Robeco quarterly june 2017 by Robeco

Robeco

Intended for professional investors only

QUARTERLY THE FUTURE IS BRIGHT – 40 CREDIT OUTLOOK: BOOM & BUST – 7 DON’T CRY FOR ARGENTINA – 19 ELROY DIMSON ON FACTORS – 28 LONG READ: IS ROBO-ADVICE HERE TO STAY? – 36

QUANT investing SUSTAINABILITY investing #4 / June 2017

“Valuation is never a good timing indicator. Buying Europe simply because it is cheap has been a loss-making exercise for the better part of the last seven years. However, cheap valuation combined with improving economic sentiment, falling political risks and overall momentum makes a compelling investment case.” Lukas Daalder, CIO Investment Solutions

Robeco QUARTERLY • #4 / JUNE 2017

No reason to be overly concerned about overcrowding

A key concern voiced by factor investing sceptics is the risk of overcrowding. The growing popularity of factors would inevitably lead to excessive bets and the disappearance of premiums. Such prophecies, however, seem to be based on misguided intuition rather than empirical research. Looking for a better Momentum factor

Monitoring benchmark underperformance risk with enhanced indexing Successfully implementing factors in credits markets

SUSTAINABILITY investing

Six ways to improve the sustainability of credit portfolios

And more…

QUANT investing

CONTENTS OPINION The outlook for credits: boom & bust TRENDS Platform power

RESEARCH Fair winds for Argentina

GREAT MINDS Elroy Dimson – Looking at the long-term evidence on factors

RESEARCH Patience and high active share is a rare combination

LONG READ Robo-advice 10.1: you get what you pay for

INTERVIEW ‘A good trend investor can only skip the sports pages’

COLUMN Lost in the Italian labyrinth

The practice of integrating sustainability principles into fixed income portfolios is gaining traction, having proved that it works in equity strategies. Robeco targets six ways of applying these principles when investing in corporate bonds. Brand management in the Global Consumer Trends Equity strategies

ESG integration is crucial in emerging equities

The pros and cons of ESG ratings for investment funds

Robeco QUARTERLY • #4 / JUNE 2017

Sustainability

Trump: #JeNeSuisPasParis The US withdrawal from the Paris Agreement is significant, as this country is the second-largest global producer of greenhouse gases, accounting for 15% of all global emissions. However, it seems that Trump is taking rearguard action, says Masja Zandbergen, Robeco’s head of ESG Integration. Other countries and regions such as China and Europe will take the lead in fighting climate change, and states and cities in the US will continue their support for a transition to clean energy. As a clear long-term commitment by governments and corporates reduces uncertainty (and therefore risk), investors are urging them to take action. Robeco recently co-signed a letter to urge all G7 and G20 nations to stand by their commitments to the Paris Agreement. World leaders agreed at the COP21 conference in Paris in 2015 to take action to limit global warming to 1.5 degrees

Ever faster Number of years it took to gain 50 million users Telephone Radio Credit card Television PC Cell phone Internet YouTube Facebook Twitter iPhone Pokémon Go

50 years 38 years 28 years 22 years 14 years 12 years 7 years 4 years 3 years 2 years 1 year 35 days

Celsius above pre-industrial levels. Ratifying nations have committed to put in place measures to achieve their reduction goals, known as Nationally Determined Contributions (NDCs). It does not seem easy for the US to withdraw from these commitments, or at least it will take time: officially three years. Another potential effect from the US exit is that the lack of regulatory incentives to a low-carbon

transition might slow down technology development in the country. The US might miss out on the drive to innovation. Furthermore, there is a financial angle to it. In the Paris accord, rich countries pledged to provide USD 100 billion a year to poorer countries to fight climate change. The US would have taken a big part in this; now other countries need to up their game.

Paris Agreement holdouts

Currently, only two nations is the world have chosen not to sign the Paris Agreement: Syria and Nicaragua. If President trump chooses to withdraw from the agreement as expected, the United States would become the third. Non-signing states • •Rest of the world

Source: Mashable

To engage or not to engage Investors increasingly wish to have a say in how companies in their investment portfolio are managed – particularly when it comes to ESG issues. Robeco’s Active

Ownership team enables them to become active owners of listed companies. The proof is in the figures over 2016.

VOTES

ENGAGES

45 (87%)

at approximately

with

out of

4,800

200

shareholder meetings in

countries

companies in

countries

engagement cases closed succesfully in 2106

(source: LinkedIn)

Robeco QUARTERLY • #4 / JUNE 2017

The value of sharing knowledge and information

“The very experienced high yield bond managers Sander Bus and Roeland Moraal are held in high regard,” Morningstar commented after it announced the two fund managers were winners of the prestigious European Fund Manager of the Year Award. Bus and Moraal feel honored to have received this award. “Thanks to our disciplined investment process and the stability of our portfolio management and analyst teams, we have been able to replicate our success”, says Bus. He stresses that the win is an achievement that should be attributed to Robeco’s credits team as a whole and is an affirmation of a long-standing investment strategy.

The investment strategy is an approach that is widely used in Robeco’s credits team which manages funds like Robeco Global Credits, Robeco European High Yield Bonds and Robeco Financial Institutions Bonds. These strategies all apply the same contrarian investment style under the motto ‘winning by losing less’. They take advantage of the low-risk anomaly: in the long run, it is the lower risk bonds that actually tend to perform better.

Robeco QUARTERLY • #4 / JUNE 2017

Editorial

Credits

Flying high

Asset managers are going to feel the effects of the new MiFID II regulations. The impact on how asset managers pay for and use external research, for example, will be huge. Under MiFID II – the Markets in Financial Instruments Directive II – asset managers are required to unbundle broker research costs from other services and either absorb research costs or set up a research payment account (RPA). The cost of the RPA can be borne by investors but it demands additional disclosure, budgeting, reporting and auditing from asset managers. And cross subsidization between funds will no longer be allowed. Hence investment professionals will not be permitted to share information and thoughts gathered from external research sources with other investment teams. This goes against our philosophy of team work and sharing knowledge and information in order to create as much added value as possible for our clients. We have extensive knowledge and experience in-house in the areas of global macro, quantitative and fundamental investing and sustainability. The challenge lies in harnessing the synergy of all of those sources. The new regulations are an additional incentive to draw on the in-house expertise. While we certainly do have specialists from every discipline, we have to avoid the pitfall of compartmentalization. That’s why we have a new building with an open-plan office and why the equities and fixed income investors all sit together. It’s why we also use our quant models for fundamental strategies, and why we also apply the ‘human overview’ derived from our fundamental research to quant. And why we use the credit analysts’ analyses for our equity funds, too. The key to success lies in pooling knowledge of all various disciplines and teams. Real progress would never be possible if the individual teams went on behaving like little islands unto themselves. No one must ever have a monopoly on knowledge or information. Combining efforts – in the firm belief that the whole is greater than the sum of its parts – involves more than just forcing collaboration by seating teams together. It also depends upon an culture where knowledge and information is freely shared. By tapping into the 'wisdom of crowds', we can achieve exponential, and not just linear, growth.

Peter Ferket, Head of Investments

The Shiller PE, or Cyclically Adjusted Price Earnings ratio (CAPE), one of the most highly regarded stock market valuation metrics, has recently risen to very elevated levels. For the US market, that is. Only prior to the Great Depression and during the dotcom bubble were valuations more stretched than they are now. Historical data implies that, with the CAPE ratio at current levels, US equities are unlikely to realize attractive returns. In fact, after correcting for inflation, these could be close to zero.

Five concerns on low volatility ETFs Low volatility

Column

CAPE Fear

Although index investing has its merits, portfolio manager Jan Sytze Mosselaar sees five potential risks for low volatility ETFs. 1. Low volatility indices are vulnerable to index arbitrage Low volatility indices, as every smart beta index, have a low capacity because of possible index arbitrage. This sounds counterintuitive, as index investing is associated with high capacity. However, this only holds for market-cap weighted indices. 2. Low volatility indices frequently go against other factors Both the MSCI Minimum Volatility and S&P Low Volatility Index can have significant negative exposure to other proven factors like value and momentum. Our research shows that this can hurt the performance of any low risk strategy substantially. 3. Limited investment universe We do not just look for low risk stocks; we want to hold low risk stocks that offer good value and momentum exposure, with a high

and stable dividend yield. A larger universe allows us to invest in the most attractive low risk stocks. 4. Too complex or too simple We consider the MSCI Minimum Volatility Index as too complex and the S&P Low Volatility Index as too simple. 5. Sub-optimal rebalancing frequency and methodology The MSCI Minimum Volatility Index rebalances semi-annually, while the S&P Low Volatility index has a quarterly cycle. We see three drawbacks: a. Between index reviews, new information on individual stock characteristics is ignored and not incorporated in the portfolio. b. Index changes have to be processed in a short period of time, which can be a challenging task for traders. c. Cash in- and outflows have to be invested according to the index composition at any point in time. This creates unnecessary turnover.

However, as with many other valuation measures, the Shiller PE is certainly not the holy grail when it comes to forecasting returns. On average, it can explain just under half of the variation in long-term returns, which demonstrates that other factors like growth, earnings and investor sentiment are also important. It is worth noting that the Shiller PE for other regions in the world is currently much, much lower, suggesting returns there will be better than in the US.

Jeroen Blokland Senior Portfolio Manager

Robeco QUARTERLY â&#x20AC;˘ #4 / JUNE 2017

The outlook for credits: boom & bust Opinion

Robecoâ&#x20AC;&#x2122;s Credit team expects inflation to pick up in the not too distant future. Monetary easing will be discontinued and wage inflation may eat into profit margins. This is good news for active managers. The team headed by Sander Bus and Victor Verberk aims to prove its added value by avoiding losers and identifying segments of the market that can still perform well in this environment.

The global economy is strong. Across the globe, economic figures are improving overall. In the US, consumer spending is still high and corporate profitability is recovering. In Europe, unemployment is steadily declining and industrial production and exports are up, even in Italy. In the meantime, the Chinese economy is still steaming ahead. Output gaps are closing with the economy growing beyond its potential. The key question is, have we reached the point where further growth will lead to inflation? We believe that ultimately this will indeed happen. For years, central banks and investors have been overestimating growth and have wrongly predicted a return of inflation. Inflation remained absent for much longer than anticipated and rates continued to decline for much longer than most investors had imagined. We are concerned that the market may now be underestimating the potential for reversal. The cycle could shift from mature to overheated. And central banks will have to respond. With the Fed in a rate hike cycle, the European Central Bank (ECB) expected to start tapering Quantitative Easing (QE) and the Peopleâ&#x20AC;&#x2122;s Bank of China (PBOC) tightening monetary conditions, monetary easing is coming to an end. Growth in itself is good for credit, but the credit cycle is mature, especially in the US. Credit spreads offer only limited potential for further tightening, especially as the quality of corporate credit continues to deteriorate, particularly in the US and China. Wage growth and higher interest rates may place pressure on profits.

Robeco QUARTERLY â&#x20AC;˘ #4 / JUNE 2017

The predictability of central banks has kept volatility in check for quite some time. This has also reduced the dispersion in markets, which made it more difficult for active management to make a difference. With monetary conditions now tightening, we should expect more dispersion between individual companies and segments of the markets, as well as less predictable correlations. That is good news for active managers such as Robeco.

Valuations are expensive On balance, spreads in all credit categories tightened over the second quarter. Valuations have therefore become more expensive. In the past, we have seen that credit markets can trade at very tight levels for an extended period of time and then suddenly widen dramatically. It is always very difficult to predict exactly when that will occur, but it is fair to say that many segments of the market are more or less priced for perfection and that there is little room for error. That means that we no longer pursue a strategy of buying the dips. That would be too risky with the end of the credit cycle approaching. We remain conservatively positioned with a preference for Europe, and a preference for financials within Europe. Even after the recent outperformance, we still believe that insurance companies trade too cheaply and generally expect a slightly more substantial recovery of financials as compared to corporates. We are most cautious with emerging debt and US high yield. Within high yield, we will maintain our underweight in the lowest credit quality. As for emerging markets, higher US yields and a strong dollar

Opinion

will place them in the line of fire. In the long term, currency devaluations will help stabilize emerging markets and restore competitiveness, but in the short term a strong US dollar and capital flows will hurt them a lot more. Trumpâ&#x20AC;&#x2122;s protectionist policies will not help emerging markets either. Currency pegs could come under pressure and capital flight will hurt current account deficit countries. Preventing capital flight is particularly important for China. Domestic debt levels are unsustainably high and money has been deployed uneconomically. This has been financed by high domestic savings. The Chinese have been lending to themselves, so a debt bubble could be solved domestically as long as the savings do not flow out of the country. Still, it is not a question of if but how the Chinese debt bubble will deflate or burst. So we continue to proceed with caution.

Monetary policy turns into a negative technical factor Monetary policy has turned into a negative technical factor for credit markets. Although the aggregate size of central bank balance sheets is still rising due to the buying programs of the ECB and the Bank of Japan (BOJ), momentum has certainly lessened.

At this point in the cycle, it is not useful to implement fiscal stimulus measures, but that is exactly what Donald Trump plans to do. The Fed is normalizing rates, which have more room to rise. Economic growth is positive for credit, but the strong technical factor will disappear when the ECB reduces its QE program. In our view, investors that have developed a high risk appetite due to the perception of low volatility pose a risk. Risk models that use implied volatility or current spreads as input are typically procyclical in nature. When markets turn, risks go up and investors can be forced out of their risky positions. We have seen huge flows into credit mutual funds in recent years, often from investors that can be classified as tourists. Low rates have pushed these investors out of money markets into higher yielding, higher risk categories.

Cautious positions We remain cautiously positioned with betas close to or just below 1 and a focus on issuer selection. In recent years, we have always advocated adding risk on weakness, as we knew that the strong technical factor on the back of central bank buying was supporting the markets. That has since changed, as a result of which we have become less daring. We are sticking to our preference for European over US credit. The US credit cycle is much more mature, as illustrated by weak corporate balance sheets. The markets are upbeat on future growth, but if for whatever reason growth fails to materialize, US credits will be vulnerable. In isolation, a long position would be justified for Europe, but when the cycle turns in the US, we know that Europe will be dragged right along with it. Therefore, we would rather express our preference for Europe as a relative value trade than as an outright long position. In emerging debt, we are preserving our short beta position and quality bias. We are approaching a time in which less monetary stimulus will also affect emerging credit markets. We prefer financials and more domestic consumer-related sectors. We are reluctant to invest in companies with a high exposure to global trade or the capital spending cycle.

Robeco QUARTERLY â&#x20AC;˘ #4 / JUNE 2017

QUANTinvesting

Overcrowded fears Could the rapid success of smart beta investment products lead to the disappearance of the market anomalies on which they rely? Should investors fear a possible overcrowding of the factor-based strategies? These are certainly reasonable questions. But while concerns over possible overcrowding are legitimate, they should not be overstated. Empirical evidence suggesting that the rise of factor-based investing might threaten the existence of some market anomalies remains conspicuously absent in the academic literature, at least for the four well-established anomalies we exploit at Robeco: value, momentum, low volatility and quality. Whatâ&#x20AC;&#x2122;s more, bets on factor premiums are still far from widespread. For example, a thorough analysis of US stock ETFs shows that, on balance, their factor exposures remain close to zero.

Robeco QUARTERLY â&#x20AC;˘ #4 / JUNE 2017

QUANT INVESTING

No reason to be overly concerned about overcrowding A key concern often voiced by factor investing and smart beta sceptics is the possible risk of overcrowding. According to critics, the growing popularity of factors will inevitably lead to excessive bets and the disappearance of premiums. Such prophecies, however, seem to be based on misguided intuition rather than serious empirical research. Rigorous analysis suggests overcrowding fears are clearly overdone, says David Blitz, Robeco’s Head of Quant Equity Research.

Do you think overcrowding poses a serious threat to factor premiums? “In a nutshell, I think such concerns are exaggerated. Allocation to factors and factor-based strategies has been done for decades, but the premiums provided by these factors have not disappeared. Moreover, if there is a rational economic explanation for eligible factors, as I think there is, there is no reason to believe such premiums will disappear even if many investors are aware of their existence.

The arguments that are used to justify overcrowding concerns are typically not evidence-based, but tend to be gut reactions. For instance, the rising valuation of low volatility stocks is cited as evidence that too much money has been poured into these strategies, while a long-term historical perspective shows that current valuations are not unusual at all. For instance, low volatility stocks were also more expensive than the market in the 1940s and 50s, when low volatility investing was still a completely unknown concept.” Could the rapid expansion of smart beta ETFs change that? “In theory it could. But let’s take a look at the evidence. In a recent academic paper1, I analyzed factor exposures of a broad sample of US equity ETFs, by regressing their returns on the returns of various wellknown factors, based on data recorded in late 2015. I found that many funds indeed offer high positive exposure to factors, such as size, value, momentum and low volatility. As such, they can be considered suitable instruments for investors seeking to systematically harvest these premiums, except perhaps the momentum premium. At the same time, however, I also found that many other US equity ETFs had a similarly high degree of negative exposure to the very same factors. On balance, the exposures to the size, value, momentum and low volatility factors turned out to be very close to zero. These findings clearly

go against the idea that factor premiums are rapidly being arbitraged away by ETF investors. They also contradict the related concern that factor strategies could be turning into overcrowded trades.” Still, impressive growth in assets under management targeting specific factors looks like a warning sign… “Yes… and no. The increased popularity of low volatility strategies clearly illustrates this. Low volatility was one of the first market anomalies to be identified. At first glance, investors looking only at the billions of dollars invested in ETFs who are specifically targeting this anomaly may rightfully be concerned about possible overcrowding. However, upon closer examination, the funds in question are found only to represent a small fraction of the total ETF market. Moreover, at the other end of the spectrum, you find a similar number of ETFs which provide exactly the opposite factor exposure, with a significant bias towards high volatility stocks. These ETFs are typically sectorfocused funds. They are obviously not labelled ‘high volatility funds’ but they do effectively neutralize the exposure of the low volatility ETFs. In other words, based on ETF data, one might just as easily argue that high volatility stocks are overcrowded, rather than low volatility stocks. Or that both are equally overcrowded, in which case the concept of overcrowding also loses its meaning.” What if some opportunistic investors start betting excessively on one specific premium? “That’s a possibility, but again, despite the fact that some factors have been identified for more than 40 years in the academic

Robeco QUARTERLY • #4 / JUNE 2017

QUANT INVESTING

literature and are now very well-known in the investment industry, we do not see it actually happening. To illustrate this, in another recent paper, I analyzed the exposure of hedge funds towards low volatility, using indices from two leading providers, Hedge Fund Research and Credit Suisse, over the ten-year period from January 2006 to December 2015. Hedge funds are by nature both opportunistic and flexible. Therefore, one would expect them to actively bet on low volatility stocks. But, as surprising as it may seem, this is not the case. On the contrary, the analysis showed very clearly that, despite their flexible approach to investing, these funds tend to bet strongly against the low volatility anomaly. This is another indication that

‘Rigorous analysis suggests overcrowding fears are clearly overdone’ the low volatility trade is still far from being overcrowded.” OK. But these findings also seem to refute one of the most frequently cited explanations for the existence factor premiums: limits to arbitrage. “That is true. Investment restrictions faced by investors, such as constraints on leverage, short-selling and being evaluated against a benchmark, are often among the

key explanations given for the existence of factor premiums. But my analysis of hedge funds returns suggests this may not be the main reason after all, since these constraints do not really apply to this category of investors. Other explanatory factors that have been proposed in the academic literature, such as portfolio managers being willing to overpay for high volatility stocks in order to maximize the expected value of their option-like compensation schemes, may be more important.” “Are Exchange-Traded Funds Harvesting Factor Premiums?”, David Blitz, 2017. (Available at: https://papers.ssrn.com/sol3/ papers.cfm?abstract_id=2912287) 2. “Are Hedge Funds on the Other Side of the Low-Volatility Trade?”, David Blitz, 2017. (Available at: https://papers.ssrn. com/sol3/papers.cfm?abstract_id=2898034) 1.

Looking for a better Momentum factor Despite the abundant academic literature evidencing a Momentum effect both in equity and fixed income markets, this factor is often treated with caution. Challenges associated with the practical implementation of Momentum strategies, such as market reversal risk, for example, can seriously damage performance and frequently deter investors. However, focusing on the idiosyncratic Momentum – based on each security’s abnormal returns – helps avoid these pitfalls, according to David Blitz, Matthias Hanauer and Milan Vidojevic.

Momentum is one of the strongest and best-documented market anomalies ever found in financial markets. The momentum effect is the tendency of stocks that have performed well in the past months to continue to do so in the subsequent period, and, conversely, of poorly-performing stocks to continue performing poorly. Although a momentum effect had already been reported in the academic literature in previous decades, this phenomenon was not extensively documented before the early 1990s. In 1993, two professors from UCLA, Narasimhan Jegadeesh and

Robeco QUARTERLY • #4 / JUNE 2017

Sheridan Titman, published what is often considered the first comprehensive study1 of the momentum effect. But while momentum can be viewed as one of the most pervasive asset pricing anomalies, it is also particularly difficult to exploit in practice. There are two well-documented issues that could hamper the successful implementation of momentum strategies. First, a momentum strategy can earn high returns, but also faces significant drawdowns when markets revert or when investor sentiment towards one particular group of stocks suddenly changes. The second issue is that momentum investing often implies high turnover and trading costs.

Introducing idiosyncratic Momentum These pitfalls remain a serious challenge for investors but recent academic studies may provide a solution. In a paper2 published earlier this year, for example, David Blitz, Matthias Hanauer and Milan Vidojevic from Robeco’s quantitative research team, addressed the debate over the workability of the momentum factor from a different perspective. They focused on stock-specific – or idiosyncratic – momentum. This concept is not new. Back in the mid-2000s, Roberto Gutierrez and Christo Pirinsky, two academics from the

QUANT INVESTING

University of Oregon and the California State University, had already identified a momentum effect in stock returns that was different from conventional momentum.3 Based on securities data recorded on the NYSE, AMEX and NASDAQ stock exchanges from 1960 to 2000, the two researchers found that portfolios based on stock-specific abnormal returns tend to outperform those based on raw returns over the longer term. In other words: portfolios based on stock-specific momentum achieve higher risk-adjusted results than conventional momentum investment strategies.

Two distinct factors These findings were later reconfirmed and expanded in a 2011 paper4 by Robeco’s David Blitz, Joop Huij and Martin Martens. But until recently, the research left important questions unanswered. For example, it failed to establish whether momentum and idiosyncratic momentum are different manifestations of the same factor, or actually represent two distinct factors. This central issue is at the heart of the new study published by Blitz, Hanauer and Vidojevic. Focusing on US market data for the 1925-2015 period, the three authors show that building portfolios

based on idiosyncratic, as opposed to total past returns, generates comparable average returns with half the volatility of a conventional momentum strategy. More importantly, they find that idiosyncratic momentum is truly a distinct phenomenon, that cannot be explained by any of the well-established factors, such as market, size, value, profitability or investment. Moreover, Blitz, Hanauer and Vidojevic also argue that the various explanations

an ‘underreaction’ to news and stocks with returns that may reverse as a consequence of a prior overreaction or simply a longterm reversal.

Out-of-sample confirmation Another important contribution of this new paper is the confirmation that idiosyncratic momentum shows robust performance in several international stock markets. Based on over two decades of out-of-sample data from four investment universes – Europe, Japan, Asia Pacific exJapan and emerging markets – to build distinct portfolios, the researchers found that idiosyncratic momentum still generated higher risk-adjusted returns than conventional momentum in all the regions considered. Moreover, the returns achieved by idiosyncratic momentum strategies in these different markets cannot be explained by the market, size, value, and total return (conventional) momentum factors.

‘Idiosyncratic momentum is truly a distinct phenomenon’ frequently given in the academic literature for the conventional momentum effect do not seem to be the real drivers of idiosyncratic momentum. Indeed, the strong link between conventional momentum and investor overconfidence and overreaction, as well as risk-based explanations, is much weaker for idiosyncratic momentum. These findings support the ‘underreaction’ hypothesis, already mentioned by Gutierrez and Pirinsky in their 2007 paper, as a major reason for the idiosyncratic momentum anomaly. The ‘underreaction’ hypothesis assumes that the diffusion of relevant information concerning stocks or bonds remains very gradual across the investment community. This explains why prices tend to adapt only slowly to news. As a result, conventional momentum and idiosyncratic momentum should be regarded more as complements than substitutes. For example, idiosyncratic momentum could be used as a tool to distinguish between conventional momentum stocks with high future returns potential, because their price movements are more likely the result of

These results are particularly significant for Japan, where conventional momentum was found to work only under specific conditions, which raised concerns over a possible data mining issue. Blitz, Hanauer and Vidojevic find that the idiosyncratic momentum of Japanese stocks included in the FTSE World Developed Index generated a statistically significant 0.44% return per month during the December 1989-December 2015 period. Ultimately, the reduced time-varying exposures to systematic risk factors of idiosyncratic momentum enhance the effectiveness of the strategy to such a great extent that they even solve the momentum puzzle in Japan. ‘Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency’, Narasimhan Jegadeesh and Sheridan Titman, Journal of Finance, 1993. 2. ‘The idiosyncratic momentum anomaly’, David Blitz, Matthias Hanauer and Milan Vidojevic, 2017. 3. ‘Momentum, reversal and the trading behaviors of institutions’, Roberto Gutierrez and Christo Pirinsky, Journal of Financial Markets, 2007. 4. ‘Residual Momentum’, David Blitz, Joop Huij and Martin Martens, Journal of Empirical Finance, 2011. 1.

Robeco QUARTERLY • #4 / JUNE 2017

QUANT INVESTING

Tackling the risk of lagging the benchmark with enhanced indexing Factor-based allocation has become increasingly popular in recent years. But how to implement it in practice still remains a puzzle for many newcomers. Possible underperformance relative to a reference index is often seen as a major issue. For investors reluctant to accept possible underperformance in the short term, enhanced indexing strategies provide a solution allowing them to reap long-term benefits of factor investing.

Academic research and many years of experience have shown that factorbased solutions can help to significantly improve the profile of a portfolio, for example by reducing downside risk or enhancing long-term returns. However, it is also important to acknowledge that allocating to factors can lead to significant tracking errors and that periods of relative underperformance compared to the broader market are inevitable. These can continue uninterrupted for several years, testing the patience of many investors. Moreover, numerous academic papers suggest it is impossible to successfully time factors and to predict which are going to do well or lag in the near future.

the past three to five years relative to a benchmark, often see factor investing as a source of additional risk, at least in the short run. An FTSE Russell survey carried out in 2016 actually suggested that underperforming the benchmark ranked

to reap the full benefit of factor investing, clients need to consciously focus on strategic asset allocation, as opposed to short-term returns relative to a certain reference index. Therefore, the relevance of factor investing strategies should be evaluated in the same way as traditional asset classes. After all, investors don’t stop investing in equities after a few years of underperformance compared to bonds, nor should they lose sight of the longterm business case when factor-based strategies have had a couple of bad years.

‘Enhanced indexing portfolios typically deliver moderate outperformance’ fifth among investor concerns with respect to factor-oriented allocation.

Introducing enhanced indexing Empirical research shows that in order

Still, for investors reluctant to accept the possibility of underperformance in the short term, enhanced indexing provides a solution allowing them to reap long-term benefits. Efficient enhanced indexing strategies are designed to systematically capture the market return and, in addition,

This explains why allocating to factors requires a long-term investment horizon. In their famous 2009 research paper1 analyzing the performance of the Norwegian government pension fund during the global financial crisis, Andrew Ang, William Goetzmann, and Stephen Schaefer explicitly acknowledge this “since the factors earn risk premiums over the long run”. This also explains why many investors, who tend to choose asset managers according to their performance over

Robeco QUARTERLY • #4 / JUNE 2017

QUANT INVESTING

Figure 1. Excess return potential grows with higher tracking errors across all regions 8

0.5%

1.0%

2.0%

3.0%

4.0%

5.0%

1 0.5%

1.0%

2.0%

1.0%

2.0%

3.0%

4.0%

5.0%

3.0%

4.0%

5.0%

Excess Return North America

Excess Return All Countries

0.5%

3.0%

Excess Return Europe

4.0%

5.0%

0.5%

1.0%

2.0%

Excess Return North America

Source: Robeco. The charts show the excess return (y-axis) on top of the relevant index for four Core Quant strategies based on various tracking error levels (x-axis). The observation period is from January 2002 to December 2015. The graphs do not represent returns of an actual portfolio.

benefit from well-rewarded factor premiums. They take the capitalization-weighted index as a starting point. Then they give slightly more weight to stocks with favorable factor characteristics and slightly less to stocks with unfavorable factor characteristics, using proprietary investment models. This ensures the investment is relatively cost effective, while preventing overcrowding and arbitrage. Enhanced indexing portfolios typically deliver moderate outperformance, or at least market-like returns after costs, depending on how much portfolios are allowed to deviate from their

‘Going passive also leads to chronic underperformance, once costs are taken into account’ benchmark. The key performance indicator for this kind of product is the information ratio, which measures the excess returns of a portfolio relative to its benchmark. Portfolios with greater tracking error flexibility are a better choice for investors who aim to consistently capture more of the factor premium. Our research shows that the looser the tracking error criteria,

the higher the expected returns tend to be, in absolute terms (see Figure 1 above).

Enhanced indexing also enables comprehensive ESG integration. For example, ranking methodologies based on sustainability scores can be introduced into the portfolio construction process. Meanwhile, passive investors either completely ignore ESG considerations or limit their efforts to rigid exclusion lists.

An alternative to passive approaches All these elements make enhanced indexing an attractive alternative to

Robeco QUARTERLY • #4 / JUNE 2017

QUANT INVESTING

classic passive strategies. Decades of underwhelming active manager performance and increasing cost awareness have pushed large numbers of investors into passive strategies, often through the use of ETFs. But going passive also leads to chronic modest underperformance, once management costs are taken into account. Furthermore, in a 2015 whitepaper2, David Blitz, Head of Quant Equity Research at Robeco, argued that enhanced indexing can also be more cost effective for boosting the return of a simple passive equity/bond portfolio than alternative investments. This is because in order to compensate for the much higher fees involved in alternative investment strategies, these need to achieve unreasonably high returns after costs.

Robeco’s Core Quant equity strategies follow this enhanced indexing approach. They exploit proven factor premiums such as value, quality and momentum, combined within a transparent portfolio algorithm and a unique set of risk controls, designed to consistently outperform the market after costs. For example, over the September 2004-April 2017 period, our Quant Developed Markets Equity strategy returned on average 9.2% per year gross of fees, or 125 basis points more than the MSCI World Index. This was achieved with a modest tracking error of just slightly over 1%, leading to a strong information ratio of 1.2. The aim of the stock selection model is to create a portfolio with holdings that, taken collectively, have the ultimate stock profile: attractive valuation, high

quality, higher than average analyst revisions and positive share price momentum. In addition, our proprietary portfolio construction algorithm features a flexible set-up, so we can easily adapt mandates to a variety of individual requirements concerning the investable universe, the risk-return profile and the integration of stricter sustainability criteria3, for example. “Evaluation of Active Management of the Norwegian Government Pension Fund – Global”, Andrew Ang, William Goetzmann, Stephen Schaefer, 2009. (Available at: https:// www.regjeringen.no/en/topics/the-economy/the-governmentpension-fund/eksterne-rapporter-og-brev/reports-on-activemanagement-of-the-gove/id2357344/) 2. “Passive Indexing? Enhanced Indexing!”, David Blitz, Robeco Whitepaper, March 2015. (Available at: https://www.robeco. com/en/insights/2015/03/passive-indexing-enhanced-indexing. html) 3. Read the related article on the customization of Core Quant strategies (Available at: https://www.robeco.com/en/ insights/2017/02/customizing-core-quant-strategies.html) 1.

Successfully implementing factors in credits markets Well-established factors, such as Low Risk, Quality, Value, Momentum and Size, generate economically meaningful and statistically significant premiums in credit markets. Robeco has been successfully applying factor-based investment strategies focused on investment grade credits since 2012, and recently started offering a multi-factor high yield solution to institutional clients. However, the specific structure of these markets also entails specific challenges when it comes to practical implementation, according to Patrick Houweling (pictured), Portfolio Manager & Researcher from our Quantitative Credits team.

Can you explain briefly what factor-based credit investing is all about? “Sure. Factor investing is a very disciplined and rules-based way of investing in credit markets. It’s based on the extensive research that we have conducted at Robeco over the past 15 years. Our research on multi-factor credits1 has been published in the Financial Analysts Journal, an academic publication of the CFA

Robeco QUARTERLY • #4 / JUNE 2017

Institute. Robeco was one of the first asset managers to carry out this type of research on corporate bonds markets.” So you rely heavily on a quantitative investment model, right? “Yes. All our empirical research ultimately finds its way into our quantitative selection and portfolio construction models. All the insights that we gained from the different studies carried out over the years have been

integrated in the investment process. This represents between 90 and 95 percent of the way a factor strategy is applied. The remaining 5 to 10 percent consists of the checks that are performed by our analysts, because not all the risks in the credit market can actually be quantified and monitored with models.” Is human oversight still needed? “Yes. Indeed, analysts and portfolio managers are still needed. They check the established link between bond data and accounting data and identify any risks that go beyond the scope of the quantitative model. But also trading in the over-thecounter corporate bond market requires a human touch.”

QUANT INVESTING

Credit markets have been quite erratic in recent years, as yields have fallen dramatically. How do you deal with this situation? “Yields are very low, and they have been for quite some time now. For asset managers, this means that the margin for error is small. We address this issue by incorporating low risk and quality factors into our strategies and through the fundamental checks performed by our analysts and portfolio managers. This kind of approach aimed at avoiding losers is definitely needed in an ultra-low yield environment.” What if markets become less liquid? “That’s another important topic. Liquidity has come down a lot in recent years in credit markets, mainly due to regulatory tightening in the banking industry. As a result, clients and prospects often ask us: ‘how do you deal with this?’ We think it is really crucial to embed liquidity management in the portfolio construction process, because a bond that may have been liquid yesterday, may not be anymore

today. To achieve this, we combine our quantitative expertise with the expertise of our traders and portfolio managers in trading in OTC credit markets. In practice, we continuously screen the investment

‘Our empirical research ultimately finds its way into our quantitative models’ universe for liquidity opportunities by collecting and reconciling a large amount of liquidity information in real time. We measure both ‘persistent liquidity’, owing to regular two-way flows, and ‘transient liquidity’, owing to short-term dealer positioning. This enables us to send only those orders which have a high probability of being executed.” What about Environmental, Social and Governance (ESG) aspects? Is that also something you take into account? “Yes, this is something we take into account and also something that our clients increasingly ask for. Because ESGrelated risks are simply one of the many different risks that a credit investor has to deal with. For example, if a company is lagging in terms of environmental policies, it could mean that it has to invest heavily to catch up with its peers. This may mean that a lot of investments have to be made by the company, and that could pose a significant risk for bondholders as well as shareholders.” Companies that do well as regards ESG and sustainability are becoming more and more attractive because investors are looking for that kind of approach, right? “Yes, because it’s not only about investing and generating good financial returns. It is also about the way you achieve those returns. And clients are increasingly becoming aware and conscious of that.

And how big is that risk for investors, in your view? “In credit markets, it’s all about avoiding losers. Holding a single loser in a portfolio could ruin the performance for the entire year. So any risk that can be avoided should be avoided. If you look at a company from an ESG and sustainability perspective and you can avoid taking on just one loser in your portfolio, your effort will already have been worthwhile.” Why should people invest in this strategy? “What we see is that our factor credit strategies appeal to two types of investors. Some of them see a factor strategy as an alternative to passive investing, because it is rules-based and uses a relatively low turnover. Those people appreciate that similarity to passive investing. The second group of investors are those who see a factor-based strategy as a diversifier for actively managed portfolios. That’s because despite the low turnover, it is still very active and clearly deviates from the benchmark, which means that it also has an outperformance objective.” Outperformance objective... do you actually outperform? Are your clients happy with the way their money has been managed so far? “Yes, since their inception the various strategies have been able to generate outperformance for our clients. For example, since its launch in July 2015, our Robeco QI Global Multi-Factor Credits strategy has achieved a 3.9% return gross of fees on an annualized basis, compared to an 3.5% return for the Bloomberg Barclays Global Aggregate Corporate Index. Moreover, all the clients that agreed to the strategy are still with us. So we must conclude that they are happy.” ‘Factor investing in the corporate bond market’, Houweling and Van Zundertt, Financial Analysts Journal, 2017.

Robeco QUARTERLY • #4 / JUNE 2017

Platform power Surging connectivity is powering a new business model: the platform company. Platform companies, such as Uber, Airbnb and Alibaba, facilitate commercial or social interaction between interested parties at low cost. Portfolio manager Steef Bergakker looks at these companies’ investment merits and the risks investors should consider. place almost instantaneously and at very low cost. This has been a huge game changer.

Speed read

Trends

• Platform companies have generated very good investment returns • Investors need to understand the nature of network effects • Envelopment is a strategic risk that should be monitored

Over the last few years, we have witnessed the meteoric rise of new businesses such as Airbnb, Uber and Alibaba, which have built a global presence within just a few years. A common feature of these upstarts is that they operate as a mediator between value creators and value consumers that either would not have otherwise interacted with each other, or to a much lesser extent.

The monetization challenge Platforms can generate tremendous economic value for their users. However, capturing a part of that economic value can be challenging for platform operators. To a large degree, this economic value is created through the reduction of search costs. However, once a potential consumer and producer have found each other, they can go off platform, negotiate a private deal and avoid having to pay a commission to the platform operator. In principle, platform operators can try to monetize by charging fees for transactions, access, enhanced access (e.g. premium articles on online newspapers) or enhanced curation (e.g. vetting services for online dating services). Analyzing, leveraging and selling the

‘The world’s five largest companies are platform companies’

Platform companies dominate in terms of market capitalization The virtual nature of the networks and meeting places means that these businesses are much easier to grow than those that rely on physical assets. The world's five largest companies in terms of market capitalization today, i.e. Apple, Alphabet, Microsoft, Amazon and Facebook, are all platform companies and became household names within a very short time. Platforms are not a new phenomenon. Physical platforms like bank branches, airports or restaurants and bars have been around for quite some time. Physical market places, which date back to early civilization, can perhaps be considered the archetype of the platform business model. What distinguishes modern platform companies from archetypal platform companies is the evolutionary leap forward in business reach made possible by the exponential increase in connectivity that has occurred over the last 15 to 20 years. Modern information and communication technologies have turbo-charged the old platform business model and expanded its reach from being mainly local to truly global. Commercial and social interaction that was previously either impossible or too expensive can now take

Robeco QUARTERLY • #4 / JUNE 2017

Trends data that platform traffic generates are additional monetization options. This can create huge commercial value, but it is also fraught with privacy issues.

‘Most platform companies have massively outperformed global equity indices’

The market is characterized by some very large companies that completely overshadow the rest. This is a manifestation of increasing returns caused by the network effect which tends to lead to winner-takes-all outcomes.

Extraordinary returns Platform companies have generated extraordinary returns. Most of them have massively outperformed both the S&P 500 and MSCI All Countries World Index over one, three and five years. To a large degree, this can be attributed to network effects being a source of growth and a competitive advantage. Once increasing returns from network effects kick in, growth becomes selfsustaining and requires very little capital. As a result, returns on invested capital improve and economic value creation soars. Growth is only limited by the market’s size. As the network grows, economies of scale grow as well, raising entry barriers and extending the competitive advantage period while further compounding profitability. Finally, as users become increasingly embedded in the network, switching costs tend to rise as well,

adding to the competitive advantage.

Investors need to understand the nature of network effects

The main task for investors is to develop an understanding of the nature of the network effect in combination with the multi-homing and user switching costs. In addition, careful examination of a company’s monetization and governance model is required to gain a full understanding of its strengths and weaknesses. Once a platform has reached a critical size, it becomes very difficult to dislodge. Investors can usually look forward to a long period of value creation. Two risks should be monitored, however. One is if competing platforms improve on the functionality. While this does happen from time to time, it seems a fairly remote risk as a platform’s main functionality is finding a match, which, by definition, a successful platform already does. The second is the risk of being enveloped by another platform. This happens when one platform provider moves into another's market, combining its own functionality with that of its target, in order to form a multi-platform bundle. This may happen if there is significant overlap in user bases or if there are significant economies of scope. Envelopment is a risk investors should be aware of.

Robeco QUARTERLY • #4 / JUNE 2017

Fair winds for Argentina Argentina seems to be back on track. This country with huge economic potential has suffered for decades under populist regimes. But the wind of change is blowing with a new generation of politicians and their dynamic leader Macri. “We are cautiously optimistic.”

Speed read

Research

• Warm welcome back to the financial markets • Reforming the economy is still ‘work in progress’ • Long-term opportunities for fixed income and equity investors

“I still bear the scars of investing in Argentina.” Emerging market bond investor Paul Murray-John was around when Argentina defaulted on USD 82 billion worth of outstanding sovereign debt in 2001. “This taught me an important lesson. When you invest in an emerging country as an outsider you have to always bear in mind that you are an easy target for populist politicians. Why should they pay you rather than their supporters, the poor, pensioners or whoever else they want to encourage to vote for them?,” says the portfolio manager of Robeco Emerging Debt.

foreign policy have made the country a shadow of its former self. The country’s urbanized and well-educated population has seen its relative wealth decline over decades of political instability and periods of hyperinflation. And the numbers reflect this. The Argentine economy has seen pretty dismal growth over the last 35 years. While the country's GDP has grown by 1.88% on average, annual per capita GDP has only increased by 0.62%. The relatively low level of the growth itself is less of issue than the fact that since 2003 it has come largely from public spending on social security, for instance, rather than from productivity or the development of competitive industry. Productivity is poor and Argentina historically lags its Latin American peers in this area. Doing business there is also difficult.

Robeco senior portfolio manager for emerging markets, Fabiana Fedeli agrees with her colleague: “Argentina is a country that demonstrates just how important political risk can be for an investor. It has a murky history of terrible political decisions and is a good example of the havoc that socialist-populist and interventionist economic policy can wreak.”

Argentina is a shadow of its former self It is astonishing how far Argentina has fallen. In the early twentieth century the economy was flourishing. It was one of the most prosperous countries in the world, with per capita income at 80% of that of the US and almost on a par with Britain. But this is all just a distant memory in today’s Argentina. Years of political populism, military coups, media control, an isolationist approach to trade and a lack of interest in

Robeco QUARTERLY • #4 / JUNE 2017

Research

In the World Bank’s ‘Ease of doing business’ ranking, Argentina (116) still trails Mexico (47), Peru (54) and Chile (57), but has now overtaken Brazil (123) and is way ahead of Venezuela (187). And it ranks 104 in the World Economic Forum’s Global Competitiveness Index – also way behind Colombia (61), Peru (67), Uruguay (73), Brazil (81) and Ecuador (91).

‘Argentina demonstrates the importance of political risk for an investor’

Long-term investment opportunity But there is a wind of change blowing in the second largest and third most populous country in South America. This started with the election of the business and market friendly president Mauricio Macri in 2015. Although they retain a ‘healthy dose of skepticism’, both Murray-John and Fedeli are ‘cautiously optimistic’ and regard Argentina as an interesting long-term investment opportunity for both fixed income and equity investors. “Do not expect Argentina to be able to extricate itself from populism and recession within a heartbeat, but the building

blocks are there,” concludes Fedeli. “Besides the new government that has rekindled hope for Argentina, the country has a rich supply of fertile land for soya, grain and beef and plentiful natural resources in the form of metals and minerals. Its shale oil and gas reserves are the third largest in the world and its long coastline provides access to rich fishing grounds.” Fedeli recently visited Argentina to talk to government and central bank representatives about the economic, monetary and fiscal reforms and with corporate management about the business climate. “There is a certain level of excitement as there are positive changes. I met a career economist at the central bank. He told me that after years in his job under the left-wing populist Kirchner regime, which massaged economic statistics to hide its mismanagement, he can finally be a real economist and do his work properly. He now gets to work with ‘real’ numbers!”

Back from the brink “The Macri government is well aware of Argentina’s economic, monetary and fiscal weaknesses and is addressing them,” says Murray-John. Fedeli adds: “We feel that the obstacles to be confronted in terms of doing business and improving competitiveness can only be overcome gradually, and this could lead to volatility in near-term growth,” says Fedeli. “However, as long as there continues to be tangible progress in reforms, we believe Argentina represents an appealing investment opportunity and selective stocks are still attractively valued. Reflecting this opinion, the Robeco EM fundamental equities strategies are currently invested in a number of Argentinian companies.” Murray-John’s EMD strategy began investing in USD denominated sovereign debt after the currency market was liberalized, and then moved into peso-denominated local debt when the central bank announced its new inflation targeting regime. “Most recent activity has been to reduce risk slightly, as we expect some volatility during the current wage negotiation round. However, we firmly believe in the long-term investment opportunity and would view sustained weakness in bonds or the currency as a potential opportunity to add. Sovereign spreads have fallen significantly in recent years, but remain good value given the substantial improvements in Argentina’s ability and willingness to service its external debt.” The scars from the Argentina default have finally healed now that the country is on a new economic path and this has opened up a long-term investment opportunity for emerging market investors.

Robeco QUARTERLY • #4 / JUNE 2017

SUSTAINABILITY investing

Six ways to improve sustainability Sustainability integration has been applied to equity investments for years, but it has only recently gained broader interest in fixed income. A growing number of investment managers now apply some form of sustainability integration to the portfolios they manage, including government and corporate bonds. Robeco has been at the forefront of using sustainability information for bonds, believing it leads to better-informed decisions, and can impact future performance. Robecoâ&#x20AC;&#x2122;s fixed income team has developed six ways to improve the sustainability of credit portfolios, from excluding controversial companies to using active engagement, and a process of reducing the environmental impact. All are based on state-of-the-art research into what is now an unstoppable trend in sustainability investing.

Robeco QUARTERLY â&#x20AC;˘ #4 / JUNE 2017

SUSTAINABILITY INVESTING

Six ways to improve the sustainability of credit portfolios The practice of integrating sustainability principles into fixed income portfolios is gaining traction, having proved that it works in equity strategies. Robeco targets six ways of applying these principles when investing in corporate bonds.

“At Robeco, we see sustainability as a long-term driver for change in countries and companies, which can impact performance,” says Jan Willem de Moor, manager of the Euro Sustainable Credits strategy. “Depending on the strategy, we have an array of methods to integrate sustainability into our investment processes,” adds Taeke Wiersma, Co-Head of Credit Research. Here are the six main methods through

which the sustainability of credit portfolios can be improved: 1: Excluding controversial companies “The first way to improve sustainability is to exclude companies we consider to be highly controversial in their business conduct,” says De Moor. “We exclude a number of companies that structurally breach the United Nations Global Compact and show no signs of improvement after an intensive, three-year engagement process.”

‘We focus on improving sustainable corporate behavior’ Such breaches can relate to human rights or corruption, while all companies that make controversial weapons such as cluster bombs are excluded. “Although we generally prefer to engage with companies to improve their conduct, we do exclude those that won’t change,” De Moor says. 2: Consistent assessment of ESG performance “The fundamental analysis of companies is the foundation of our approach,” says Wiersma. “Our credit analysts perform an in-depth assessment of a company’s business position, strategy, corporate structure and financial position, and then analyze ESG matters.” An ESG assessment complements traditional

analysis because it can identify risks that otherwise would remain below the surface. Examples include the risk of claims related to pollution, or weak corporate governance that could lead to fraud. In 30% of cases, this leads to an adjustment in the appraisal. This approach earned Robeco the highest possible score by the UNPRI in its assessment of asset managers’ sustainability for three years in a row. 3: Actively engaging with companies Unlike shareholders who invest in equities, bondholders don’t have voting rights for investee companies. Nevertheless, bondholders can exert their influence as creditors to seek improvements in business conduct. “We focus on improving sustainable corporate behavior, as this can result in better long-term performance of the company, and hence better quality of our investments,” says Wiersma. “We focus on the most material issues a company must address, such as data privacy at telecom companies, health and safety in the clothing sector, and improving sustainability in the meat and fish supply chain. The selection of the right engagement themes and topics per industry is a joint effort between portfolio managers, active ownership specialists and sustainability researchers from our sustainability specialist RobecoSAM.” 4: Reducing the environmental impact This essentially aims to reduce the aggregated environmental footprint of portfolios. In its annual Corporate

Robeco QUARTERLY • #4 / JUNE 2017

SUSTAINABILITY INVESTING

Sustainability Assessment, RobecoSAM measures a company’s greenhouse gas emissions, energy consumption, water use and waste generation. “We use this information to substitute companies with the largest negative impact on society with those that have less of an impact,” says De Moor. 5: Investing part of the portfolio in green bonds More and more institutions and companies are issuing bonds which are used to finance environmental projects. These ‘green bonds’ comprise a growing part of the investment grade credit universe, and so one way to improve the sustainability of portfolios is to allocate to this type of bond.

‘We only invest in green bonds with an attractive performance potential’

6: Constructing a best-in-class universe “For those investors who want to take sustainability a step further, and who consider a portfolio’s sustainability perhaps even more important than its returns, we can adjust the investment universe in such a way that only the most sustainable companies are included,” says Wiersma.

But this doesn’t mean ignoring traditional principles. “We only invest in green bonds with an attractive performance potential given the fundamental quality of the issuer,” says De Moor. “Furthermore, we thoroughly screen the green documentation of the bonds to ascertain whether the proceeds are actually used to finance green projects.”

“For this we can apply a ‘best-in-class’ approach. For each business industry we rank the companies based on their RobecoSAM sustainability score, and only include the top 50%. Regardless of the subsequent investment decisions, the resulting portfolio is by nature much more sustainable than its benchmark.”

Brand management in the Global Consumer Trends Equities strategy Brand management is a central topic in sustainability investing. As strong brands account for around one third of the Robeco Global Consumer Trends Equities strategy, it is crucial for the portfolio managers to assess the quality of the brand management of the companies in which they invest. sustainability research focuses on how brand management strategies support a company’s brand strength, addressing the dimensions that are essential to maintain it. These include clarity, commitment, responsiveness, protection, authenticity, relevance, understanding, differentiation, presence, and consistency.

Engagement helps them gain in-depth insight into the risks and opportunities. Good supply chain management, for example, is crucial to prevent incidents such as accusations of child labor from making global headlines. Such reports can seriously damage a company’s reputation and, consequently, its brand. Transparency is another key element that contributes to consumer and investor trust in a brand.

Aligning brand with sustainability

This is especially relevant for consumer goods companies, whose brand is often their most valuable intangible asset. It differentiates a company’s products from those of its competitors and encourages customer loyalty. Robeco’s

It is important to understand how a company’s brand values are aligned with the needs of its target customer group, and how the company’s sustainability goals align brand and sustainability values. Research by BrandFinance has found that strong brands are often

Robeco QUARTERLY • #4 / JUNE 2017

correlated with strong sustainability performance. Robeco believes that companies that are able to convey a clear and consistent brand message are best positioned to win and retain market share in their industries. Strong brands make up one of the three trends of which fund managers Jack Neele and Richard Speetjens aim to take advantage, alongside the advance of digitalization and the emerging consumer. The strong brands constitute the more defensive part of the portfolio. Neele and Speetjens actively cooperate with Robeco’s Active Ownership team, which engages with companies to improve

SUSTAINABILITY INVESTING

their supply chain management and transparency. To show how this works in practice, here are three examples of how Robeco has engaged with three companies whose stocks are included in the Global Consumer Trends portfolio, and how this influences the conviction of the fund managers. 1. Health and safety issues The Active Ownership team began engaging with an apparel company in 2013, within the framework of a wider engagement theme, ‘Health & safety in the clothing sector’. This sector is highly globalized, with buyers often sourcing from numerous suppliers worldwide. The value chain extends from raw material supply through to textile manufacture, clothing design and manufacture, to marketing and retail. Buyers are often large multinational companies, which usually only have direct business relationships with clothing manufacturers in the first tier of their supply chain. They therefore have limited insight into the practices of the higher tier suppliers. However, if bad practices are exposed in those parts of the chain – as was the case when the Rana Plaza factory collapsed in Bangladesh in 2013 – the buyer’s brand will suffer regardless. Impact on the investment case: The success of this company’s main brand is founded on the concept of getting catwalk-inspired designs onto the high street as quickly as possible. To achieve this, an efficient and reliable supply chain is absolutely crucial. Managing the risks within the apparel supply chain is therefore not only a matter of reputation or cost risk management for this company, but also lies at the heart of its corporate strategy, underpinning both its growth and profitability. Disruptions in the supply of season-specific clothing can have a significant financial impact. The process of engagement gives the portfolio managers additional insight into the steps

‘If bad practices are exposed in the supply chain, the buyer’s brand will suffer’ the company is taking to keep its supply chain processes up-to-date. 2. Data privacy in social media The second example is a social media company, for which user trust is key, as a large user base attracts advertisements. The Active Ownership team is involved in ongoing discussions with this company about its privacy policy and practices, and is challenging the firm to improve its transparency on privacy issues, and on sustainability in general. The company has a privacy policy that applies to all of its employees throughout the world, all of its products and its business partners, such as advertisers. Training is provided regularly to ensure that all parties understand the importance of the topic. The company’s

advertising partners do not have access to the personal data, but can use it through a hashing process, which safeguards the consumer’s identity.

Impact on the investment case: For the portfolio managers, the engagement is particularly helpful to deepen their understanding of the company from a risk perspective. Can the company’s management and staff see the risks identified by the portfolio managers, or do they have blind spots? If employees are aware of the potential risks, how do they expect them to affect the company’s brand, and how do they address them? How do they stay abreast of rapidly changing regulations? The engagement provides valuable information on how the company deals with them, and its progress is closely monitored. 3. Human rights in the cocoa supply chain Thirdly, an engagement process was

Robeco QUARTERLY • #4 / JUNE 2017

SUSTAINABILITY INVESTING

conducted with a food and drink company which depends on raw materials, and runs risks if these materials are not produced in a sustainable manner. It is therefore crucial for the company to have a good understanding of the circumstances under which the raw materials are produced. Also, agricultural land and irrigation water are becoming increasing scarce, which may lead to problems in supply reliability, and to higher prices. This creates a direct operational risk for food producers, as price fluctuations cannot always be passed on directly to the consumer. The company has developed a human rights impact assessment report, which has now been applied in a number of countries. In terms of labor standards, the company has

developed a robust child labor monitoring and remediation program, and the results are good. For new suppliers, the company

from sustainable farms. Transparency is crucial, as it forces companies to deal with these issues. Driven by client demand, the company has set responsible sourcing targets. Past criticism has led to the realization that a proactive approach works best, and that management can take action to prevent risks and protect their brand. Their increased transparency and constructive cooperation with our engagement specialists gives the portfolio managers the peace of mind that if they can identify the risks, that the company will be able to uncover them as well, and, most importantly, will address them.

‘Transparency is crucial, as it forces companies to deal with these issues’ has a stringent supplier screening process that helps them eliminate suppliers which do not meet their sustainability requirements. Impact on the investment case: Clients are increasingly aware of where products come from. More and more of them want chocolate, for example, to be sourced

ESG integration is crucial in emerging equities ESG issues play an essential role in emerging markets equities – even more so than in developed markets. Corporate governance in particular is a factor to watch, as emerging countries have varying standards of governance, which can have a substantial impact on returns.

Environmental issues Robeco has been incorporating sustainability into its analysis of emerging markets companies for over 15 years, believing it to be crucial to pick the real winners and avoid the losers. Market inefficiencies caused by lower standards of data availability, poor transparency and issues relating to climate change, human rights and product safety standards are a potential source of alpha for emerging markets investors. The main focus is on corporate governance: when there are fewer external institutions to protect minority shareholder interests, which is the case in many emerging markets, good governance becomes more important.

Robeco QUARTERLY • #4 / JUNE 2017

Environmental issues can also be material. Climate change, for example, can be both a business threat and an opportunity. Opportunities may be investments in renewable energy, while threats encompass the potential costs of future capex adaptation requirements or even asset impairment (such as stranded assets) which the market underappreciates. Social issues, such as labor problems at manufacturing companies, can also pose risks to companies’ sustainability and financial profitability and, ultimately, investment returns.

if they want to expand their global market share to new markets which expect them as standard. But they need checking, and to do this we use the Emerging Markets Equities team’s proprietary ESG survey. Three pillars currently underpin Robeco’s ESG efforts in this regard: • The integration of ESG factors into country and stock selection research. • Engagement with companies and voting at shareholder meetings. • The use of an exclusion list for those entities that cannot meet UN standards.

ESG integration Emerging market companies are increasingly striving to adopt developed market standards; indeed, they must do so

ESG factors are integrated into both the top-down country allocation and the bottom-up stock selection process.

SUSTAINABILITY INVESTING

Not all ESG information is relevant: it is important to identify the ESG factors that are financially material to the companies covered. This means focusing on those factors that can have a substantial impact on a company’s business model and value drivers such as sales growth. For the top-down country allocation, fundamental analysis is the dominant factor. A key part of this entails comparing emerging markets’ economic, political and social strengths. This evaluation includes ESG issues such as a country's transparency, political stability and protection of shareholder rights. In addition to using the team’s own ESG survey, RobecoSAM’s Country Sustainability Ranking and third-party data such as the Corruption Perception

‘Climate change can be both a business threat and an opportunity’ Index or the International Country Risk Guide on political risk also make excellent contributions. Analysis of ESG factors can lead to a country risk premium becoming implicit in the valuation analysis of individual stocks. In the bottom-up stock selection process, ESG information is integrated into company analysis, and this can have an impact on company valuation. The team’s ESG survey, which covers 1,125 companies in emerging markets, enables Robeco analysts to determine a company’s ESG performance. The scope is significant, since it includes all the constituents of the

MSCI Emerging Markets Index along with other key emerging markets names, across the large cap, mid cap and small cap spheres. In addition, RobecoSAM’s sustainability scores and external research from Glass Lewis and Sustainalytics are used. ESG performance ultimately does not become the sole reason to buy or sell a stock, but if the risks and opportunities are significant, the ESG analysis will impact a stock’s fair value. It could lead, for example, to the calculation of the weighted average cost of capital being raised by 100-200 basis points. Other input factors such as sales growth or margins can also be impacted both positively or negatively. For example, if

Robeco QUARTERLY • #4 / JUNE 2017

SUSTAINABILITY INVESTING

China were to introduce a carbon tax, this would increase the operating cost of a coal-fired power producer and make it less attractive for investment. In practice, ESG factors have impacted a stock’s fair value, and therefore its weight in a Robeco portfolio, in approximately 30% of all the investment cases and stock updates conducted last year. So it is materially significant, and can make all the difference in a decision whether to buy or sell a stock, or how much of it to include in the fund.

Engagement and exclusion For engagement & voting, the portfolio managers, in close cooperation with

Robeco’s Active Ownership team, maintain an active dialogue with companies and vote at shareholders meetings. Topics raised may include the appointment of board members or the availability of

weapons such anti-personnel mines, cluster bombs or chemical or biological weapons, in accordance with international treaties. Companies violating the United Nations Global Compact principles are subject to an enhanced engagement process.

‘ESG factors have impacted a stock’s fair value in 30% of investment cases’ financial statements before the proxy voting deadlines pass. An exclusion list is used as a last resort. Companies that are excluded include those manufacturing controversial

Companies that decline to engage, or do not change their stance after extensive discussions, may be excluded, though this also means that influence can no longer be exerted on them, and that there is no longer the option of dialogue to address the core issue.

Picture perfect? The pros and cons of ESG ratings for investment funds More investors are incorporating ESG into their investments, and so many market participants are coming up with solutions to measure the ESG profiles of investment funds. But these snapshots may not always reveal the full picture, says Masja Zandbergen, Head of ESG Integration at Robeco.

The straightforward rating approach usually starts with measuring the ESG scores of the portfolio holdings and comparing them to peers. Sometimes this is supplemented by including the past controversies of the companies owned, along with their carbon footprints. The end result is a score or rating which provides some insight into how the companies that are currently held in a portfolio score on sustainability.

achieve the desired outcome. Investing means looking forward, but these ratings only provide a snapshot of the current situation.” “If there is no clear sustainability investment policy for the fund, then an investor can buy into a portfolio that is highly ranked, only to discover after a few months or years that the score has completely changed.”

Three ways forward “The good thing about these ratings is that they can be produced at relatively low cost for relatively large numbers of funds,” Zandbergen says. “But it raises the question of whether they actually

Robeco QUARTERLY • #4 / JUNE 2017

Zandbergen says there are three things that would really improve these ratings. “First, you should adjust for biases in the ESG scores: large cap European stocks, for example, on average give a better ESG

score than US small caps,” she says. “Second, it is important to be more forward looking, rather than taking a snapshot picture. This includes taking into account the investment process and the engagement efforts of an asset manager. This analysis is more time consuming and costs more, but is of much higher quality.” “Finally, while focusing on financial materiality in scores, also incorporating a top-down view of sectors and issues can help. For example, how does a worst-in-class media company compare to a worst-in-class mining company? From both a societal and financial perspective, the impact of the latter is much bigger.”

Elroy Dimson

Looking at the long-term evidence on factors Great Minds

Elroy Dimson (pictured) chairs the Newton Centre for Endowment Asset Management at Cambridge Judge Business School, and is Emeritus Professor of Finance at London Business School. We spoke with him about the current state of academic research in that particular field and the appetite for factor-based and smart beta investment strategies.

Your work provides compelling evidence for the existence of an equity risk premium. Do you think the evidence for factor premiums is just as convincing? “I think there is a difference. My work, together with Paul Marsh and Mike Staunton, shows it is difficult to measure precisely the equity risk premium. And, from that point of view, factor premiums are almost certainly estimated with greater error. I do not favor seeking exposure to a large number of factors. One should be considering premiums that are well supported by academic evidence across multiple markets and over multiple research periods.” Factor investing has become increasingly popular among investors. Do you think we have enough hindsight from an academic research point of view? “There is considerable scope for investigations in this field. Research shows that factor premiums tend to be smaller ‘outof-sample’. That is, premiums tend to be smaller when the data analyzed is not the same as that which initially revealed the factor. Several papers have been published over the past couple of years highlighting the disappointing performance of many factor strategies after the research findings have been published. Professor Campbell Harvey, confirmed in his 2017 presidential address to the American Finance Association that ‘many of the research results being published will fail to hold up in the future’1.” “Statisticians refer to the risk of misjudging a certain pattern and wrongly identifying a factor as ‘p-hacking’ or ‘data mining’. The ‘p’ value refers to the probability that a researcher detected a phenomenon that is really robust and significant. And ‘p-hacking’

is the term used for trying many different forms of analysis until you appear to have found something which looks like a premium. This concept is commonly used in medical sciences, where pharmaceutical companies are often accused of putting forward, among a large number of existing studies, only those that show the most favorable results. This is also a very serious issue for investors. In a way, if they still made those old telephone books, it would be like searching through one of these books and trying to find some kind of pattern in the phone numbers that would suggest the existence of a factor premium. But finding a pattern in one book would not necessarily mean that it could be found in another phonebook, in particular for another country.” Which factor premiums do you think are strongest, and which do you think are more questionable? “If you would ask randomly any two experts to name five factors that they consider the most relevant or interesting ones, they would probably come up with different answers. Having said that, a few factors would likely be common to both lists. In a recent article2 I and my co-authors focused our analysis on the following factors: size, value, income or yield, volatility and momentum. Why these? Well, we always look at data globally and over long periods of time, which is a distinctive feature of how we like to work. This obviously has an influence on the kind of data we choose to look at. For example, it is very difficult to analyze the low volatility effect across a large number of countries for a very long period of time. This is an important aspect, because the research that underpins some of the factor premiums that have become popular among investors often relies heavily on US stock market data. These studies may show very compelling results, but we don’t really like the idea of basing investment strategies solely on US evidence. Ultimately, the resulting investment strategies

Robeco QUARTERLY • #4 / JUNE 2017

Elroy Dimson chairs the Newton Centre for Endowment Asset Management at Cambridge Judge Business School, and is Emeritus Professor of Finance at London Business School. He also chairs the Advisory and Policy Boards of FTSE Russell, and serves on the Advisory Council of Financial Analysts Journal and the Steering Committee of the Financial Economists’ Roundtable. Until 2016 he chaired the Strategy Council of the Norwegian Government Pension Fund Global, and before going to Cambridge was a Governor and Professor at London Business School. A significant part of his academic research – together with fellow researchers Paul Marsh and Mike Staunton – has centered around measuring very long-term investment returns for different asset classes across numerous countries and regions. The three academics also focused their work on the long-term evidence concerning factor premiums.

Robeco QUARTERLY • #4 / JUNE 2017

Great Minds

could prove very profitable in one particular country, and yet fail in other countries.” “This is a dilemma for academics as well as for investors and asset managers because there are only two to three decades of market data available internationally. Take the quality factor, for example. It has drawn a lot of attention from academics and investors in recent years. But quality remains a relatively new and more subjective concept than value or low volatility, for example. To assess the quality factor rigorously, researchers should analyze data globally over numerous decades. In my view, looking only at a quarter of a century is not enough. Things could go well or turn bad simply due to chance. This is why investors and asset managers need to remain cautious when analyzing and exploiting market data. They should not rush towards one single factor that they find attractive. In addition, while empirical evidence is important, it is also key to gather some theory behind it. If you cannot find economic reasons to explain the existence of a factor premium, then I think it is more questionable whether it will persist.” In particular, what is your view concerning the Size factor? “Evidence for a size premium was first published in the very early 1980s for US stocks, but it has since been found across many different equity markets. Taking the result from various research studies and updating them using available small and large-cap indices, Paul Marsh, Mike Staunton and I showed that small caps have achieved a long-term premium of 0.32 percent per month, on average, relative to large caps. This study was based on data from 23 countries with an average history of 43 years. The length of the research period for individual markets ranges from 16 years for countries such as Austria, Norway or Portugal to 91 years for the US.” “Still, the relative long-term outperformance of small-capitalization stocks has not been consistent and steady over time. There were some periods of relatively disappointing performance, in particular from the mid-1980s to the mid-1990s. The small cap effect seems to have somewhat faded in recent decades. Small caps continue to perform differently from large caps, but not to the extent suggested by the first studies that reported the existence of a very pronounced size premium. If researchers were to investigate this factor for the first time nowadays, they would probably only find a modest smallcap premium and would most likely not deem it a major anomaly. In terms of performance, investors with a long-term horizon should expect a ‘normal’ reward for the illiquidity risk and the higher management costs associated with running a small cap fund. Buying such stocks often implies a more sophisticated investment process than with large caps and requires greater patience when building a position.”

What about the Income factor? “This is actually a very long-established factor. I think it is reasonable to assume that, if you go back long before any modern financial theory, investors already looked at income or yield. So this is probably one of the best substantiated approaches to investing. Moreover, it seems to have paid off. A number of studies published over the past decades have shown a significant premium for higher-yielding US stocks, based on data going back as far as 1927. In the UK, my research together with Paul Marsh and Michael Staunton has also evidenced a similar pattern since the beginning of the 20th century. Meanwhile, outside the US and the UK, our analysis also showed a clear income effect in almost 20 countries over the 1975-2016 period.” “Some people may say that income has paid off because there is a reward for taking certain sorts of risks. For example, one risk that you take with a high yield strategy is buying a stock whose price declined for legitimate reasons. As such, they may become more volatile or they may be more prone to collapse, for example. However, our analysis shows that, on all the measures we can come up with, those risks are not very large. In other words, the Sharpe ratios are much higher for high yield than for low yield securities. Not only is the return higher, but the ratio of reward to risk is also larger for high yield stocks.” What is your view on the economic explanations that are often brought forward to justify the existence of factor premiums? “I think there is still a lot of research to be done in this area too. Let me take the very popular momentum and low volatility factors, for example. Momentum strategies are nothing new. They used to be called ‘relative strength’ and they were a standard investment approach half a century ago. In practice, you would buy stocks that are moving up and you would avoid stocks that are moving down. Back in the 1960s, there were already a number academic papers that demonstrated that this approach had worked. One of these studies was even published in the Journal of Finance, one of the most prestigious academic publications. At some point, however, these articles were ridiculed because the reasons mentioned to explain this phenomenon were considered unconvincing and the empirical research lacked rigor. People felt uncomfortable about that.” “The main explanation that was brought forward in the 1960s for the ‘relative strength’ effect was that investors only adjust gradually to information. First, some particularly smart investors would spot good or bad news concerning a specific company and they would buy the stock. The next day, less smart investors would buy the newspapers and they would buy the stock as well. A week or two later, other investors would see prices going up

Robeco QUARTERLY • #4 / JUNE 2017

‘In my view, looking only at a quarter of a century of data is not enough. Things could go well or turn bad simply due to chance’

and only then they would also buy the stock, and so on. But it is also not very difficult to imagine that those smart investors, who bought the stocks in the first place, could have foreseen the coming adjustment and could have taken action. Doing so, they would arbitrage away this price anomaly. After a while, these strategies would just self-destruct. Moreover, in today’s world, you don’t have to wait for tomorrow’s paper to appreciate what’s happening. News cannot take days and weeks to permeate though the market, so the momentum anomaly is really puzzling.” “Now, let’s turn to the low volatility factor. I have a deep desire to discover long-term evidence concerning low vol stocks around the world. It’s an intriguing anomaly because one of the explanations most frequently mentioned is the asset management industry’s focus on performance relative to benchmarks. But many decades ago, people were not engaging in benchmark driven investing. In the UK, the FTSE All-share Index was launched only in 1962 and the total return version of this index did not appear until 1993. Before that, you just had capital gains indices and an average income to work with. As a result, if you go back to the 1970s for most countries, and to the 1960s for almost every country, people had little reason to be interested in relative to benchmark investing.” “If this explanation is correct and benchmarked management is the main driver of the low volatility effect, we should not be able to find any convincing evidence of this phenomenon in prior decades. Well, I have no data to support this and I just don’t know what the answer is. But I suspect the anomaly was already

Robeco QUARTERLY • #4 / JUNE 2017

Great Minds

there. To be sure, other factors such as size or value were about as prominent many decades ago as they have been in more recent years. This is why the search for long-term evidence is so crucial. I think we, academics, should join forces with asset managers to carry out this kind of research. Putting together very long series of market data is arduous and tends to be done only on a singlecountry basis. Using lengthy single-country datasets we can test models out of sample. We can see what happens using data going back to long ago. Otherwise, looking forward, we’ll need to wait for an unacceptably long time do get sufficient new data.” Would you recommend institutional investors to allocate strategically not just to traditional asset classes, but also to factor premiums? To what extent? Monitoring factor exposure or actively seeking to capture premiums? “It does depend on their time horizon and the costs they face, but I think investors should at least monitor factor exposures. Let me give you a concrete example of this. I was once a member of the investment committee of a charity which was hungry for income. It was made clear to the manager that the charity wanted more income because it could not spend out its capital. As a result, all other things equal, the manager tried to buy high yielding securities. And when high yield stocks did well, this fund did very well. When high yield stocks did not do so well, the fund would lag. This illustrates the fact that simply having a view about sustainable levels of spending can drive asset managers into unplanned factor exposures. I believe factor tilts are important and that both asset managers and their clients need to be aware of their existence. Even conventional investors, not just the very sophisticated, quant-oriented ones, need to assess and to take into account their exposure to different sources of risk.” What is your view on the current smart beta frenzy and the numerous product launches? “Factor investing was highlighted in a December 2009 report, ‘Evaluation of Active Management of the Norwegian Government Pension Fund – Global’, prepared at the request of the Norwegian Ministry of Finance. The authors were three finance professors, Andrew Ang, then at Columbia Business School; William Goetzmann, Yale School of Management; and Stephen Schaefer, London Business School. Sometimes referred to as “AGS”, they revealed the substantial impact of factor exposure on the investment performance of Norway’s sovereign wealth fund. As I document in work with two co-authors3, Norway has been a model for other asset owners, and the AGS analysis had a farreaching impact on asset owners, investment managers and index compilers.” “Often marketed as smart beta, factor investing has taken the

investment community by storm. You can see its impact in the successive editions of the annual smart beta survey published by FTSE Russell. By 2017, nearly three-quarters of survey respondents had either implemented, or were evaluating or planning to evaluate, smart beta index products.” “Is the increasing enthusiasm for smart beta a passing fad – or, in your words, a frenzy? In the FTSE Russell survey, the primary objectives of institutional adopters have been return enhancement and risk reduction. Another important factor that asset owners cite is cost savings, which suggests that smart beta is increasingly perceived as an alternative to active strategies. Retail investors, such as buyers of ETFs, may well be pursuing the latest fashion, and smart beta is certainly in vogue among individual investors as well as institutions. But I don’t think it is a full blown frenzy – at least, not yet. There is still upside for promotors, suppliers and consumers of factor-driven products to increase the penetration of factor strategies in the investment marketplace.” What is your view on overcrowding risk for certain factor-based strategies? “A typical example of the concern about possible overcrowding relates to the income factor. All managers, not just quantitative managers, are worried about the possibility that they could be overpaying for income stocks or bonds. In the current low-yield environment, investors are chasing all sorts of sources of income, sometimes with the mistaken conviction that higher income will not be associated with lower capital appreciation. Asset owners want exposure to this factor, so of course there is a risk of overcrowding. Thoughtful investment professionals now voice the fear that high yielding securities may have been pushed to unsustainable valuation levels, in multiple countries and for many asset classes.” “However, other investors may consider that the need for income is still there. As a result, there may still be upward momentum for high yield assets. Many managers are certainly wondering whether they are overpaying for income right now. But they also probably fail to see an obvious alternative for meeting their clients' performance targets. I think that, for an academic, it is too close to call. Certain segments of the market may turn out to be overvalued, but we don’t know which segments or when the top will have been reached. But I would also say that overcrowding is an important issue and something investors should clearly be paying attention to.” Could you tell us a bit more about the Norway model and its approach to factor investing? What lessons for other investors? “The Norwegian Government Pension Fund-Global (GPFG)

Robeco QUARTERLY • #4 / JUNE 2017

‘I think factor tilts are important and both asset managers and their clients need to be aware of their existence’

was formally established in 1990 to channel and manage the country’s oil revenues in a long-term and sustainable way. Several key characteristics set its model apart. I would highlight its large size, its long-term horizon and its public ownership. Moreover, its investment strategy builds extensively on modern financial theory, as well as robust empirical evidence. As such, it takes advice from leading consultants and prominent academics across the globe. This is important if one is to understand the fund’s approach to factor investing, because many of these external advisors have recommended that the GPFG should consider it.” “After the AGS report at the turn of the century, the fund started to make small allocations to styles tilts, such as value or momentum. These tilts only contribute to a small portion of GPFG’s active risk, mostly because of the fund’s considerable size. But the impact of the AGS recommendations on the asset management industry worldwide has been profound. The Norway model is increasingly seen by other investors and investment managers, as an approach that can and should be emulated. We’ve already discussed the growing number of factor-based investment solutions available in the market. Low cost products, exchange traded funds and factor strategies make it easier for smaller asset owners to mimic Norway in running an inexpensive, diversified global portfolio with moderate factor tilts that meet the needs of investors.”

In C. Harvey, “The scientific outlook in financial economics”, Duke I&E Research Paper No. 2017-05 E. Dimson, P. Marsh and M. Staunton, “Factor based investing: The long term evidence”, Journal of Portfolio Management (2017), Vol. 43, No. 5, Pages 15–37. 3. D. Chambers, E. Dimson and A. Ilmanen, “The Norway model”, Journal of Portfolio Management (2012), Vol. 38, No. 2, Pages 67–81. 1.

Robeco QUARTERLY • #4 / JUNE 2017

Patience and high active share is a rare combination The rise of passive investing is profoundly changing how people invest. Assessing the real degree of ‘activeness’ of a strategy has become crucial for asset owners. But this is only a starting point, says Martijn Cremers (pictured), a professor of finance known for introducing the concept of ‘active share’ back in 2009. this concept has come into widespread use across the financial industry.

Speed read

Research

• The rise of passive investing is major disruption • Investors must assess the degree of ‘activeness’ of a fund • Active share can be considered as a useful tool

The recent rapid expansion of passive strategies represents a major shift in the way people invest in funds and a serious disruption for active managers. However, it is also important to put it into perspective, says Martijn Cremers, a professor of Finance at the University of Notre Dame in the United States. In a recent research paper1 analyzing the performance of US mutual funds, this academic showed that the rise of passive investments happened largely at the expense of ‘closet index funds’. These are funds that do not deviate much from their benchmark, but are still marketed as being actively managed.

But although active share can be considered as a useful indicator to help asset owners select active managers that are likely to really add value to their portfolios, it is still far from being the ultimate decision-making tool. “Our work does not prove anything regarding any particular fund or any particular group of funds, as it is based on fairly long periods of time and large samples of funds,” Cremers says. “Instead, it is conceptual, and provides concepts and tools to better understand what investment managers are doing.” According to Cremers, there are three things active managers need to be successful: skill, conviction and opportunities. And

‘Our work provides tools to better understand what managers are doing’

In this context, accessing the degree of ‘activeness’ of a fund, finding evidence of the differences between that fund and its benchmark, and comparing it to the fees they are charged, has become crucial for investors. “There are two basic measures of activeness,” Cremers says. “The first one is the tracking error, which shows the difference in returns, and the second is active share.”

active share does not measure the manager’s actual skill; it only measures how much stock picking the manager does. So it is clearly just a starting point. Indeed, there are many other key elements, for example patience and tenacity. In another recent paper3 written together with Ankur Pareek, Cremers found that patient funds had the strongest outperformance among high active share managers, but also that most high active share managers are not very patient, and most patient capital isn’t very active. “Patience and high active share is a rare combination, probably because it is hard to be patient in a generally impatient world,” Cremers says.

Concepts and tools Back in 2009, Cremers and fellow researcher Antti Petajisto published a research paper2, in which they introduced a measure of active management dubbed ‘active share’, which compares the holdings of a fund with those of its benchmark. Over the years,

‘Active share and the three pillars of active management: Skill, Conviction and Opportunity’, Martijn Cremers Financial Analysts Journal (Available at: https://papers.ssrn.com/sol3/papers. cfm?abstract_id=2860356) 2. ‘How active is your fund manager? A new measure that predicts performance’, Martijn Cremers and Antti Petajisto, 2009, Review of Financial Studies (Available at: https://papers.ssrn.com/sol3/ papers.cfm?abstract_id=891719) 3. ‘Patient Capital Outperformance: The investment skill of high active share managers who trade infrequently’, Martijn Cremers and Ankur Pareek 2016, Journal of Financial Economics (Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2498743) 1.

Robeco QUARTERLY • #4 / JUNE 2017

LAST BUT NOT LEAST

Apocalyptic topics – continued After our article on Artificial Intelligence in the previous issue of Robeco Quarterly, we will now tackle another apocalyptic technology: robo-advice in the asset management industry. Will robots take over from our trusted advisors? Probably not, but that doesn’t mean asset managers can afford to ignore them either. Although the current form of robo-advice is still in its infancy, it is bound to evolve into a more sophisticated technology, which can offer low-cost, efficient and tailor-made advice to a larger group of clients. Although it poses a real enough threat to traditional advice, we think, in the long term, humans and robotic algorithms should be able to achieve some form of symbiosis.

Robeco QUARTERLY • #4 / JUNE 2017

Robo-advice 10.1: you get what you pay for Jeroen van Oerle and Marco van Lent – Robeco Trends Investing Robo-advice is a hotly debated topic in the world of fintech. On the one hand, it has opened up the low-wealth market, which was previously very difficult to service, by enabling individuals to be advised at a lower cost and with improved transparency. On the other hand, it is often a dressed down version of full advice that potentially fails in risk categorization. Robo-advice platforms are not very sophisticated and it’s difficult for them to be economically viable on a stand-alone basis. But it would be unwise to categorize robo-advice as a hype. We believe current robo-advice solutions will evolve into robo-advice ‘10.1’, which will be much more complete in terms of customer profiling and asset allocation. This is not the time for complacency and incumbents will need to make serious investments if they are to remain relevant.

Infancy does not justify complacency The main drivers of robo-advice demand are the shift in social-security schemes – especially the change from defined benefit to defined contribution pensions, the availability of technology that makes the advice process cheaper, and also increasingly stringent regulatory requirements. People have to take care of their own financial wellbeing and decisions. This now encompasses an increasingly wide variety of assets, consequently making the process more complex. In many countries there is an advice gap – people who should be advised on their finances in order to prepare for the future are currently not being serviced because their wealth level is insufficient. The introduction of technology allows a larger proportion of this group to be reached and this is actively being stimulated by several regulators. However, reaching a large number of people with cheap solutions does come at a price. Currently, people are not generally receiving a satisfactory level of advice. Besides that, there is too much focus on pricing. This is too one-dimensional, as it is more important to present customers with a complete view and proper advice, taking into account the many different aspects of the financial planning valuechain, than to be the cheapest.

The value chain for robo-advice 10.1 Current robo-advice solutions don’t operate in all parts of the advice

value chain, neither do they offer an in-depth solution in those activities they do engage in. But, although there is a lot of room for improvement, the introduction of robo-advice has opened the eyes of the wealth management industry. Closing the financial advice gap is essential for a healthy financial climate in a society where the government is taking a less active role. By deepening the service and integrating the full spectrum of advice as shown in Figure 1, we believe the insights of robo 1.0 have the potential to lead to the required and desired 10.1 version.

Acquisition The starting point of the investment advice value chain is customer acquisition. There are about 125 robo-advisers domiciled in the US, 100 in Europe and 10 in Asia at the time of writing. In addition to these robo-offerings, traditional financial advisers and wealth managers are also active in the market. In order to attract customers in this competitive environment, it is important to have a good customer acquisition strategy, but that comes at a price. Morningstar estimates that the acquisition costs range between USD 500 and USD 1,000. Given the low fees charged by robo-advisers (averaging 60bp of AuM) and the short average holding period of customers, it is very hard to break even with this cost basis. It is estimated that the average breakeven period per customer is between five and ten years, while the average holding period is only between 2.5 (UK) and 3.3 (US) years. Given these high customer acquisition costs, it is unlikely that many of the new entrants will break even on a stand-alone basis. This is the main reason why most robo-advisers are seeking cooperation with large incumbents so they can bring down customer acquisition costs by using an existing customer base. We expect the usage of artificial intelligence, combined with big data sources, to increase the success rate of engagement. Instead of cold calling, robo-advice 10.1 will use an analysis of customers’ activities in order to contact them when they most need it. We imagine this will predominantly occur in cooperation with large wealth managers which have migrated their own customer base to robo 10.1.

Robeco QUARTERLY • #4 / JUNE 2017

Onboarding process After the customer has been acquired, he or she needs to be onboarded. In the current robo-offering this entails the mandatory ‘know-your-customer’ (KYC) and ‘anti-money-laundering’ (AML) tests as well as checking internal compliance boxes. This is a costly approach. We expect onboarding costs for start-ups to come down substantially over the coming years thanks to changes in regulation and distributed ledger technology. Specialized KYC/AML services are also appearing. On the other hand, increased regulation will add costs to those with prime customer relations because the costs made do not necessarily result in increased sales. This particularly applies to mid-sized institutions.

platforms. We expect robo 10.1 to use a wide range of tools to continuously monitor behavior and classify customers accordingly, thereby offering a solution for costly new regulatory requirements.

Asset allocation After completing the full customer profile, the next step is to advise on asset allocation. Current robo-advice includes the following asset classes: equities, fixed income, cash and, to a certain extent, commodities. Most of the asset class exposure is gathered via passive investment vehicles (ETFs), because of their low costs and greater transparency. Although we do not want to go too deeply into the ETF discussion, we question whether ETFs really are cheaper. The argument of transparency is not completely justified either, as a lot of ETFs are not transparent at all about costs and their true exposure to the underlying assets. We do not claim that ETFs do not have a place in an asset allocation, rather that they should be combined with alpha generating active funds.

‘The introduction of robo-advice has opened the eyes of the wealth management industry’

Profiling

Governance and supervision

Communication and marketing

Customer profiling is crucial. If a customer gets the wrong investment profile, there are not only financial consequences but also legal ones. In addition, we think future asset allocation should consider The current customer profiling methodology of many robo-advisers alternative asset classes such as private is questionable. By asking clients to fill out equity, lending, venture capital, direct real an eight- to twenty-item questionnaire, a risk Figure 1 | The advice value chain for estate, art, small caps and frontier markets profile is created. However, a good customer robo-investing 10.1 as examples for an enhanced portfolio profile consists of more than risk alone. Key •Customer acquisition tools and costs •Customer holding period that is better diversified and possibly easier items are Risk, Return, Liquidity, Legal, Tax, Acquisition to customize to individual requirements Timing and Unique circumstances (RRLLTTU). •4-step process than an ETF-only approach. Besides the In addition to formalizing the objective (risk/ •KYC, AML, compliance Onboarding choice of investment vehicle, the actual return), a list of constraints also needs to be asset allocation in current robo-advice taken into account in order to give sound •RRLLTTU •Data collection vehicles differs widely. In a comparison advice. •Behavior monitoring Profiling report by Cerulli Associates (2015), there is a •Asset categories in the mix substantial difference in the asset allocation We do not think such questionnaires can •Investment-vehicle selection Asset •Asset allocation model outcome of the various digital advice platforms. Equity effectively determine risk profiles, nor do they allocation allocation for a 27-year old customer (same provide insights into the constraints. Data on profile used for all platforms) ranges from behavior (income versus costs, mortgage, Portfolio selection 51% to 90%, fixed income from 10% to 40% buying behavior, sports and activities etc.) •Portfolio management infrastructure and, perhaps most striking, cash holdings can be much more insightful. The issue with •Investment-vehicle selection Trade •Rebalancing procedures execution of up to 8.5%. The suitability of such a cash questionnaires is that people do not have level for a 27-year old is very questionable. the patience to fill out the complete list and Portfolio rebalancing it is a well-known fact that many people manipulate the answers to get the outcome Selection, execution and •Tax loss harvesting they desire. rebalancing •Cross-regional tax optimization Tax optimization After the asset allocation has been In many cases, the true test for risk appetite determined, the appropriate portfolios •Performance tracking and reporting Analysis and •Life-events comes when markets show a big correction. need to be selected, the trades executed review Something that has not happened since and the portfolio also needs to be regularly the growth in popularity of many current rebalanced. There are not many roboSource: Robeco Trends Investing 1

Robeco QUARTERLY • #4 / JUNE 2017

advice on this topic only pay off for large accounts, while robo 10.1 will bring this service to the mass market.

advisers that currently do this in an appropriate way. Portfolio selection is often tilted towards passive portfolios as discussed in the previous section. We believe that alpha funds will take a more prominent portfolio position in the future. This is mainly because better data will become available at fund level that allows for better comparisons between active funds and between active and passive funds.

Analysis and review Most robo-offerings have good customer interfaces and are providing tools to analyze the client’s portfolio. However, life events are not always incorporated appropriately. Job changes, family expansion or the death of family members are examples of events that can change the investment objectives or constraints. Often, once the onboarding is completed, there is no regular review of whether the profile still fits. Robo-advice 10.1 will likely provide analysis tools as well as a regular review of objectives and constraints. It will offer advice on life events and use such moments to deepen the customer relationship.

Most platforms offer a choice between several standard mixes (often defensive, offensive or neutral). These are not tailored to the needs of individual customers. Several platforms make this selection once (during the onboarding), but do not maintain the appropriate portfolio, which drifts as a consequence of market movements.

Tax optimization Governance, communication and marketing

Not many platforms use tax harvesting methodologies for the portfolios they manage. We believe this will change, as artificial intelligence is integrated into the process. As an example, IBM robot Watson is now able to advise Americans on their tax questions by scanning six million data points and continuously updating these according to the latest tax regulations available in order to optimize the user’s tax filing. The implications of combining multiple asset categories, life events and other changes to the portfolio for the purpose of tax optimization are very complex. The costs of human

Activities such as governance, communication and marketing affect every part of the value chain and are continuous processes. Although many robo-advisers are well known for their marketing and communication efforts, they often lack governance and supervision models. This is also an important point for regulators. Are there people within the advice platform that know how the algorithm is built up and how it selects funds based on the client’s objectives and constraints?

Figure 2 | Future robo-advice scenarios

Stand alone Robo-adviser

Financial intermediary

Segregated Robo-adviser Financial intermediary

Fully integrated Robo-adviser Financial intermediary

Robo 4 Advisers Financial intermediary

Robo-Adviser

Pure Robo-Adviser

Advice

Portfolio construction

Robo-Adviser

Client profiling

Robo-Adviser

Account ownership

Consultant

Source: PWC, 2016, Robeco Trends Investing

Robeco QUARTERLY • #4 / JUNE 2017

Many robo-advisers are currently dodging regulation by claiming to make suggestions rather than to advise. Customers are quite likely to file complaints if there is a big market correction and their risk profile then seems inappropriate with the benefit of hindsight. This is a reason why many traditional advisers are not willing to advise on single events. Robo 10.1 will no longer be able to avoid regulation, in fact, it will need to have procedures in place to be able to withstand litigation and comply fully with both local and international regulations. This might become a costly affair, requiring scale.

Potentially large market size

Cooperative models most likely long-term outcome We think it will be very hard for stand-alone robo-advisers to survive. The high costs of customer acquisition are particularly problematic. In order for the current solutions to grow into robo 10.1, we believe robo-advice is most likely to proliferate in cooperation with financial intermediaries and as part of a B2B solution. Financial incumbents, from banks to insurers and asset managers, that seek cooperation and integrate their service are likely to come out as long-term winners. Given the current immaturity of robo-solutions, we believe there is enough time for incumbents to respond to the changing market conditions.

‘We expect the potential market size for robo 10.1 to be around USD 30 trillion’

We expect the potential market for robo 10.1 to be around USD 30 trillion in assets under management (AuM) by 2025. This compares with market estimates of between USD 5 and 10 trillion today versus current AuM of USD 100 billion. We see two important considerations that are lacking in current estimates. The first one is that robo-advice offerings as we see them today add little value to the top of the wealth pyramid and are, therefore, not used by this customer group. We think that robo 10.1 will be able to add value to a much larger part of the wealth pyramid, which will make the total addressable market much larger. Our second consideration, is that the robo-solutions will be used more often in a B2B setting. We see the potential for automated advice to be used as an input source for traditional advice. Once the proliferation of technology progresses from a B2C to a B2B offering, the addressable market will grow with it.

Four scenarios There are four possible scenarios for the proliferation of robo-advice models as shown in Figure 2. Robo-advice can thrive as a standalone business model. In that case, scenario 1, the financial intermediary would not have a direct link to the robo-advice platform, other than potential referrals. The potential disruption in this scenario would be biggest, but we view this as the least likely outcome. In scenarios 2 and 3, the robo-solution is integrated into the existing banking offering, either as a separate solution or as a fully integrated solution. We would describe scenario 2 as the app store scenario. An intermediary (platform, wealth manager, insurer or bank) could offer several robo-advice solutions on its platform. In scenario 3, roboadvice is fully integrated into the services of the financial intermediary, and the robo-adviser works with the full customer account that is available from the financial intermediary. In this case, the robosolution has migrated towards a B2B service. Examples of financial intermediaries that use a set-up as described under scenario 3 are Schwab, Vanguard and Van Lanschot Bankiers.

Robeco QUARTERLY • #4 / JUNE 2017

Scenario 4 is a full B2B offering, where the platform is used as tool by a financial adviser. There is no direct link in scenario 4 between the robo-adviser and the customer. An example of such a platform is Wealth Wizards in the UK.

Platforms that work as an aggregator (scenario 2) are likely to appear in the near term. Changes in regulation allow these platforms to aggregate financial data more easily and technology allows them to filter and direct customers towards full solutions, taking into account pensions, insurance, housing, estate planning, taxes and other required input in one holistic approach. Although we argue that the price discussion is overdone, since we believe one should view the added value versus the costs rather than costs alone, it could be a trigger for investments. If incumbents are able to migrate customers to their more efficient robo-platforms, the operational spread could be maintained. An example would be the transition of Schwab’s customer base to their Intelligent Advisory platform. Although about 80% of the hybrid robo-solutions are internal customers, the operational margin per customer has grown as a result of the more efficient value chain. Although robo-advice in its current form is not yet mature, we believe it is real enough to be a challenge to traditional advice. We believe the integration of algorithms with human advice is the most likely long-term outcome, but not all traditional advisers have the technical or financial capabilities to keep up. If robo-advice 10.1 becomes a reality, the traditional advice models are not likely to survive. Although we do not expect traditional advisers that do not invest in technology to disappear overnight, we do believe that the gap they will need to close in a couple of years’ time might prove very expensive or even insurmountable.

Henk Grootveld

‘A good trend investor can only skip the sports pages’ Interview

A trend investor doesn't need a vivid imagination. He just has to want to know everything that is happening around him. Henk Grootveld, trend investor at Robeco, is just such a type of person.

By definition, trends are a constant source of quirky anecdotes and imaginative reflections about the future, but to what extent can investors benefit from them? “But the anecdotes serve a purpose, they’re the best way to explain trends. Basically each trend has to be supported by one of these three elements: demographic developments, technological innovation or regulation. Demographic change is usually slow, but strong, technological developments, often in combination with new business models, can enable new players to supersede monopolists. Regulation leads to innovation – something that is evident in today's financial markets. Most fintech initiatives occur in countries where the financial sector is undergoing rigorous regulatory overhaul.”

The speed at which these developments occur stretches the bounds of our imagination. How important is it for a trend investor to be imaginative? “The most important thing is to be aware of what is going on right in front of your nose. Soon we will be able to generate 200% of our energy needs, not with panels, but with roof tiles. And energy will be free. If we fill 10% of the Sahara with solar panels for five years, it will become a jungle and we can turn salt water into fresh water. At the 2020 Tokyo Olympic Games, all the passenger traffic between the airport and the games will be handled by robo-taxis. That's just three years from now.”

Do crises cause trends? “Crises have often been the catalyst. When your back is against the wall, it often makes you more creative. For instance, during the Cold War when President Kennedy woke up one morning to find that Russia had send a dog into space and let an astronaut orbit the earth, it awakened his ambition to make sure the US was the first country to put a man on the moon. But it’s not only crises that trigger innovation. In the semiconductor industry it was hippies with wild ideas that laid the foundations for Silicon Valley.”

Industrial production will be completely turned upside down in the next few years. So what’s going on? “Factory investments worldwide were put on hold as a result of the financial crisis and there is now some serious catching up to do. A number of major economies are having to cope with aging – it's no coincidence that these are the countries (Germany, Japan, China) with the highest degree of robot density. The technology is available: artificial intelligence, big data tools, the Internet of Things, cheap robots. And political populism also supports this trend. Ford is closing huge factories in Mexico with the loss of thousands of jobs and opening a factory in Chicago with 50 employees and 100 robots.”

“In India, Prime Minister Modi recently abolished all the 500 and 1,000 rupee denominated banknotes in a campaign to combat money laundering. But to exchange that money you have to have a bank account. A month ago, less than 60% of the population had one, now almost everyone does, complete with digital finger print and iris scan – the whole of the Indian population has a biometric passport. E-commerce is now booming in India.”

How important is it to time trends? “In the early stages, many new trends are not accessible to investors. Fintech is now usually financed with private equity. Facebook launched its IPO without having made a profit and with people wondering how it ever would. These are situations where you act first and ask questions later. In the case of every major trend, first there are losers and only in a later phase does it become

Robeco QUARTERLY • #4 / JUNE 2017

‘Hippies with wild ideas laid the foundations for Silicon Valley’

clear who the winners are. So it is often difficult to invest in the winners early on, but you can identify a trend’s losers and avoid them.”

What makes a good trend investor? “Curiosity is the most important quality. You can skip the sport pages, but should devour everything else – cultural, scientific, political and economic news, because, however you look at it, in the long term, they are all related and they all determine our future. Having an open mind is more important than being imaginative. You don’t have to come up with all the ideas yourself, but you have to be aware of the changes that are taking place in the world. The shift from smartphone to the Apple Watch means technology is physically attached to us. The next step will be implanting it in us. All good ideas are ridiculed hundreds of times before they eventually catch on.” But some people worry about all this technological advancement. For example, issues relating to loss of privacy and ethical medical questions. “This is nothing new: in the Middle Ages there were people who refused to walk around with a piece of glass on their nose. Nowadays the newest Samsung television even records your conversations to establish when conversation picks up so that commercials breaks can be adjusted to reflect this. Privacy? This is an unknown phenomenon for today’s younger generation. And they don't miss it either. It only existed for about 40 years. And that’s the generation that still sometimes thinks about Orwell's 1984, but younger people in today's world voluntarily allow Big Brother into their homes.“

Robeco QUARTERLY • #4 / JUNE 2017

Column

Lost in the Italian labyrinth Europe breathed a sigh of relief after the French presidential elections. Some observers even suggested that it has now become highly unlikely that the euro will unravel in the current electoral cycle. Angela Merkel will probably win a fourth term in Germany’s autumn elections. It’s easy to see what kind of deal could be reached between France and Germany: supply side reform in France (mostly labor market reform) in exchange for fiscal initiatives on a European level which could strengthen macroeconomic stabilization policies in the Eurozone. A bilateral working group aiming to draft an ambitious roadmap for further economic integration within the Eurozone will report to a joint Franco-German cabinet meeting in July. The Franco-German axis is purring along again, now that ‘le kid’ Emmanuel Macron has energetically taken over from ‘le concierge’ François Hollande. But the euro is more than a Franco-German affair. The elephant in the room is Italy, the Eurozone’s third largest economy. Italy’s economy grew a meager 0.9% in 2016, around half the average rate of the Eurozone, following growth of 0.8% in 2015. Italy’s unemployment rate exceeds 11% and the ratio of its government debt to GDP is now at more than 130%. Italy is also facing

a general election in the current cycle which has to be held by no later than 20 May 2018. The President is in no hurry to call early elections, as around half of the electorate intends to vote for the Eurosceptic ultraleft (five-star movement) and the ultra-right (Fratelli d’Italia, Lega Nord). Moreover, an attempt is still being made to reach an agreement on a new electoral law in order to achieve greater alignment in the compositions of the Lower and Upper House. The current system is hideously complex: due to the majority bonus that applies in the Lower House, the party receiving more than 40% of votes gets 55% of the seats. If no party has over 40%, the seats are allocated on a proportional basis among parties that receive more than 3% of the vote. In the Upper House, seats are allocated proportionally on the basis of regional votes (there are 20 regions) with two election thresholds: 8% for individual parties and 3% for parties that have formed a coalition (provided that the coalition has more than 20% of the regional votes). Therefore, the election systems are very misaligned, despite the fact that the two houses have the same powers. Furthermore, a government needs to have the confidence of both in order to function properly. So, Italy’s parliamentary election system is a recipe for ungovernability. It may be a blessing in disguise in the short term, because it prevents the formation of an anti-euro majority government, or of any majority government, for that matter. However, the inability to pass reforms and vigorous measures has led to a chronically weak economy, and is, in turn, causing the euro to steadily decline in popularity. Not even the new electoral system proposed by the former Italian premier and the newly confirmed secretary of the left-leaning Democratic Party (PD) Matteo Renzi (I will spare the reader the details) is likely to succeed in guaranteeing the formation of a majority coalition capable of stabilizing the government. In the meantime, investors will continue to fret about a possible Italexit.

Léon Cornelissen, Chief Economist

Robeco QUARTERLY • #4 / JUNE 2017

Important Information Robeco Institutional Asset Management B.V., hereafter Robeco, has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This statement is intended for professional investors. Therefore, the information set forth herein is not addressed and must not be made available, in whole or in part, to other parties, such as retail clients. Robeco disclaims all liability arising from users other than those specified herein. Without further explanation this presentation cannot be considered complete. It is intended to provide the professional investor with general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. All rights relating to the information in this presentation are and will remain the property of Robeco. No part of this presentation may be reproduced, saved in an automated data file or published in any form or by any means, either electronically, mechanically, by photocopy, recording or in any other way, without Robeco's prior written permission. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco's services are not available. Additional Information for investors with residence or seat in France Robeco is having the freedom to provide services in France. Robeco France has been approved by the French prudential control and resolution authority (formerly ACP, now the ACPR) as an investment firm since 28 September 2012. Additional Information for investors with residence or seat in Germany This information is solely intended for professional investors or eligible counterparties in the meaning of the German Securities Trading Act. Additional Information for investors with residence or seat in Italy This document is considered for use solely by qualified investors and private professional clients (as defined in Article 26 (1) (d) of Consob Regulation No. 16190). If made available to Distributors and individuals authorized by Distributors to conduct promotion and marketing activity, it may only be used for the purpose for which it was conceived. Therefore, the information set forth herein is not addressed and must not be made available, in whole or in part, to other parties, such as retail clients. Robeco disclaims all liability arising from uses other than those specified herein. Additional Information for investors with residence or seat in Spain The Spanish branch Robeco Institutional Asset Management BV, Sucursal en España, having its registered office at Paseo de la Castellana 42, 28046 Madrid, is registered with the Spanish Authority for the Financial Markets (CNMV) in Spain under registry number 24. Additional Information for investors with residence or seat in Switzerland This document does not constitute a distribution of collective investment schemes within the meaning of Art. 3 of the Swiss Collective Investment Schemes Act (CISA). The material and information in this document are provided "as is" and without warranties of any kind, either expressed or implied. Robeco and its related, affiliated and subsidiary companies disclaim all warranties, expressed or implied, including, but not limited to, implied warranties of merchantability and fitness for a particular purpose. All information contained in this document is distributed with the understanding that the authors, publishers and distributors are not rendering legal, accounting or other professional advice or opinions on specific facts or matters and accordingly assume no liability whatsoever in connection with its use. In no event shall Robeco and its related, affiliated and subsidiary companies be liable for any direct, indirect, special, incidental or consequential damages arising out of the use of any opinion or information expressly or implicitly contained in this document. Additional Information for investors with residence or seat in the United Kingdom Robeco is subject to limited regulation in the UK by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. Additional Information for investors with residence or seat in Hong Kong This document has been distributed by Robeco Hong Kong Limited

Robeco QUARTERLY • #4 / JUNE 2017

(‘Robeco’). Robeco is licensed and regulated by the Securities and Futures Commission in Hong Kong. The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Additional Information for investors with residence or seat in Singapore This document has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, this document and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of Shares may not be circulated or distributed, nor may Shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor under Section 304 of the Securities and Futures Act, Chapter 289 of Singapore (the “SFA”) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. Additional Information for investors with residence or seat in Shanghai This material may not be copied or used with the public. This material is prepared by Robeco Investment Management Advisory (Shanghai) Limited Company (Robeco Shanghai for short) and is only provided to the specific objects under the premise of confidentiality. This material must not be wholly or partially reproduced, distributed, circulated, disseminated, published or disclosed, in any form and for any purpose, to any third party without prior approval from Robeco Shanghai. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable but Robeco Shanghai does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Neither Robeco Shanghai or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline or other expectations which involve assumptions, risks, and uncertainties and is only as current as of the date indicated. Based on this, there is no assurance that such events will occur, and may be significantly different than that shown here, and we cannot guarantee that these statistics and the assumptions derived from the statistics will reflect the market conditions that may be encountered or future performances of Robeco Shanghai. The information in this material is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. The information contained herein may not reflect the latest information on account of the changes and Robeco Shanghai is not responsible for the updating of the material or the correction of inaccurate or missing information contained in the material. Robeco Shanghai has not yet been registered as the private fund manager with the Asset Management Association of China. This material was prepared solely for informational purposes and does not constitute a recommendation, professional advice, an offer, solicitation or an invitation by or on behalf of Robeco Shanghai to any person to buy or sell any product. This material should not be viewed as a recommendation to buy or sell any investment products or to adopt any investment strategies. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to your individual circumstances, or otherwise constitutes a personal recommendation to you. Robeco Shanghai is a wholly foreign-owned enterprise established in accordance with the PRC laws, which enjoys independent civil rights and civil obligations. The statements of the shareholders or affiliates in the material shall not be deemed to a promise or guarantee of the shareholders or affiliates of Robeco Shanghai, or be deemed to any obligations or liabilities imposed to the shareholders or affiliates of Robeco Shanghai. Additional Information for investors with residence or seat in Australia This document is distributed in Australia by Robeco Hong Kong Limited (ARBN 156 512 659) (‘Robeco’) which is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) pursuant to ASIC Class Order 03/1103. Robeco is regulated by the Securities and Futures Commission under the laws of Hong Kong and those laws may differ from Australian laws. This document is distributed only to “wholesale clients” as that term is defined under the Corporations Act 2001 (Cth). This document is not for distribution or dissemination, directly or indi-

rectly, to any other class of persons. It is being supplied to you solely for your information and may not be reproduced, forwarded to any other person or published, in whole or in part, for any purpose. In New Zealand, this document is only available to wholesale investors within the meaning of clause 3(2) of Schedule 1 of the Financial Markets Conduct Act 2013 (‘FMCA’). This document is not for public distribution in Australia and New Zealand. Additional Information for investors with residence or seat in the Dubai International Financial Centre (DIFC), United Arab Emirates Robeco Institutional Asset Management B.V. (Dubai Office), Office 209, Level 2, Gate Village Building 7, Dubai International Financial Centre, Dubai, PO Box 482060, UAE. Robeco Institutional Asset Management B.V. (Dubai office) is regulated by the Dubai Financial Services Authority (“DFSA”) and only deals with Professional Clients and does not deal with Retail Clients as defined by the DFSA. Additional Information for investors with residence or seat in Brazil The fund may not be offered or sold to the public in Brazil. Accordingly, the fund has not been nor will be registered with the Brazilian Securities Commission - CVM nor have they been submitted to the foregoing agency for approval. Documents relating to the fund, as well as the information contained therein, may not be supplied to the public in Brazil, as the offering of the fund is not a public offering of securities in Brazil, nor used in connection with any offer for subscription or sale of securities to the public in Brazil. Additional Information for investors with residence or seat in Colombia This document does not constitute a public offer in the Republic of Colombia. The offer of the fund is addressed to less than one hundred specifically identified investors. The fund may not be promoted or marketed in Colombia or to Colombian residents, unless such promotion and marketing is made in compliance with Decree 2555 of 2010 and other applicab le rules and regulations related to the promotion of foreign funds in Colombia. The distribution of this document and the offering of [Shares] may be restricted in certain jurisdictions. The information contained in this document is for general guidance only, and it is the responsibility of any person or persons in possession of this document and wishing to make application for the fund to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. Prospective applicants for the fund should inform themselves of any applicable legal requirements, exchange control regulations and applicable taxes in the countries of their respective citizenship, residence or domicile. Additional Information for investors with residence or seat in Panama The distribution of this fund and the offering of Shares may be restricted in certain jurisdictions. The above information is for general guidance only, and it is the responsibility of any person or persons in possession of the prospectus of the fund and wishing to make application for Shares to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. Prospective applicants for Shares should inform themselves as to legal requirements also applying and any applicable exchange control regulations and applicable taxes in the countries of their respective citizenship, residence or domicile. This document does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation. Additional Information for investors with residence or seat in Peru The fund has not been registered before the Superintendencia del Mercado de Valores (SMV) and are being placed by means of a private offer. SMV has not reviewed the information provided to the investor. This document is only for the exclusive use of institutional investors in Peru and is not for public distribution. Additional Information for investors with residence or seat in Uruguay The sale of the fund qualifies as a private placement pursuant to section 2 of Uruguayan law 18,627. The fund must not be offered or sold to the public in Uruguay, except in circumstances which do not constitute a public offering or distribution under Uruguayan laws and regulations. The fund is not and will not be registered with the Financial Services Superintendency of the Central Bank of Uruguay. The fund corresponds to investment funds that are not investment funds regulated by Uruguayan law 16,774 dated September 27, 1996, as amended.

CONTACT Robeco P.O. Box 973 3000 AZ Rotterdam The Netherlands T +31 10 224 1 224 I www.robeco.com