes self-referential. Interestingly, the two moments in history when the share of financial activities as part of GNP reached its highest peaks were in 1929 and in 2007. So, it’s clear that there are times when finance becomes its own justification. This is when we start inventing things such as CDOs-squared and other things that are not useful for funding the economy.” “The question of the common good is a difficult one. It is a fairly Western concept. I have talked with Chinese people and there is nothing equivalent in their culture. They have things such as harmony or peace. I think we can describe it as a harmonious development of our societies or what in new international jargon is known as sustainable development. In other words, a development model that respects the remuneration of not only financial capital but also human capital, social and societal capital and natural capital.” In your book, you explain that the private sector has an important role to play in this context. Nonetheless, a large part of the
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book is devoted to the public sector, particularly multilateral development banks (MDBs). So, what exactly can the private sector do? “You are right. That’s probably because until recently I spent several years working for these multilateral institutions. My take is that MDBs are valuable, but that we could do much more with them. We have to, in fact; and that’s where the private sector should come in. Let me explain a little to give you an idea of the challenges we face.” “A few years ago, I coordinated the publication of a World Bank report1 on the resources needed to meet the United Nations’ Sustainable Development Goals (SDGs). I wanted the report to be no more than 20 pages long, to be written in accessible English and to have a catchy title: ‘From Billions to Trillions’. All this may sound a bit basic, but these things don’t necessarily come naturally in the world of multilateral institutions.” “More importantly, the report had to provide concrete orders of magnitude. Oftentimes, people struggle with orders of magnitude when it comes to money. As soon as an amount exceeds a few hundreds of millions, or even a billion, we tend to simply say it's a lot. We have difficulty distinguishing between 1 billion, 10 billion and 100 billion. And the global financial crisis compounded this issue. Remember the G20 summit in 2008? Some USD 5,000 billion were committed for fiscal expansion, but no one actually knew what that figure meant.” “So, what the title ‘From Billions to Trillions’ attempts to communicate is disparity: on the one hand we have a global economy estimated at around USD 80 trillion in nominal terms and USD 100 trillion from a purchasing-power-parity perspective,
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Bertrand Badré is CEO and founder of Blue like an Orange Sustainable Capital. Previously, he was managing director of the World Bank and chief financial officer of the World Bank Group. Prior to joining the World Bank, he was group chief financial officer at Société Générale and Crédit Agricole, and represented these institutions at the FSB, G7 and G20. Badré also served as a member of President Jacques Chirac's diplomatic team where he was the president's deputy personal representative for Africa and as spokesman for the working group on new international financial contributions to fight poverty and fund development. He also spent seven years at Lazard – half of which as a partner in New York and London, and the other half as managing director in Paris where he co-led the restructuring of Eurotunnel and focused on financial initiatives. He started his career in Paris as an inspector, then deputy head, of the auditing service of the French Ministry of Finance and has served as director on a number of company boards. Badré recently authored the book Money Honnie, si la finance sauvait le monde? (published in English in 2017 under the title Can Finance Save the World?). He has also led the publication of several articles. He is a graduate of ENA (Ecole Nationale d'Administration), SciencesPo (Institut d'Etudes Politiques de Paris), La Sorbonne and HEC business school (Hautes Etudes Commerciales), and a regular speaker and teacher at these institutions and at the universities of Georgetown, Johns Hopkins, Princeton and Oxford.
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Great Minds
‘It’s obvious that money is being poorly allocated’ and the desire to put this economy on a trajectory of lower carbon consumption, and sustainable development. On the other hand, only around USD 100 billion per year by 2020 has been committed by governments as part of the COP 21 Agreement. Moreover, the combined amount managed by the IMF, the World Bank and all the big public institutions is somewhere between USD 120 and 140 billion per year, while global official development assistance is around USD 150 billion annually.” “We can see that although we have a USD 100 trillion economy, only around USD 250 or 350 billion is available to fund sustainable development. There are many estimates of what is really needed, but basically it’s several trillion dollars. So there’s a clear gap, hence the title. How are we bridging this gap? The answer is quite simple: basic math.” “Part of the difference will be filled by local resources, namely savings and taxes. This is also how Europe and the United States funded their development in the 19th and 20th centuries. Emerging and developing countries will have to develop sound taxation policies. I often like to mention that in 1789 France’s estimated public spending rate was about 10% of the country’s GDP. Today, it’s 45%. This doesn’t mean we should all aim for 45%, but 10% is clearly not enough. So, local public spending will be the first resource and it will be a very important one.” “The second resource will be private money, in other words savings. I believe that the development of physical infrastructure – roads, ports, telecom towers, etc. – and social infrastructure – schools and hospitals – requires financial infrastructure. People need to have somewhere to put their money. Even if it's just a dollar a month, you need a financial system that enables you to save so you don’t have to keep your money under your mattress. Local contributions from both the public and private sectors will therefore form the lion’s share of the funding for sustainable development.” “But that probably won’t be enough. Some of the money may also have to come from foreign private savings. Unfortunately,
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this type of financial resource often does not make its way into sustainable projects in developing and emerging countries. And so my deep conviction – which I stress in my book – is that public development institutions have a role in helping private investors, to take them by the hand, as it were. MDBs need to understand that while it’s important for them to fund development operations, it’s probably even more important that they mobilize resources.” With this in mind, what role can asset managers play? “To me, this question concerns one of the most important challenges we face today: how we allocate resources at a global level. We've never had so much money in savings and under third-party management. We’ve never had so many asset managers and so many large asset owners, including large pension funds and sovereign wealth funds. And yet, a significant part of this money is invested in debt that offers low or even negative rates of interest. It’s obvious that money is being poorly allocated.” “Money needs to be allocated differently, through regulation and
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incentives, using market economy mechanisms. Endcustomer demand is clearly pushing in this direction. Obviously, it will be modest at the beginning, as there is no higher power who can say “take it from here and move it here”. But if clients say they want their money to be invested in energy projects in Latin America, or in agriculture in Africa, and if regulation and financial conditions make it viable, the private sector – which includes asset managers – has a role to play. This should be our aim.” “Clearly, the amount of money flowing into these kinds of projects will be small at the beginning. But we need to make sure that in time the trillions I spoke about in my previous answer become just that. Otherwise, the current refugee crisis may well be a mere taste of things to come. And this brings me to the blueprint I developed with Ronnie Cohen,2 which probably sounds a bit simplistic but I think is useful.” “In the 19th century, investors focused on ‘return’. So, it was OK to make steam engines that produced smoke in abundance and it was OK to dig coal mines in dreadful conditions; it was only ever about return. In the 20th century, investors started focusing more on the combination of ‘risk and return’, which led to the creation of things such as venture capital or private equity, which otherwise wouldn’t have got through the filter of a simple ‘return’. What Ronnie and I say about the 21th century is that every euro or dollar invested should take into account not only return and risk, but also impact. And it is this ‘risk-return-impact’ trinity that needs to be the new compass for investors. The three concepts form a whole, they are complementary.” Does this mean that all asset managers will have no other choice than to embrace sustainability investing? “On a 20 to 30-year horizon, I think it’s a given. But let’s not be naïve, it won’t happen overnight. People have to get used to it – they will have to test it and realize that it actually works. We’ll need to develop new products and new ecosystems on a more industrial scale. We’ll also need new breeds of rating agencies that specialize in assessing sustainability risks. I think this is a task for the next market cycle.” Although we’re still at a very early stage, we’re already seeing major disparities in the quality of what is proposed by asset
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managers in terms of sustainability. There seems to be a lot of enthusiasm but few rigorous approaches. What’s your take on this? “I’m not really surprised. We are on the cusp of a very positive transformation, so it is quite natural that things are a bit all over the place. We are seeing a flurry of new concepts that people don’t always understand, from ESG to PRI and impact investing. At the same time, we must make sure that we don’t wake up with a hangover in five years, thinking we’ve been brainwashed. The current commotion will have to stop at some point, regulators will need to set the tone.” So regulators will have to step in? “Yes, of course. That’s normally how things go. I am not against creativity, but this creativity should not be dishonest.” Looking back over the past decade, would you say asset management has made significant progress in terms of sustainability investing? “I think there has been some progress. Sustainability has become a key concern. It’s just an example, but I’m now asked to speak at conferences much more frequently. At the same time, a recent study said that 80 or 90% of pension funds have not yet integrated climate change into their policies. So, while we can celebrate things like the rise of green bonds, blue bonds and social impact bonds, we should also remember that this is still just a drop in the ocean.” “My hope is that we will soon pass the tipping or trigger point and move on to the next level. From that perspective, the example of green bonds is quite interesting. Green bonds were initiated by the World Bank in 2008. From 2008 to 2012/13, it became a market worth a few billion US dollars in issuance each year. And then suddenly in the run-up to COP 21 a number of major insurers made commitments, and we have now reached an annual USD 200 billion in just five years.” What do you think are the key factors that distinguish a good approach to sustainable investing from a bad one? “I don’t think we can say there is only one good approach. There are several good approaches. When is an investment sustainable? In some clear-cut cases, the obvious answer is sustainable investment and in others it’s a different approach. But a very large part of all investments falls in between the two, and it is very difficult to say where you should draw the line. So, you have to be very honest and accept that you don’t have all the answers, and that you will probably make mistakes at some point.”
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Great Minds
“Let me be a bit provocative and use the thermal coal example. We know that coal is bad for climate change, so the logical reaction is to stop investing in coal. This is one of the first, quite visible moves big banks and insurance companies like to make. It's a good idea but you have to push the reasoning further: is it better to have a responsible investor that remains invested in coal while encouraging the coal industry to move towards a cleaner, more responsible approach? Or, is it better to withdraw, tick the box and let less scrupulous investors do it instead?” “I say this because the coal industry is still heavily subsidized. And if you look at energy consumption forecasts for the next 30 years, coal will continue to account for 25 or 30% year in and year out. So, there will be investments in coal, but they will simply not be made by sustainable investors. Once again, this brings us back to the global allocation problem; how to bridge the gap between individual behavior and collective goals.” Critics of sustainability investing often oppose profitability and social and environmental impact. Would you agree? “Well, that’s not an easy question. My answer is that sustainability investing requires a whole set of financial tools. Some sustainable investments simply cannot be financed by the market. A primary school in an African country is not something the market will fund, let’s be honest. For this, you need public or private donations. But that’s certainly not the only kind of sustainable investment you can make. There’s a whole range of possibilities, from public schools to deep-water ports in exporting emerging countries. For the latter, market forces can work perfectly.” “So, you really need the whole toolbox: public or private donations, public or private concessional funding that seeks to have an impact and therefore accepts lower remuneration, and standard market compensation. And you have to be able to combine these tools, which can be complicated because it means bringing together players from very different cultures – cultures that are sometimes even suspicious of each other. You might hear things like ‘You are just a ruthless capitalist!’, ‘You are just slow and corrupt bureaucrats!’ or ‘You are an NGO and you are very generous, but so naive!’” “You need to get all of these different players talking to each other, which is possible. And if you can speak all the different languages – private-sector language, public-sector language and NGO language – you can really make a difference. But let’s face it: it’s difficult. It's like salad dressing: you have to shake the oil and
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vinegar to get the desired result. These ingredients don’t naturally mix.” Investors often face the paradox of wanting to finance sustainable investment projects in emerging countries but finding themselves confronted with, for example, local governance standards that are incompatible with their ESG approach. How can this be addressed? “Of course, our big developed countries are obviously so much more virtuous and have perfect governance systems and no corruption (he smiles). I think we have to be able to look at ourselves in the mirror. Some years ago, for example, Norway agreed a large publicprivate partnership on gas concessions. Two years later, they changed the pricing conditions and they are now being sued by half the world. Does this change the general perception of Norway? No, because Norway is rich and nice. So, we need to be modest as well. In developed countries, we are forgiven because we are rich and powerful. But if something similar happens in Senegal or in Bolivia, for example, people will say: these guys can’t behave themselves.” “That being said, let’s not pretend perceptions don’t exist. As I often say in conferences, perception matters and it’s true that many of these countries face huge challenges in relation to political stability, the rule of law or corruption. But what you have to keep in mind is that these risks also explain why investments are also typically better rewarded in emerging countries than in developed ones.” Yes, but what I mean is how can investors be consistent and finance projects in countries where those resources are needed while at the same time remaining faithful to their ethical principles? “You are right. There is no simple answer. And that’s why efforts by international and multilateral institutions are so important in helping improve the situation. The reality is that there has been some significant progress in this area. In Africa, there is more and more contrast between those countries that are emerging from the pandemonium they have been stuck in and those that are still in great difficulty.” “But let me give you a more concrete example. A few years ago, the rating agency Moody’s published an excellent study3 in which they analyzed the default and recovery rates for over 4,000
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‘There are risks the financial sector simply cannot dismiss’ a meeting of the Financial Stability Board. There was a general lack of interest among central bankers, who did not feel at all concerned by these issues. They thought their decision-making horizon was somewhere between one and five years, certainly not the timescale needed to address climate change.” “At the end, Mark Carney, the governor of the Bank of England and chairman of the FSB, made a memorable speech titled ‘The tragedy of the horizon’. His message was the following: a trader deals with the next second, a CFO deals with the next quarter, a CEO deals with the next year and a central banker deals with the next three years. And since addressing climate change involves making decisions on a 10-, 15- or 20-year horizon, it does not interest anyone. Well, that’s a false perception, according to Mark Carney. There are risks the financial sector simply cannot dismiss.”
project finance bank loans between 1983 and 2011. One of the main conclusions was that the average years to default and ultimate recovery rates were quite similar in both OECD and nonOECD countries. This means it is possible to invest in developing and emerging countries with satisfactory conditions in terms of governance, rule of law, etc.” Let’s say I am an asset owner wanting to embrace sustainability investing. Where should I start? “Most so-called asset owners own their assets only by proxy. So, they should probably start by acknowledging what the ultimate asset owners – you and me – are looking for, and what matters to them. In that sense, the realization that we are in a fragile world, that from early August every year we start to overuse the Earth’s natural resources, is bound to have an impact.” “Let me tell you an anecdote that will illustrate how important it is for governments, as well as public and private institutions to realize this. Back in 2015, we were discussing climate change at
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“First, there’s the physical risk. There is little doubt that the recent increase in the frequency, intensity and cost of natural disasters can be attributed at least in part to climate change. So, for insurers and reinsurers, it's already a problem today, not in 20 or 30 years. If an insurer or reinsurer is hit by a huge natural disaster, this has an impact on the system. Second, there’s liability risk. You let me build a house by the sea in 2017, while COP 21 said that the sea level was rising. You knew this but still you let me do it, so now I'm suing you.” “Third, there’s transition risk. If we are serious about limiting global warming to 2 degrees Celsius, we know we won’t be able to burn all of the existing fossil fuel reserves. So, we also know that a significant part of the reserves on many companies’ balance sheets are actually worth nothing. And I am not talking about millions of US dollars here; I am talking about trillions. How do we address this? You see, even if climate change may seem like a very distant threat, in reality it is already upon us.” 1 ‘From Billions to Trillions: Transforming Development Finance’, report prepared jointly by the African Development Bank, the Asian Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the Inter-American Development Bank, the International Monetary Fund, and the World Bank Group for the 18 April 2015 Development Committee meeting. 2 Sir Ronald Cohen is an Egyptian-born British businessman and political figure. He is one of the founding fathers of British venture capital and a pioneer of impact investing. 3 See: ‘Default and Recovery Rates for Project Finance Bank Loans, 1983–2011’, Moody’s Special Comment, February 2013.
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Positioning for a shift towards value stocks Now is a very good time for investors to introduce value stocks to their portfolios, says Robeco strategist Peter van der Welle. Investors adopting a more defensive investment strategy would be wise to gradually make space for value stocks in 2019.
changes. If the US economy continues to fire on all cylinders, the Fed will have no choice but to gradually, but resolutely, continue hiking rates to a level that will, on balance, put the brakes on the real economy. Historically, this transition to net tighter monetary policy has been a favorable environment for value stocks.
Speed read
Research
• Value stocks lagged growth stocks by 35% since 2009 • Changing economic picture might now favor value stocks • Investors do wise to adopt a more defensive approach
Value stocks have lost a staggering 35% against growth stocks in bull markets since 2009. Due to this long period of lagging returns, the relative performance of value versus growth stocks now seems completely out of balance. First, a similar performance in around 2000 heralded a rotation out of growth stocks into value stocks. This rotation also took place in a macroeconomic environment that we can typify as ‘late cycle’ – a phase we also seem to have reached now. Second, the price-earnings ratio of the MSCI Value Index is currently some 20% below that of the MSCI World Index, which represents an above-average discount level. While value stocks should be cheap now, too, based on other valuation criteria such as dividend, price-cash flow ratio and book value, they look even more attractive compared to their historical average discount.
Rising rates will hurt the more rate-sensitive momentum and growth stocks and gradually more fine cracks will appear in this momentum-driven bull market, thereby increasing the downside risk. This environment will thus also set the stage for restoring more balance between the typical initial indifference of investors to value stocks and their corresponding disproportionate enthusiasm for growth and momentum stocks.
Rotation Nevertheless, there are also a number of risks that may hamper a value-stock comeback. As long as momentum stocks continue to forge ahead, there are few gains to be made for value investors. The leadership of momentum-driven growth and technology stocks in this bull market could persist given the negligible variation in sector rotation that has so far characterized the current market. Second, short-term investing has become so commonplace in this market that there doesn’t seem to be any place for an investment style − like value investing − that requires patience.
Rising interest rates As we look further on the horizon, the economic picture slowly Figure 1 | S&P 500 Value vs. Growth index 100 95 90
Third, discount rates for the future cash flows (that result from the current low interest rates) of companies are still so low that, despite the rise in interest rates we envisage, they continue to boost the more interest-rate sensitive growth and momentum stocks.
85 80 75 70 65 60
2009
2010
2011
2012
2013
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Rebase (S&P 500 Value/S&P 500 Growth), 01-01-2009 = 100
2015
2016
2017
2018
We think now is still a very good time for investors to introduce value stocks to their portfolios. While there is no urgency for this rotation, investors adopting a more defensive investment strategy would be wise to gradually make space for value stocks in 2019.
Source: Thomson reuters Datastream, Robeco
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LAST BUT NOT LEAST Panem et circenses In many areas of our lives, we see the boundaries between the digital and the real world starting to blur. eSports is a nice example of this, in that digital or computer games are moving back into the real world through large-scale physical events in stadiums. In essence, however, the two worlds have become so intertwined that the distinction between the two is becoming meaningless. In 2017, there were an estimated 385 mln eSports viewers worldwide, while the top digital athletes – our modern-day gladiators – can earn up to USD 500,000 per month with streaming services. Prize pools of recent tournaments have reached the USD 100 mln mark.
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eSports – the next generation of gaming monetization Vera Krückel
Already strengthening the biggest franchises, eSports will bring diversified revenues to the gaming ecosystem. The developers of games with the largest fan base will be the big winners. Gaming platforms, microchip companies and gaming accessory makers also stand to benefit. Like virtually all areas of our lives, entertainment – including gaming and sports – is going digital. The eSports phenomenon is taking the world, especially Asia, by storm, with tens of thousands of people packing into stadiums to watch star players compete in their favorite games. Hundreds of thousands more watch online via streaming platforms, such as Twitch and YouTube Gaming.
The digitization of sports
eSports is the next step in strengthening gamers’ business models, which have already benefitted from more stable, better diversified revenues and less dependency on the launch cycles of top (or flop) new games. In our view, there are four distinct steps on the path to higher-quality business models for game developers:
1. The shift from physical to digital downloads Over the last ten years, game sales have transitioned from physical retail sales to digital downloads. Cutting out the middlemen has boosted margins, but with digital downloads now accounting for over 70% of game sales, much of the uplift for developers is now largely a thing of the past. However, digital delivery brings further benefits for developers, building a feedback loop with gamers that enables developers to respond to their suggestions for improvements, thereby keeping them engaged with tweaks and online updates. Digital engagement has helped developers manage the risk of not meeting gamers’ and investors’ expectations, contributing to gross margin expansion of 20% for many game developers.
‘Advertising and merchandising are major sources of new revenue for gaming companies that are diversifying their income’
Star digital athletes like Ninja, Faker and Kuro Takhasomi wow fans playing games such as League of Legends, Dota 2, Fortnite, Overwatch, Counterstrike or Honor of Kings. In 2017, eSports attracted an estimated 385 million viewers worldwide, with top digital athletes earning up to USD 500,000/ month from streaming. Recent tournament prize pools have even reached USD 100 mln.
Game developers own the eSports games For investors, the primary eSports actors are the companies that develop the games. In the Western world, the dominant developers are Activision Blizzard and Valve Corp, owners of Overwatch League and Counter Strike, although rivals Electronic Arts, Ubisoft and TakeTwo are ‘upping their game’. In Asia, Tencent (owner of Honor of Kings) is by far the biggest player, while the US and European markets are relatively fragmented. Now let’s explore the games developers’ business models, examine how eSports influences game monetization and analyze who stands to benefit most from its meteoric rise. We’ll also discuss eSports-related investment opportunities beyond the developers themselves.
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2. The contribution from in-game purchases and the effect on operating margins In addition to the initial game purchase price, developers can benefit from add-on in-game microtransactions. However, there’s a balance to be struck as some developers optimized game design for microtransactions rather than game quality and user experience, paying a reputational price in the gamer community and even running the risk of losing their fan base. Certain practices have even forced the regulator to step in.
3. Gaming subscriptions: greater consolidation and higher quality Much of the tech industry is shifting to the ‘software as a service’
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eSports in (very big) numbers USD 100 mln – Tencent-owned developer Epic’s Fortnite eSports tournament prize pool USD 655 mln – estimated annual revenue generated by eSports in 2017 USD 110 bln – the size of the total global gaming market in 2017 USD 1.5 bln – Newzoo’s estimate of the size of the eSports industry by 2020 USD 3.6 bln – the annual run rate revenue generated by ‘free-to-play’ game Fortnite EUR 500,000 – top gamer Tyler Blevins’ monthly earnings, streaming Fortnite on Twitch 2.2 bln – the number of active gamers worldwide in 2017
business model and such a move to a subscriptionbased service could address the ‘initial purchase versus in-game add-ons’ balancing act. Subscription models bring benefits for suppliers, such as stabilizing revenue streams and raising barriers to entry on the basis of repeat purchases rather than one-off sales. Gamers are likely to get better quality games as subscriptions push developers to keep the updates coming as a means of maintaining player engagement. But gaming-as-a-service works best if developers offer players a broad range of games, thereby potentially supporting moves towards industry consolidation focused on the owners of gaming intellectual property. That said, the need for higher-quality offerings might necessitate developers spending more on game design, potentially squeezing margins. An alternative model would see distribution platforms offering subscription services featuring a very broad range of games from multiple developers.
– new customers with much deeper pockets – can be new sources of revenues. Media rights and advertising have the potential for substantial growth, benefitting content owners via royalties as league operators, among others, share revenue streams.
The monetization of eSports Despite the impressive figures, eSports is still a young industry and in the early stages of growth, with penetration of just 5% of the 2.2 bln total active gaming population. However, penetration of 20% in mature markets, such as South Korea, and continually strong growth rates of 30%+ are indications of the potential for years to come, particularly as eSports fans are by no means all active gamers, in much the same way that football fans don’t necessarily play the game themselves. Moreover, revenue conversion of USD 1.80 per fan remains low compared to USD 54 per fan for traditional sports, due mainly to eSports’ lack of formalization and organization, a situation that is rapidly changing.
4. eSports to further diversify gaming companies’ revenues In the near term, the most significant effect of eSports will be to strengthen the protective ‘moat’ around existing game franchises, extending their life expectancies on the back of greater user engagement. With a game franchise potentially lasting decades, the returns on the development costs can be hugely improved, up to as much as 18% of revenue as in the case of publisher Activision Blizzard. Moreover, sponsors, advertisers and media broadcasters
Professionalization of eSports
Figure 1 | Digital vs. physical video game sales 100 80 60 40 20 0
2010 Physical
2011 Digital
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Source: Barclays Research
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In the context of the entire gaming market, eSports revenues remain low. However, things are changing − the setup of industry organizations, official leagues and tournaments with online/TV streaming rights are among the catalysts for eSports to boost its monetization potential. Globally, the opportunity is significant. Gaming market intelligence bureau Newzoo sees eSports as a USD 1.5 bln+ business in 2020. As the sector is new and unpredictable, longer-term estimates vary widely, ranging from USD 3 bln in 2022 to USD 20 bln in 2025. But, impressive as these figures are, they are modest compared to the USD 140 bln projected for the overall gaming market by the end of 2018. 2016 However, besides being a new source of revenues,
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‘Beyond the game developers themselves, we see a wide and growing range of eSportsrelated investment opportunities’
eSports offers incremental value, mainly due to the high level of engagement, the social nature of the games and the highly attractive demographics of users. With young, digital and wealthy eSports fans particularly valuable to advertisers struggling to reach the younger generation through traditional channels, more eSports advertising deals have been closed in recent years, a trend that looks set to continue.
Whereas traditional sports generate money from media rights, mainly for TV, the internet is eSports’ main medium, with lucrative licensing deals with streaming platforms like Twitch taking shape and traditional outlets like ESPN also entering the arena. But eSports’ digital nature makes for a highly engaged user base, with gamers forming groups and communicating both with star gamers and the audience. This aspect should not be underestimated given how the degree of ‘socialness’ has determined the success or failure of a great deal of web content over recent years. We therefore expect media rights and advertising to be eSports’ fastest-growing revenue stream.
Investment opportunities in the eSports ecosystem Beyond the game developers themselves, we see a wide and growing range of eSports-related investment opportunities as participants in the field become more numerous and diverse. In addition to the game publishers themselves, opportunities include hardware manufacturers, streaming platforms, event organizers and league operators, plus sponsors and marketers.
of making it big in eSports. Unlike in traditional sports, in eSports those who own the content − or ‘own’ the users − have the strongest negotiating position.
Meanwhile, given their recurring revenue streams and network effects, distribution platforms can also represent interesting investment opportunities, although few pure plays are available given that Twitch and YouTube Gaming are owned by Amazon and Google respectively, and, purely in the context of these colossal wider businesses, are immaterial. Digital gaming download platform Steam, part of privately held game developer Valve Corp, is nevertheless a very attractive asset. The Chinese market is less consolidated than Western markets, with three players vying for the top spot. Huya’s streaming platform recently went public, although given the winner-takes-all model, the risk of fierce competition remains. Should subscription-based models succeed in gaming, we believe that distribution platforms could play a leading role given the range of games required to press home the advantage, although given the difficulty of incentivizing publishers to hand customer contact to the platforms, the lack of content ownership is a major downside. Figure 2 | Comparison of revenue per eSports fan vs fan of traditional sports
60 50 40
We believe that the strongest gaming franchises will become even stronger, with eSports acting as a catalyst for industry consolidation as the social aspect makes eSports a game of scale. Therefore, in our view, competing with the larger franchises will become increasingly difficult. Given rising barriers to entry, and with consideration to the importance of games offering quality ‘spectator modes’, we believe that the biggest franchises with the most followers and longest lifespan have the best chance
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30 20 10 0 2017 Sports
2017 Esports
Source: Berenberg and Newzoo
Robeco QUARTERLY • #10 / DECEMBER 2018
eSports – surprising facts
eSports – opportunities in hardware and beyond
• eSports will be part of the 2018 & 2022 Asian games. Participation in the Olympics is under discussion. • Allied eSports has built nine eSports arenas globally, including a flagship venue in Las Vegas. • PlayerUnknown’s Battlegrounds (PUBG) has more viewers than players. • Tencent says that 29% of eSports users are parents, while 24% are female. • Twitch reportedly paid USD 90 mln for Overwatch League seasons 1&2 streaming rights. • Activision Blizzard reported that gamers spent 40 bln hours playing their games in 2016.
For those concerned by the unpredictability as to which game will become the next hit in gaming and eSports, semiconductor companies such as Nvidia and Advanced Micro Devices (AMD) stand to benefit from the increased popularity of gaming, regardless of which particular game becomes the next big thing. Graphics-intensive professional gaming requires high-end graphics processing units (GPUs) which generally carry higher price points and margins for the semiconductor companies. Meanwhile, league owners represent further investment opportunities; as eSports professionalizes, third party tournament organizers such as Madison Square Garden and Modern Times Group (owner of Electronic Sports League, or ESL) will enjoy rising demand for their services. These companies’ revenue streams come from media rights, ticket sales, sponsorship, advertising and merchandise revenue, all of which should grow substantially. However, some bigger publishers such as Riot and Activision Blizzard have limited the availability of their games to their proprietary-owned leagues, thereby cutting out independents such as ESL. Moves of this kind are clearly a risk for league owners. Additionally, given that they do not own any intellectual property (IP) themselves, league operators run low-margin businesses. Returning to hardware, specialized gaming component manufacturers, such as Logitech, Asus, Acer and Intel, represent another segment benefitting from the uplift eSports will bring to the gaming industry. However, makers of mice, keyboards and headsets will see the benefit partially reduced by the transition of gaming and eSports to mobile devices. Not only do we expect gaming to become increasingly mobile over time, we also expect the same games to become more platform agnostic, i.e. playable across different types of hardware and operating systems. For example, you might play the same game on your PC or game console at home, on your iPad at a friend’s place and on your mobile phone while commuting to work. You can pick up your game
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where you’ve left off on any other device. This capability will have a real impact on the ‘hardware barrier to entry’ that was previously enjoyed by Microsoft (Xbox) or Nintendo. As in so many other industries, software or IP is becoming much more important than hardware. Also, eSports is starting to become more popular on mobiles, especially in Asia. This could potentially expand the user base since there is no incremental upfront spending required as there is with gaming consoles, for instance, and the market penetration of mobiles is much greater than that of PCs. On the other hand, mobile gaming is a notoriously fragmented market: games are more casual, gamers quickly switch between the games, particularly the lower quality ones, but they are more social overall. Profitability in mobile gaming is therefore very skewed in favor of a relatively small number of games. However, we see considerable long-term potential in virtual reality for gaming applications, to the benefit of equipment makers such as Microsoft (HoloLens), HTC (Vive), Facebook (Oculus), Samsung and Google (Cardboard). In our view, gaming will be one of the first major use cases for virtual reality. While the technology is still in its relatively early stages, virtual reality promises to be big. Games could become much more interactive and engaging as spectators could participate in them, either to support star gamers or play the role of the adversary. As often happens with very new technologies, virtual reality will likely see the rise of completely different games and game developers. Refitting an existing game franchise to a new technology generally has its disadvantages compared to designing a game from scratch, purpose-built for the new technology. Therefore, virtual reality, while offering massive opportunities, could have a disruptive effect, too. What we can say for sure is that cards will be reshuffled as virtual reality technology and the eSports market continue to rapidly develop.
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Wilma de Groot
’We have a much better proposition than passive’ Interview
Robeco’s Enhanced Indexing Equity strategies have enjoyed renewed popularity in recent months, with inflows totaling nearly EUR 4 billion over the past year, thanks to a series of major mandate wins. We talked to Wilma de Groot, Head of Core Quant Equities at Robeco, about the reasons for this success.
How do you explain the recent string of large mandate wins for Robeco’s Enhanced Indexing Equity strategies? “I think this is because investors increasingly acknowledge the merits of this approach as a valid alternative to passive strategies. It shows that in the current massive shift away from traditional active management to seemingly cheap passive strategies, a growing number of investors are looking for better options. And in my view, they have good reasons for doing so.” Because despite its growing popularity among investors, passive investing is far from perfect, right? “Passive strategies have their merits. I don’t dispute that. They offer attractive fees with portfolio return-risk characteristics that are close to the market portfolio. Furthermore, with passive strategies, you know what to expect. But at Robeco, we think investors can do much better than simply following a marketcapitalization index. More specifically, we identify five major concerns associated with this kind of approach. These concerns have been extensively documented in the academic literature and investors should not overlook them.” “The first concern is that passive investing inevitably lags the market index, due to management fees and transaction costs. Second, because they are fully transparent, passive strategies are prone to arbitrage by opportunistic investors who anticipate trades once changes in an index have been announced. Third, passive investing ignores decades of academic insights on market anomalies and factor premiums. As a result, replicating the market index implies investing a significant part of a portfolio in stocks with negative expected returns.”
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“The fourth concern is that passive strategies do not take sustainability considerations into account. At best, they can apply very basic negative screening in the form of rigid exclusion lists. Finally, passive investors cannot engage efficiently with companies. Since passive strategies track the results of thirdparty indices based on variables such as market capitalization and liquidity, passive investors can’t do much to influence the management of the companies they own.” So, do the Robeco Enhanced Indexing strategies address all these concerns? “Yes. Enhanced Indexing strategies address all the pitfalls I just mentioned and, at the same time, the portfolio’s characteristics are similar to those of the market portfolio. So, while we do not offer passive strategies, we think we have a much better proposition. Some of our recent mandate wins, where we were competing directly with passive asset managers, show that clients from around the world and with very different backgrounds are increasingly acknowledging this. Wholesale advisors are also realizing the added value of our proposition compared to basic passive strategies.” “The idea behind Enhanced Indexing is to systematically capture the market return and benefit from factor premiums. Enhanced index portfolios take the selected capitalization-weighted market index as their starting point. They then give slightly more weight to stocks with attractive stock characteristics and slightly less to those with unattractive characteristics. This enables us to deliver stable outperformance after costs, with a low tracking error, as only slight deviations from the benchmark are allowed.”
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‘For some of our recent mandate wins, we were competing directly with passive asset managers’
“For more than 15 years now, our Enhanced Indexing strategies have actually proven their ability to consistently and significantly outperform their reference index, both in developed and emerging markets. Recently, we also launched a series of regional Enhanced Indexing strategies that focus on specific equity markets, such as Europe, US or China. Carveouts based on the realized long-term performance of our existing strategies indicate that the concept of Enhanced Indexing not only works for broad global investment universes, a but also at a more local level. Even for the US market which is perceived to be very efficient, the strategy shows strong results.” What about sustainability aspects? This has clearly become a major issue for investors in recent years… “At Robeco we take sustainability very seriously. And within Enhanced Indexing portfolios, we incorporate ESG factors in the
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investment and decisionmaking process at every step of the investment process. First, sustainability scores are taken into account when determining the quality characteristics of companies in developed markets. Second, when building the Enhanced Indexing portfolio, we make sure that the weighted RobecoSAM sustainability score of the portfolio is always better than that of the index.” “In addition, we have advanced Sustainable Enhanced Indexing strategies available which even take sustainability integration several steps further. In those strategies we apply a broader exclusion list and we ensure that the weighted RobecoSAM sustainability score of the portfolio is 30% better than that of the index. On top of that, based on four different dimensions (e.g. greenhouse gas emissions), the environmental footprint is 20% lower than that of the index.”
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Column
Merkeldämmerung The twilight of the Merkel era (playfully referred to in German as Merkeldämmerung) could be added to the list of political risks for the Eurozone in 2019. After 13 years as chancellor, part of which during the worst recession since the Great Depression of the 1930s, it is difficult to imagine life without Mutti (mummy). As if – with the populist revolt sweeping across the world – there aren’t enough reasons to worry about political stability in Germany and the Eurozone. If we look more closely, however, there is less reason to panic. Firstly, whatever Merkel’s merits in a broader political sense, it is difficult to be impressed by her handling of the euro crisis, which has been characterized by rather nervewracking ‘just-in-time management’. In particular, the much too lengthy crisis in Greece – a country insignificant in an economic sense but geographically (geopolitically) indispensable part of NATO on its southern flank – has been allowed to run completely out of control. OK, Merkel gave an approving nod to ECB President Mario Draghi when he made his famous “whatever it takes” comment. But one of the consequences has been an overreliance on monetary policy. On the fiscal side, the Eurozone has turned into a larger Germany, with an impressively – some would say irresponsibly – large current account surplus. Under Merkel’s leadership, a chronic lack of sufficient aggregate demand has become a structural weakness of the Eurozone – a deflationary bias, as was feared by many economists when the Maastricht Treaty was signed.
Proposals by French President Emmanuel Macron to create a sufficiently large macroeconomic stabilization fund on a European level have been blocked by Merkel. As has the completion of a banking union and the creation of a deposit guarantee for the Eurozone. The architecture of the Eurozone remains dangerously incomplete and Merkel’s attitude has been reactive, defensive and cautious. The new finance minister, the Social Democrat Olaf Scholz, has changed nothing. His lack of ideas has been impressive. We shouldn’t expect any exceptional initiatives from the Merkel-Scholz team. Secondly, there is broad consensus within the German electorate on the EU, NATO, the euro, the strategic importance of the Franco-German alliance and other matters. It is impossible to predict who will be the new chancellor: Merkel-clone Annegret Kramp-Karrenbauer – also known as ‘AKK’ – who like Merkel lacks “the vision thing”? The pro-business Friedrich Merz, which would be interesting seeing that Germany has “too few answers to the proposals of Emmanuel Macron”? Or, much less likely, the CDU’s young, openly gay and ‘burkaphobic’ anti-Merkel populist Jens Spahn? Whoever takes up the baton could never be as inclined to continue the current Reformstau (reform jam) on a European level. Every change would be an improvement, especially in the case of Merz. Thirdly, we are highly likely to see general elections in Germany before the end of next year, prompted by the new CDU party leader or the increasingly unhappy coalition partner of the current government, the SPD. The meteoric rise of the center-left Greens in the polls is an interesting political development in Germany and makes a so-called ‘Jamaica coalition’ (black-blue-green: CDU/FDP/Greens) much more likely. I would expect the Greens to be much less of a disappointment to Macron than the current SPD. Moreover, Germany would really fast-track implementation of its policy to reduce the economy’s dependence on coal (don’t be overly misled by all those windmills). There are reasons to be hopeful about political developments in Germany.
Léon Cornelissen, Chief Economist
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Additional Information for investors with residence or seat in Singapore This document has not been registered with the Monetary Authority of Singapore (“MAS”). Accordingly, this document may not be circulated or distributed directly or indirectly to persons in Singapore other than (i) to an institutional investor under Section 304 of the SFA, (ii) to a relevant person pursuant to Section 305(1), or any
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CONTACT Robeco P.O. Box 973 3000 AZ Rotterdam The Netherlands T +31 10 224 1 224 I www.robeco.com