Robeco Quarterly September 2018 by Robeco

Robeco

QUARTERLY Intended for professional investors only

NOW IS THE TIME FOR SUSTAINABILITY INVESTING QUANT investing SUSTAINABILITY investing #9 / September 2018

“Investors need to continue climbing the Wall of Worry that characterizes this bullmarket somewhat further – but keep an eye on downside risks” Peter van der Welle, Robeco strategist, in the five-year Expected Returns 2019-2023

Robeco QUARTERLY • #9 / SEPTEMBER 2018

10 | K eep calm and reduce downside risk

And MORE

QUANT investing

CONTENTS

OUTLOOK Expected Returns: Patience is a virtue

OPINION End of the easy money era

OPINION Value investing – this time it’s no different

MUST READ – LU ZHANG ‘Most reported anomalies fail to hold up’

RESEARCH The A-G of trends in fintech

LONG READ The logistics of ecommerce: improving returns on delivery

INTERVIEW Gilbert Van Hassel – ‘The time is now for sustainability investing’

COLUMN Excessive

11 | P rudent quant strategies can thrive in the A-share market

13 | U pside down world in this late-cycle bull market

15 | I mproving portfolio diversification with factor-based solutions

SUSTAINABILITY investing

Lu Zhang – page 28

22 | T hanks a trillion! World reaches renewable energy milestone

23 | H uman rights high on the radar of clothing companies

25 | P assive investing is incompatible with sustainability investing

27 | Robeco joins Brazilian engagement group

Robeco QUARTERLY • #9 / SEPTEMBER 2018

Sustainability

Walking the sustainability talk Robeco has received the highest possible rating from the UN Principles for Responsible Investment (PRI) for all aspects of its sustainability investing approach. The PRI awarded A+ for every facet of Robeco’s SI operations, from strategy and ESG integration, to active ownership work. It is the fourth year in a row that the PRI has awarded Robeco the highest score for its sustainability investing strategy and governance work. To make sure that the highest standards can be maintained, Robeco has conducted an internal audit on the assessment report since last year. “As clients and other stakeholders are increasingly scrutinizing the sustainability investing approaches of asset managers, there is a growing demand for accountability and verification,” says Carola van Lamoen, Head of Active Ownership.

Cratering currencies Are all currencies equal? This year some emerging currencies are less equal than others. Argentinian peso Turkish lira Brazilian real South African rand Russian ruble Indian rupee Chilean peso Pakistan rupee

-49.9% -41.1% -18.4% -17.9% -17.0% -11.2% -10.9% -10.4%

For comparison, performance of developed currencies vs. US dollar: Euro -3.6% Japanese yen +1.4% Source: Robeco, performance ytd versus USD as per 11 September 2018

The PRI is an international network of investors working together to put the six Principles for Responsible Investment into practice. These range from incorporating ESG into the decision-making process, to using voting and engagement to improve corporate behavior, and regularly reporting on the results. Robeco was one of the first signatories of the PRI in 2006.

launched its Big Book of SI (available via Robeco.com) covering every aspect of sustainability investing. The book details the role sustainability now plays in modern investing, and how Robeco uses it by integrating ESG across its entire fundamental equities, fixed income and quantitative ranges. Robeco CEO Gilbert Van Hassel discusses the Big Book of SI in more detail, along with the reasons for publishing it, on pages 40-41.

To demonstrate clearly how theory is turned into practice, Robeco in July

Unicorns – huge things happen in Chinese technology

Unicorns – hugeheld things –startup huge happen thingsin happen Chinese in technology Chinese technology Unicorns are Unicorns privately companies with a current valuation of USD 1 bln or held more. Unicorn startups are Unicorn privately startups held startup are privately startup Total market Total market Chinese unicorns companies with a current companies valuation with aof current USD 1 valuation billion of USD 1 billion value of 158 value of 158 Other unicorns China holds seven places in the top-10 and represents or more. China holds or more. 7 places China in the holds top-10 7 places and in the top-10 and unicorn startups unicorn startups represents 57% of represents the global market 57% of value. the global market value. worldwide worldwide 57% of the global market value. USD 892 billion USD 892 billion

Top-10 unicorns Top-10 unicorns Market value in USD Market billionvalue in USD billion Ant Uber Financial (US) 70 63

Airbnb (US) 30

Airbnb Didi (US) Chuxing 30 56

Ali Didi Ali MeituanCloud Cloud Chuxing Dianping 39 56 30 39

CATL 20

Palantir (India)

Ant Xiaomi Financial 45 70

Top-10: USD 393 billion Top-10: USD 393 billion

Uber (US) 63

Xiaomi 45

Toutiao CATL 20 20

MeituanDianping 30 Toutiao 20

USD 504 billion USD 504 billion Source: TechStartups.com ©Robeco,Robeco, Source: techstartups.com ©Robeco, Source: techstartups.com

Total market valueTotal of 56market value of 56 unicorn startups from unicorn China startups from China

Robeco QUARTERLY • #9 / SEPTEMBER 2018

Chinese unicorns Other unicorns

To exclude or to engage – that is the question

Which nation leads the world in industrial robots? You might think it’s the country with too few people to do the work. In fact, it’s the world’s most populous nation – China. The country of 1.3 billion people is now the world’s largest robot market, accounting for 27% of all global shipments. Robot installations are set to rise from 90,000 in 2016 to 160,000 in 2019, according to the International Federation of Robotics. The government’s current five-year plan targets an increase from 49 robots per 10,000 manufacturing workers in 2016 to over 150 per 10,000 by 2020. Why so many? “The country is determined to move its vast manufacturing industry up the value chain, to become a quality

Editorial

Emerging markets

Automation nation

To exclude or to engage? That is the question facing sustainable investors. The easiest and cheapest option is exclusion. We prefer to engage, but our approach is a combination of both. Two aspects need to be considered when deciding which approach to take. First, you need to be sure that, whatever you choose, you have your clients’ best interests at heart. In other words, their returns. Second, there's your social responsibility. You can have a bigger impact through engagement than through exclusion, as you have access to the boardroom and can persuade companies to improve on areas they don’t score well on. We are convinced that this has a positive effect on shareholders' long-term returns. Dieselgate. Cybercrime. Money laundering at banks. You only need open a newspaper to see the challenges that lie ahead. Engagement enables you to raise companies’ awareness of the risks. And as a proactive shareholder, you’ll want to offer your input and help them minimize the risks of reputational damage. To achieve this, you have to be a credible shareholder. Engagement is only really worthwhile if you are a long-term shareholder and a reliable partner. And you need to have the people and means to do it in a credible way: experienced engagement specialists and experienced investment teams that work and decide on engagement themes together. Focus is crucial. There is no point in taking a shotgun approach. You have to focus on the areas that will ultimately help boost returns. We are investors, after all.

rather than a quantity manufacturer,” says Victoria Mio, co-head of Robeco Asia Pacific Equities. “Robotics and exponential growth in digitization will make factories smart. They increase productivity, improve quality, shorten lead times for new products and require less energy to produce them. It’s also for labor replacement. China faces rising labor costs and a shrinking workforce. The resulting shortage in staff is solved by using robots instead.”

Robeco QUARTERLY • #9 / SEPTEMBER 2018

And sometimes you have to be able to say, “this is pointless”. With engagement, you set the objectives beforehand and monitor progress during the process. If you eventually decide that engagement is futile, you have to be able to exclude the stock or divest as a last resort. Engagement has become an essential element of our overall company analysis. The importance of both voting and engagement is growing rapidly, and ESG integration is slowly becoming mainstream. Clients now expect it from us and ask how we approach it. This is very different from three, four years ago and a huge step forward. The challenge is to keep moving forward. We have to forge ahead to stand out from the crowd and not only retain but also strengthen our leading role in this area.

Peter Ferket, Head of Investments

The power of earnings

The average unemployment rate in OECD countries has fallen to an historical low of 5.16%. Yet, inflation has failed to reach the levels targeted by central banks. Doubts about the relevance of the Phillips curve, which indicates that inflation should rise as unemployment falls, seem legitimate. So what’s going on?

Investors should focus on the E and not just the P in the price/earnings ratio, says portfolio manager Jeroen Blokland. Some fear that markets which keep hitting new highs may ‘correct’ at some point if valuations become overstretched.

One possible explanation is that the drop in unemployment is largely due to the

Opinion

Column

Inflation set to rise?

However, investors need not worry as long as the earnings component of the price/earnings ratio which underpins all stock market valuations remains strong, says Blokland, who manages multi-asset funds within Robeco Investment Solutions. “There has been a lot of talk about equity valuations in the last couple months – and even years – especially when it comes to US price/earnings (P/E) ratios,” he says. “And while US stock markets are certainly not cheap, at times it seems that investors give too much weight to the price component of the P/E ratio, when it is really the earnings component that is driving the market.”

“Share prices and earnings per share tend to move together, although the relative pace at which they move changes from time to time. For example, the earnings of S&P 500 companies have risen roughly 20% during the last 12 months and are expected to grow even faster in the coming 12 months. This means the earnings of S&P 500 companies are, at least for now, growing faster than their stock prices. And that is precisely why concerns about elevated valuations have faded considerably.” This is also true in regions outside the US, Blokland says: “In Europe, the importance of earnings is even more clearly demonstrated than in US stock markets. Over the last two years, the earnings of companies included in the MSCI Europe Index have risen by an impressive 88%. Stock prices, however, have gone up by ‘just’ 17%. So the power of earnings should not be underestimated.”

increase in lower-wage part-time and temporary jobs. While this was certainly the case in the years after the crisis, companies are now hiring more permanent workers. A second explanation is that it takes time for wages and, ultimately, inflation to register the effects of lower unemployment levels. A third possibility is that this long period of low inflation is just an anomaly. Whatever it may be, I’m not convinced yet that the relationship between unemployment and inflation is broken.

Jeroen Blokland Senior Portfolio Manager

Robeco QUARTERLY • #9 / SEPTEMBER 2018

Expected Returns: Patience is a virtue Modest returns on equities and bonds that are still in negative territory mean investors will need to be patient, our new five-year outlook predicts.

Speed read

Outlook

• A careful approach is advisable amid headwinds seen for 2019-2023 • Equities again seen returning the most, government bonds the least • Economic cycle in prolonged mature phase, recession likely

With the current period of economic expansion set to break a new record, the introduction of tighter monetary policy already underway, and the expectation that a recession will end the decade-long bull markets, a more careful approach is advisable, say Léon Cornelissen, Jaap Hoek and Peter van der Welle of the Robeco Investment Solutions team. Forecasts in Expected Returns 2019-2023 once again predict that equities will be the best-performing asset class over the next five years, with emerging market stocks returning 4.5% a year and developed markets 4% for euro investors. And the team continues to believe that German government bonds will deliver negative returns of -1.25% a year, while developed global government bonds should return -0.25%. Emerging market debt in local currencies is seen returning 3.75%

a year, while investment grade corporate bonds should deliver 1% and high yield (non-investment grade) credits 1.5%.

Low returns for longer The main headwinds are led by the end of multitrillion-dollar quantitative easing stimulus programs along with the belief that markets are now ‘playing in extra time’. Given the uncertainties, it means that ‘patience is a virtue’ is the new order of the day. “The title of last year’s Expected Returns, ‘Coming of Age’, reflected our view that what was then an almost record-long period of economic expansion still had some way to go. One year later, many indicators are virtually unchanged and the global economic cycle is enjoying a prolonged mature phase, as evidenced by the recent cyclical upswing,” says Robeco Chief Economist Léon Cornelissen. “But as central banks continue their shift away from quantitative easing to tighter monetary policy, this expansion will slow. With valuations for every major asset class looking stretched, a transition to the next phase could easily send markets into a tailspin. A recession at some point seems inevitable.”

Global growth is good Expected annual returns 2019-2023 Developed market equities

4.00%

Emerging market equities

4.50%

German government bonds

-1.25%

Developed global government bonds

-0.25%

Emerging government debt (local)

3.75%

Investment grade credits

1.00%

High yield

1.50%

Listed real estate

3.25%

Commodities

4.00%

Cash

0.50%

Returns are denominated in euros. Bond and cash returns are euro hedged, except for local currency emerging market debt. The value of your investments may fluctuate and past performance is no guarantee of future results. Source: Robeco.

Robeco QUARTERLY • #9 / SEPTEMBER 2018

So, what should investors do? “Opting for a more defensive portfolio is often the default solution, but in the current economic climate there are risks associated with doing too much, too soon,” says portfolio strategist Jaap Hoek. “The advantages of adopting a more patient approach therefore seems a fitting theme for this five-year outlook. ‘Patience is a virtue’ is thus our theme this year and underscores our view that there are still opportunities to harvest risk premiums in the major asset classes.” There is certainly no need to panic, as the global economy is still in relatively good shape, and growth remains solid. The US, ever the engine of global growth, is still going strong, and the Federal Reserve’s tighter policy has not put a spanner in the works. Meanwhile, China has done well to bring down unsustainable debt-fueled growth to more sensible levels, and the once-troubled Eurozone has continued to grow, while emerging economies are

Outlook

seen continuing to outperform developed economies. “Hence, our motto for the world as a whole is ‘steady as she goes’,” says strategist Peter van der Welle.

Too good to be true? “For investors, this may all sound a bit too good to be true. On a five-year horizon, we are likely to experience a US recession at some point – if only on the maxim that ‘stability breeds instability’. It is difficult to predict when this will happen, but it could take place after the presidential elections in November 2020. Trade tensions are likely to be kept in check, as a serious escalation would be counterproductive, and self-harm is not generally considered to be a viable political strategy.” “It is clear that the investment environment could change dramatically in the next five years and that current conditions are already quite challenging, with compressed spreads, widespread overvaluation in the major asset classes, and low volatility. For long-term investors, it makes sense to start anticipating these changes, but they should not forget that patience is a virtue in the world of investing, too.”

Special topics As in previous years, Expected Returns has looked at five special topics relevant for investors, with the recurring theme that patience is a virtue. ‘Time to get defensive?’ uses the cyclically adjusted price-to-earnings ratio to analyze whether stocks are currently overvalued. We follow up on this theme with ‘The potential rewards of diversifying away from US equities’, using another investing tool, the Equity Risk Premium, to investigate what the implications are from the lower compensation for taking equity risk in the US. In ‘All roads lead to Rome, but few lead to Italian debt sustainability’ we compare today’s QE and market manipulation programs with the 18th century ‘pretended payments’– a phenomenon Adam Smith then called ‘the juggling trick for skyhigh debt’. ‘Oil will have to be written off at some point. But not yet!’ argues that stranded fossil fuel assets due to global warming targets do not currently threaten the prosperity of oil companies, though their day will eventually come. Finally, ‘Bond. Corporate Bond’ debunks the idea that credits can be dumped from portfolios on the basis that returns are a cross between equities and sovereign bonds, and so can be easily replicated.

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QUANTinvesting Navigating CAPE fears High valuation multiples have been a matter of concern for several years now. As the CAPE ratio for the US stock market continues to hover around 1929 levels, the question for prudent, long-term equity investors is not so much whether a correction is imminent or not, but rather how to prepare for it. One way to minimize the consequences of a sharp downturn is to apply a prudent approach based on a simple quantitative investment formula. This formula selects stocks based on three main criteria: volatility, net-payout-yield (NPY) and price momentum. We refer to this defensive equity style, that has proved an efficient way to navigate choppy waters, as ‘conservative’.

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Keep calm and reduce downside risk High CAPE ratio levels do not signify an imminent end to the bull market for equities. But they do sound a note of caution. Our research shows that higher CAPE ratios are typically followed by periods of higher downside risk. Fortunately, investors can reduce this risk substantially by tilting their equity portfolios towards low-risk stocks, says Pim van Vliet, Head of Conservative Equities and Quant Allocation.

The cyclically adjusted price-to-earnings ratio, commonly known as the CAPE ratio, recently reached levels seen on the US stock market in 1929, sparking renewed fears that global equity markets could be ripe for a correction. But this may not be the case. As Nobel prize winner Robert Shiller – one of the fathers of the CAPE ratio – indicated earlier this year, equity markets could remain bullish for years. The CAPE ratio is a valuation measure of the stock market that can be defined as stock prices divided by the moving average of ten years of earnings per share, adjusted for inflation. It is a widely followed measure, usually applied to broad equity indices to assess whether the market is under- or overvalued. But a closer look at the relationship between CAPE ratios and equity returns shows that the CAPE ratio is a poor predictor of market performance. An analysis of US stock market data for the period 1929-2018 reveals only a weak negative relationship between the CAPE ratio and the subsequent three-year equity returns adjusted for inflation.

The expected three-year equity returns over the entire sample period are lower when the CAPE ratio is high and, generally speaking, enter negative territory when CAPE ratios are very high (above 30). However, there is also quite a lot of variation in returns, with considerable losses visible for CAPE ratios of

the probability and magnitude of an expected loss. Table 1 illustrates this. It shows the expected downside risk over a threeyear investment horizon for US stocks, throughout the 1929-2018 sample, for five different CAPE level groups. The main finding is that the chances of losing money go up from 4% when CAPE is below 10 to 65% when CAPE is above 25. In addition, the average loss is also much higher, going up from a -4% loss to a -24% loss. As a result, the expected downside risk goes up significantly from -0.2% to -15.8%.

‘A closer look at the relationship between CAPE ratios and equity returns shows that the CAPE ratio is a poor predictor of market performance’ around 25, and solid returns for CAPE ratios of around 30. But while the CAPE ratio may not be a very reliable indicator for predicting market reversals, it can definitely help assess downside risk. Our research shows that higher CAPE ratios are typically followed by periods of higher downside risk, as measured by the lower partial moment (LPM), which is calculated by multiplying

Downside risk monotonically increases across the different CAPE groups. This pattern has been visible not just for US equities over the past 90 years but, more generally, in global developed and emerging stock markets, as well.

Time for a ‘conservative’ approach? High CAPE ratios do not, therefore, signify an imminent end to the bull market, but they do sound a note of caution about downside risk. The good news for investors is that they can reduce this risk substantially by tilting their equity portfolios towards low-risk stocks. A simulation using a simple

Tabel 1 | US stock market risk in relation to CAPE All

<10

10-15

15-20

20-25

>25

% observations

CAPE 1929-2018

100%

12%

28%

24%

31%

Chance of loss

22%

32%

28%

65%

Average loss

-21%

-4%

-10%

-20%

-26%

-24%

-4.7%

-0.2%

-0.7%

-6.3%

-7.0%

-15.8%

Downside risk (LPM) Source: Robeco

Robeco QUARTERLY • #9 / SEPTEMBER 2018

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Figure 1 | Risk reduction with the Conservative Formula across CAPE ratio ranges 0%

Downside Risk

-4% -8% -12% -16% -20% Market

CAPE <10

10-15

15-20

20-25

CAPE >25

reduces the chance of losing money on the stock market over three-, 12-, 36- and 60-month investment horizons. Moreover, the Conservative Formula also proves to be very effective at reducing downside risk, as measured by the LPM, when CAPE ratios are high. For example, the threeyear downside risk is reduced significantly, from -15% to -2%, when the CAPE ratio is above 25. Figure 1 shows this reduction of downside risk compared to the broader equity market, across different CAPE ratio ranges.

Conservative Formula

Source: Robeco, paradoxinvesting.com. Risk = three-year downside risk

low-risk investment formula, dubbed the ‘Conservative Formula’, in a universe of 1,000 large US stocks shows that the risk of losing money can be reduced significantly – even when CAPE ratio levels are high. The Conservative Formula divides the investment universe into two groups of the same size based on the historical volatility

of returns over a three-year period. Within the group of 500 lower-volatility stocks, it selects the 100 most attractive stocks based on net-payout-yield (NPY) and price momentum. We refer to this defensive equity style as ‘conservative’. Our calculations show that using this simple investment formula significantly

As we head into the final months of 2018, equity markets remain at or near all-time highs and volatility is low. This might be a good time for investors to take a strategic look at their long-term investment portfolio and consider a more ‘conservative’ approach. 1 Blitz, D. and Van Vliet, P., ‘The Conservative Formula: Quantitative Investing Made Easy’, March 2018.

Prudent quant strategies can thrive in the A-share market On 1 June, MSCI added A-shares from 226 companies to its global and regional indices, marking an important milestone for global equity investors. From a quantitative investment perspective, this addition presents both an opportunity and a challenge. While A-shares constitute an exciting playground for quant investors, practical implementation also requires taking additional precautions, says Yaowei Xu, a senior portfolio manager from our Quantitative Equities team.

How do you see this first wave of Mainland China-listed A-share inclusions? “To me, this is very important. It illustrates that A-shares, which used to be considered an exotic potential source of alpha, are slowly becoming a ‘must-have’ for global

Robeco QUARTERLY • #9 / SEPTEMBER 2018

investors. Although the number of stocks included by MSCI is small, this is a first step towards a USD 8.5 trillion stock market.” “After this initial MSCI inclusion, China A-shares represent just 0.75% of the MSCI

Emerging Markets Index and 0.1% of the MSCI ACWI Index, while China accounts for 15% of global GDP, 11% of global consumption and 11% of global trade. A-shares also represent 20% of global equity turnover and 11% of global equity market capitalization, making them the second largest national stock market after the US. This means A-shares remain clearly underrepresented in global equity indices, and their weight is set to increase significantly over the coming years.” “Moreover, A-shares offer investment

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opportunities that are not accessible through Chinese offshore markets. Compared to Hong Kong-listed H-shares, they enable greater diversification across sectors such as consumer goods and services, health care, industrials, commodities and technology. By investing in A-shares, international investors can obtain greater and more diversified exposure to many of the fast-growing sectors.” Does that mean A-shares data should be treated differently when used for quantitative investment strategies? “Yes and no. ‘No’, because Robeco’s quantitative research methodology and stock selection models, based on proven factors, also apply to the A-shares market. And ‘yes’, in the sense that we take

additional steps to ensure the quality of the data used as input for the models. It is important to make sure this data is reliable.” “China’s economy has experienced tremendous changes over the past three decades, and so have Chinese companies. Such radical changes have translated into businesses transforming at a rapid speed and sometimes taking convenient ‘shortcuts’ towards the capital markets, such as backdoor listings on the A-shares market.” “To verify the quality of the data, we first look at its consistency. For example, if a water pump company ‘changed’ into a digital marketing company a year ago, the stock’s prior historical data is not valid

is spotted, we refrain from buying or overweighting the stock, to avoid any risk. These governance screenings are done by the quantitative portfolio managers, in close cooperation with Robeco’s fundamental A-shares team based in Shanghai.” But despite these challenges, A-shares still represent an opportunity for quantitative investors, right? “Definitely. Chinese equity markets still feature very specific characteristics that really set them apart and make them particularly interesting from a quantitative investment point of view. Unlike most major equity markets, the A-shares market is still very much dominated by retail trading flows and foreign participation remains extremely low, close to 2%.”

‘Chinese equity markets still feature very specific characteristics that really set them apart’ anymore. Second, we take an active stance concerning corporate governance issues. If a company is suspected of significant manipulation of its financial statements, then the data for that stock is not reliable.” “A typical illustration of this is off-balance sheet financing. Some construction companies, for example, generate most of their revenues through contracts owned by off-balance sheet special purpose vehicles, which are usually highly leveraged. With some creative accounting, the firm can manipulate its financial statements to make its leverage appear lower, its profits look higher, or its free cashflow seem stronger.” “Whenever this kind of dubious practice

“And since it remains largely underexplored by rules-based investors, prudent quantitative strategies have the potential to thrive in such a less efficient market. Our research shows that stock selection based on the factors we firmly believe in, like low volatility or value, also works well with A-shares. These factors show strong performance, both taken together and on a stand-alone basis.”

How are A-shares considered in Robeco’s quant equity strategies? “Current quantitative emerging markets strategies already include A-shares in their investable universe. As of July 2018, our Emerging Conservative Equities strategy invests 1.5% in A-shares, while Emerging Markets Active Quant invests 0.6% and Emerging Markets Enhanced Indexing invests 0.4%. Additionally, I will be managing two dedicated A-shares quantitative strategies: Quantitative Active China A-shares and Conservative China A-shares. Clients investing in our

Robeco QUARTERLY • #9 / SEPTEMBER 2018

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quantitative strategies through segregated emerging markets accounts can now choose whether to invest in A-shares within their mandates, through Stock Connect or via the Robeco funds.”

uses the same stock selection model as the Emerging Markets Active Quant strategy. Since inception, the strategy has outperformed the benchmark significantly, with a 50% targeted active share.”

“The Robeco QI Chinese A-share Active Equities strategy was launched in November 2017, aiming to consistently outperform its benchmark by incorporating a high multi-factor exposure to three proven return factors: value, quality and momentum. This strategy ranks the 1,000 largest A-shares and

“In August of this year we also launched the Robeco QI Conservative China A-shares strategy that will aim to maximize the Sharpe ratio in the long run with a substantially lower downside risk. Both strategies invest in Chinese companies that have an A-shares listing, but can invest up to a certain amount in H-shares, as an

alternative to Mainland China-listed stocks.” “These days, the dual listed A-shares trade at a 25% premium (market capitalizationweighted) to their H-share counterparts. We choose the most efficient securities based on multiple criteria, such as liquidity differences, premium/discount, trading costs, index exposure and client guidelines. We believe that, as China’s capital account opens up further, the valuation gap between A-shares and H-shares will gradually decrease.”

Upside down world in this late-cycle bull market The past two years have been characterized by unusually high equity returns and low volatility. Cyclical stocks have also significantly outperformed defensive ones. This raises an important question: how long can this situation last? Investors who subscribe to a ‘back to normal’ view should look ahead instead of looking in the rear-view mirror. They should also make sure their equity positions are consistent with their own long-term expectations, says Jan Sytze Mosselaar, a portfolio manager from our Conservative Equities team.

The current bull market in global equities is now well into its ninth year, making it one of the longest up-cycles on record. As US equity valuations recently matched 1929 levels, many investors have started wondering if this bull market could be on its last legs. Indeed, the last two years have been characterized by a combination of extremely favorable circumstances, that hardly seem sustainable. Global equity markets have posted annual returns at levels that were almost twice the historical average. From 30 June 2016 to 30 June 2018, the broad MSCI AC World and MSCI EM Indices achieved annualized returns of around 15% and

Robeco QUARTERLY • #9 / SEPTEMBER 2018

the UK and Switzerland. But, overall, the rise in global equities has been relatively broad-based, as Table 1 shows.

Almost bond-like volatility At the same time, the level of market volatility has been only about half the historical average. In the 24 months between July 2016 and June 2018, the volatility of the MSCI World has averaged approximately 8%, which is low by any standard, as Figure 1 shows. At the end of 2017, the one-month rolling volatility even fell below 4%. Such a low level of volatility is normally associated with bond markets.

‘We think an extended period of extremely low volatility is improbable’ 16%, respectively. This is almost twice the expected and historical global average of 8% per year. Of course, there were significant differences between the markets. Chinese stocks fared especially well, helped by the solid performance of index heavyweights Alibaba and Tencent. Meanwhile, European markets lagged somewhat, most notably non-euro markets such as

Historically, market volatility has been closer to 15% on average, although periods with substantially lower or higher volatility have been known to occur. Given that market volatility historically tends to revert to the mean, we think an extended period of

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Figure 1 | Equity returns over the July 2016-2018 and July 2003-2018 periods Local returns July 2003-2018

Local returns July 2016-2018 China

27.2%

China

14.7%

Japan

19.2%

MSCI EM

11.6%

South Korea

16.2%

South Korea

10.2%

MSCI EM

16.0%

Australia

9.1%

France

15.7%

United States

8.7%

United States

15.6%

Germany

8.6%

MSCI AC World

14.9%

MSCI AC World

8.1%

MSCI World

14.8%

Canada

8.1%

Taiwan

14.2%

United Kingdom

8.1%

Australia

13.9%

MSCI World

7.9%

United Kingdom

12.4%

Taiwan

7.3%

Germany

12.1%

MSCI Europe

7.2%

MSCI Europe Canada Switzerland

12.0% 11.1% 7.1%

France

6.9%

Switzerland

6.2%

Japan

6.0%

Source: MSCI, Robeco. Annualized total returns in local currency over the periods 30 June 2016 to 30 June 2018 and 30 June 2003 to 30 June 2018.

extremely low volatility is improbable. From that perspective, the recent jump in market volatility in early February and late March 2018 could be a sign of a new period of higher volatility ahead.

Another important feature of the recent market environment is that cyclical growth stocks have significantly outperformed defensive stocks, which is not unusual in the final stages of a strong bull market. The most

Figure 2 | One-month rolling daily volatility of MSCI World, July 2003-2018 80% 70% 60%

significant turnaround in the current bull market happened in July 2016, when cyclical sectors started to outperform defensive sectors by a wide margin. This trend of cyclical stocks outperforming defensive, high-dividend ones has been quite consistent over the last two years. As a result, both the minimum volatility and high dividend factors have lagged the market by quite a wide margin, both in developed and emerging markets. Given these trends, it should come as no surprise that momentum has worked well, especially over the past 12 months.

Reassessing expectations In this environment, one would almost forget that equity markets are dynamic and that investment circumstances evolve over time. Therefore, every forwardlooking investor constantly has to make an educated judgement as to whether trends will persist or change in the foreseeable future and adjust portfolios accordingly. Of course, timing the short-term direction of markets and factors is always a daunting task. But, given the strong performance seen in global equity markets over the past couple of years, returns are likely to be significantly lower and more in line with long-term averages going forward. And conversely, volatility levels are expected to rise substantially. In this context, investors who subscribe to the ‘back to normal’ view might want to look ahead instead of looking in the rearview mirror, and make sure their equity positions are consistent with their own long-term expectations.

50% 40% 30% 20% 10% 0% June June June June June June June June Jun2003 2004 2005 2006 2007 2008 2009 2010 2011

Jun- Jun- June June June June June 2012 2013 2014 2015 2016 2017 2018

Source: Robeco, Bloomberg, MSCI

Robeco QUARTERLY • #9 / SEPTEMBER 2018

QUANT INVESTING

Improving portfolio diversification with factor-based solutions Factor investing is useful for achieving common investment goals, such as reducing downside risk or enhancing long-term returns. But it can also help investors with more specific targets. For example, it can help improve portfolio diversification. Empirical research shows that diversification into and across factors is more effective than traditional asset class approaches. As a result, well-designed factor-based products tend to enable a balanced and stable outperformance.

‘The quest for more robust diversification techniques has caused many investors to turn to factor investing’

Diversification is often said to be the only ‘free lunch’ for investors. And for centuries, asset owners have applied this principle by dividing their holdings across different asset classes. But the dramatic increase in correlations between asset classes during the market wobbles of the 2000s, especially during the global financial crisis, has started to cast doubt on the benefits of traditional diversification.

Strong scientific basis Contrary to traditional asset allocation, which often lacks any scientific basis, factor allocation is based on decades of robust empirical analysis. This research documents a number of significant,

persistent and relatively uncorrelated riskreturn patterns across financial markets. Investors can take advantage of these patterns and select securities with different risk-return characteristics to achieve better diversification. A 2012 paper2 by Antti Ilmanen and Jared Kizer analyzing market data on a number of asset classes dating back to 1927 reported that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than traditional asset class approaches. And while the authors acknowledged that long-short investing generates the most diversification benefits, which implies short selling and leverage, they also found meaningful benefits in a long-only context. More recently, in a research report3

One of the key debates today in the financial industry is whether quantitative approaches to portfolio selection and construction are more effective than traditional ones, in particular in terms of diversification. For instance, the influential 2009 study1 on the Norwegian Oil Fund and factor investing showed that despite a seemingly diversified profile, the fund’s active returns had considerable exposure to systematic risks, mainly due to bottomup decisions. The quest for more robust diversification techniques has caused many investors to turn to factor investing. In fact, a recent FTSE Russell survey of asset owners found that improved diversification ranked third among the top investment goals that led them to consider factor-based strategies.

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QUANT INVESTING

Figure 1 | Balanced and stable outperformance 150% 120%

shows the simulated performance of a multi-factor portfolio over the period from 1988 through 2015. It also shows which of the four factors (value, momentum, low volatility and quality) targeted in our quantitative equity strategies outperformed in each year.

250%

Cumulative excess return of multi-factor portfolio and years when factors outperformed*

200% 150%

60%

100%

30%

50%

Ultimately, the result is a balanced and stable outperformance, compared to the broader market (gray area), with positive contributions from at least three factors in three out of four full calendar years.

Outperforming factors

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

90%

Concentration risk still matters Low-Vol

Quality

Momentum

Value

Source: Robeco, MSCI. Excess returns are measured relative to the MSCI World index from June 1988 through December 2015. Returns are measured in USD. The Robeco factor strategies are based on portfolio simulation and net of transaction costs of 75 bp. The factor weights in the multi-factor proposition are 25% Value, 25% Momentum, 25% Low-Volatility and 25% Quality. The bars show whether an individual factor strategy yielded a positive excess return in each year. The value of your investments may fluctuate. Past performance is no guarantee of future results.

initially prepared for Robeco, Kees Koedijk and Alfred Slager, from Tilburg University, and Philip Stork, from VU University Amsterdam, also looked at the degree to which diversification can be achieved using a factor-based approach instead of an assetbased one. They argued that diversification across factors has major benefits, as the

correlation between factors such as value or momentum is much lower than between investment categories. The diversification benefits of factor investing are also evidenced by the performance of Robeco’s Multi-Factor Equities strategy over time. Figure 1

Although the focus should remain on optimizing factor exposures to ensure diversification, the merits of investing in a broad and varied selection of securities should not be forgotten. Robeco’s inhouse research shows that adding sector weight constraints to an unconstrained portfolio reduces concentration risk while not significantly altering returns, at least to a degree. At a certain point, however, concentration limits start to have a negative effect on performance. This implies that an optimal level of concentration exists, and this should be taken into account by investors. Efficient factor strategies should therefore not only focus on finding the best factor exposure, but also prevent unintended geographic or sector biases, as well as undue concentration on some single securities or sub-segments of the financial markets. One way to ensure this is to establish strict but workable concentration rules, as this would lead to a varied selection of stocks or bonds while avoiding excessive sector and country tilts. 1 A. Ang, W. Goetzmann and S. Schaefer, ‘Evaluation of Active Management of the Norwegian Government Pension Fund – Global’, prepared at the request of the Norwegian Ministry of Finance, 2009. 2 A. Ilmanen and J. Kizer, ‘The Death of Diversification Has Been Greatly Exaggerated’, The Journal of Portfolio Management, Spring 2012. 3 K. Koedijk, A. Slager and P. Stork, ‘Investing in Systematic Factor Premiums’, European Financial Management, 2016.

Robeco QUARTERLY • #9 / SEPTEMBER 2018

End of the easy money era For the first time since 2009 all the major central banks are singing from the same hymn sheet: the only way is up! Even the Bank of Japan has now decided to increase the bandwidth within which it will allow bond yields to move, wa signal that it is prepared to let interest rates start moving higher.

Speed read

Opinion

• Policies of major central banks are starting to converge • Potential for higher bond yields and more market volatility • Active duration management offers protection as yields rise

And, although the central bank chiefs are not exactly shouting it from the rooftops, the message is clear: they are gradually going to increase interest rates and let bond markets worldwide move more freely. As a result, actively managing interest-rate risk is likely to become more important for bond investors and potentially also more lucrative. An environment of increased volatility and higher yields is challenging for bond investors. Robeco QI Global Dynamic Duration’s portfolio manager, Olaf Penninga outlines why we can now consider the easy money era to be behind us and the impact we can expect this to have on bond markets. He also shows how a strategy designed to exploit yield moves, like the one he manages, is well-positioned to benefit in this environment.

its actions than in its words: intervening before 10-year yields reached 0.2% and purchasing JPY 400 billion (EUR 3 billion) of 10-year bonds in an unscheduled operation after yields had only ticked up to 0.14%.

…but one giant leap for bond markets Although the Bank of Japan is taking things gently and letting bond yields rise only very gradually, this step means the policies of the major central banks are now all pointing in the same direction: the Fed is hiking rates and shrinking its balance sheet, the Bank of England has just hiked rates again and the ECB is winding down its bond-buying program and signaling

One small step for the Bank of Japan… The Bank of Japan (BoJ) has implemented more extreme policy measures than any other central bank in recent years. Not only has it introduced negative interest rates and bought up a huge amount of its own sovereign debt – it owns more than 40%

‘Dual challenge of increased volatility and rising interest rates’ of all outstanding Japanese government bonds – it has also introduced a 0% target for 10-year government bond yields and ensured that yields remain within 10 basis points of this level. Japan’s central bank is now relaxing the last of these measures and, in its recent meeting, decided to allow yields to rise gradually. In the ensuing press conference, President Kuroda said that the target yield range would be doubled. However, just two days later, the BoJ proved to be more measured in

Robeco QUARTERLY • #9 / SEPTEMBER 2018

Opinion

‘The policies of the major central banks are now all pointing in the same direction’

that it is likely to start hiking rates in the third quarter of next year. Global bond markets will now have to cope with higher short-term rates and central banks that are on aggregate reducing rather than increasing their bond portfolios. Furthermore, higher Japanese bond yields make foreign bonds less attractive to Japanese investors and the lower demand this may cause could also lead to higher yields on Eurozone government bonds. US bonds are no longer attractive to Japanese investors, as the Fed’s rate hikes have increased the costs of hedging the currency risk. As a result, Japanese investors are reducing their holdings of US Treasuries.

Duration strategy performs well when yields rise Now that all the major central banks are moving towards tighter

monetary policy, yields are starting to rise, especially in the US, and we can expect bond markets to become more volatile. Robeco QI Global Dynamic Duration can offer protection against rising yields by reducing its interest-rate sensitivity. It can add more value when bond yield levels move more significantly, irrespective of the direction. This is because the strategy actively times its bond market exposure. When yields lack direction, the strategy has fewer opportunities to add value as it reduces or increases its interest-rate sensitivity (duration) according to market circumstances. This makes Dynamic Duration an effective solution for investors looking for ways to protect the value of their government bond portfolios in an environment where they are likely to be confronted with the dual challenge of increased volatility and rising interest rates.

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Value investing – this time it’s no different Value investing will come back into fashion, despite the long rally in growth investing, say market specialists Mike Mullaney and Dan Farren. The value investment style has consistently underperformed over the last decade, prompting many to question whether the cyclical nature of investing will bring about its eventual return, or whether the internet age means ‘this time it’s different’.

Speed read

Opinion

• Value investing has underperformed growth since the financial crisis • Understanding growth stock drivers is key to success in value • Inflexion points seen in Energy, Financials and macro factors

However, an inflexion point is likely to come sooner or later, triggered by a number of formerly unfashionable sectors and some macroeconomic factors that favor value stocks, says Farren, senior portfolio analyst with Boston Partners. He says this time is no different, and the ‘bargain hunting’ principles of value investing are still valid. Value investing is the practice of looking for companies whose share price does not reflect their underlying business fundamentals or prospects, allowing for considerable upside in the stock. Boston Partners has been a value investor since the 1980s, following the ‘three circles’ concept. This involves looking for companies that are relatively cheap, have strong fundamentals and have an underlying business momentum, where there are catalysts for positive change that are not reflected in the share price.

Trying to beat indices that are loaded with growth stocks has therefore proved troublesome, particularly since the market correction of early 2018, which caused a stampede into ‘expensive defensives’. These stocks also pose problems for value investors, as they trade on high earnings per share multiples, but with little likely upside for the stocks. As such, they don’t meet the three circles criteria and cannot be bought, meaning a fund will likely lag an index in which they feature prominently.

Value still makes sense As always, it’s important to be a long-term investor, with an eye on the main prize. “Value has outperformed growth pretty meaningfully since 1979, but growth has now outperformed value since 2007, the longest stretch ever,” says Farren. “So, people are asking if value investing as a concept is broken. Is it different this time, and does gravity no longer apply? We don’t think that this is the case.” “The idea of buying assets that are undervalued where there is a

Bitten by FAANG The biggest problem for value investors is that growth stocks have significantly outperformed their value stock counterparts since 2007. This process has been exacerbated by the rising dominance of the FAANG stocks – Facebook, Amazon, Apple, Netflix and Google – which make up 21% of the Russell 1000 Index. As the internet era has created these new mega-companies, their inexorable growth has brought handsome returns for their shareholders, says Mullaney, director of global markets research for Boston Partners. The combined market value of FAANG is now USD 3.4 trillion, or higher than the GDP of most countries. In 2018 alone, Netflix has doubled in value, while Apple became the world’s first trillion-dollar public company.

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Opinion

reasonable catalyst for change is always going to make sense. If you have a longenough time horizon, most money in the world has always been made by people who were liquid when everyone else was panicking, and we think that that is still incredibly pertinent.”

‘The idea of buying assets that are undervalued where there is a reasonable catalyst for change is always going to make sense’

“Value is timeless. From 1920 to 2006, buying value stocks yielded a 5% annual premium, but this has inverted since 2007, becoming a negative 1% return, a reversal of 6%. The mentality changes, but the cyclicality is always there: from 1969 to 1977, value outperformed by 145%, and from 1999 to 2005 the outperformance was 90%. So, there is great potential for value, when the market eventually turns.”

Upcoming tailwinds Mullaney says value investors can look forward to several upcoming tailwinds, one of which is the likely future performance of formerly out-of-favor sectors such as Energy and Financials, which have recently benefited from higher oil prices and interest rates, respectively. “Even if you do still like the growth stocks, you must expect a reversion at some point... so what would start it?” he says. “Energy is currently only 0.7% of the Russell 1000 Growth Index

and 11.4% of the Value Index, but as a result of the rise in oil prices, the sector was the biggest gainer in the second quarter.” “If financials also do better, then this could be the inflexion point that we’ve been looking for, since all the factors that benefit financials such as rising interest rates are now in place. If the technology sector slightly underperforms the market, you’ll see some meaningful outperformance by value stocks.”

Another potential tailwind is a technical change to the composition of indices against which funds are benchmarked. “In September, both the MSCI and S&P are changing the composition of their indices, taking media technology and internet out of the Technology classification, and putting them into a new sector called Communications Services,” Farren says. “This means the Technology weighting in the Russell 1000 Growth Index will come down from 32% to 24%. That’s meaningful, because a lot of people have said you won’t get to see value outperform because of the structure of the value and growth index weightings. Performance won’t change, but the Technology weighting change could have a subtle impact.”

Raiders of the lost art Then there are activists and corporate raiders who buy into troubled companies in order to turn them around. “Activists are constantly finding companies in the US and Western Europe that are poorly run or are part of conglomerates and can be spun off,” says Mullaney. “They find ways to cut costs, sell assets and return cash to shareholders. Our screening typically finds them before these activists do, and that’s allowed us to invest in a lot of specialist situations. There’s still a lot of stuff out there that’s overlooked or unloved that can benefit value.” Meanwhile, research shows that macro factors for value investors are positive when corporate earnings are strong, GDP growth is above 2%, and interest rates are rising. Boston Partners focuses entirely on bottom-up stock picking, but sometimes understanding the top-down view can also offer insight. “We do know from past experience when these three factors are present, value eventually outperforms growth,” says Farren. “We hit the perfect storm after the financial crisis, but it will turn around. These things are always cyclical, and this time is no different.”

Robeco QUARTERLY • #9 / SEPTEMBER 2018

SUSTAINABILITY investing

Remarkable renewables If there is any investor still out there who thinks renewable energy is niche, then treat yourself to a flight between London and Rotterdam. You’ll fly over thousands of wind turbines, including the world’s largest wind farm, the London Array field in the Thames Estuary. They form part of colossal renewable energy projects that have propelled wind and solar energy into the mainstream. And it’s just the start; as the world tries to reach global warming targets, many more renewable projects are coming online to replace fossil fuel use. For our leading sustainability story in this edition, we digest some truly stunning statistics.

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SUSTAINABILITY INVESTING

Thanks a trillion! World reaches renewable energy milestone Renewable energy has hit a new milestone, with one trillion watts of wind and solar capacity now installed around the world. And it’s just the start of a renewables revolution, says portfolio manager Chris Berkouwer.

At the end of June 2018, global installation capacity could generate 1,013 gigawatts, with 54% coming from wind and 46% from solar, according to the Bloomberg New Energy Finance database. Although this one terawatt only constitutes roughly 6% of the total global electricity consumption, it could still power about 10 billion 100-watt home lightbulbs. BNEF predicts that the second terawatt will be generated within the next five

including the world’s largest wind farm – the London Array field in the North Sea. Together with onshore turbines, they currently provide enough energy to power four million homes.

years and will cost 46% less to install than the first. Total installed wind and solar capacity has now quadrupled since 2010 and grown 65-fold since 2000, the data shows. As the world battles global warming, replacing fossil fuels use with natural energy sources from wind, solar, hydro or biomass is turning renewables from niche to mainstream. The industry is reaching

The UK is a good example of how renewables are gradually replacing traditional reliance on fossil fuels. In 2016, the country generated more electricity from renewables – mostly wind farms – than coal for the first time. In April 2018, Britain went more than two days without using coal power for the first time since coal-fired stations were built in the late 19th century. The UK also possesses Europe’s largest floating solar park and has a significant presence in biomass.

‘The statistics that illustrate just how far renewable energy has come read like a shopping list of superlatives’ critical mass, to the point where it is replacing traditional industries such as coal without the need for subsidies. The statistics that illustrate just how far renewable energy has come read like a shopping list of superlatives. Morocco, for example, is building a solar farm in the Sahara Desert that will be the size of Paris. The colossal USD 9 billion project covering 1.4 million square meters will eventually generate enough electricity to power more than one million homes.

UK leads in offshore wind Perhaps surprisingly, the country that now leads the world in offshore wind turbines is the island nation of Britain, with more than 1,400 turbines already installed,

The transition forms part of attempts to meet the Paris Agreement of 2015 and limit global warming to between 1.5 and 2 degrees Celsius above pre-industrial levels. The EU’s Europe 2020 targets include commitments to reduce greenhouse gas emissions by at least 20% compared to 1990 levels; increasing the share of renewable energy in final energy consumption to 20%; and moving towards a 20% increase in energy efficiency. It is also creating millions of jobs. Employment in the renewable energy industry has topped 10 million people for the first time, a 5.3% rise since 2017, according to the International Renewable Energy Agency. Almost half of this tally is in China, while 14 times as many people in the US work in the renewables sector than in the coal industry.

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SUSTAINABILITY INVESTING

Stunning statistics The relentless rise of renewables is taking many by surprise, says Berkouwer, a portfolio manager in Robeco’s Global Stars Equities team who specializes in the sector. “Who, for example, would have thought that the state of Texas, the birthplace of America’s oil and gas industry, is by far the leading employer in wind-related jobs?”, he says. “As the technology has improved dramatically, the opportunities to deploy renewable energy technologies has increased exponentially. Wind energy only used to work in high wind speed areas, onshore, yet far away from civilization. Nowadays, turbine makers are launching floating offshore wind platforms

‘One of the main drivers behind this dramatic increase will be the improvement in storage technology’ which could substantially increase the geographic coverage of wind power generation.” At the current rate of progress, BNEF projects that renewable energy will account for two-thirds of the global power system by 2050 – a threshold that could be reached in Europe by 2030. “One of the main drivers behind this dramatic increase

will be the improvement in storage technology,” Berkouwer says. “This will lower costs significantly, thereby accelerating the adoption of renewable energy globally.”

“As the first terawatt of renewable energy required USD 2.3 trillion of capital spending and was accompanied by only 7 gigawatts of storage (only about 0.7% of global installed capacity), the second terawatt will come at almost half the cost and with nearly 20 gigawatts of storage, as estimated by BNEF.”

Human rights high on the radar of clothing companies Apparel companies have set high standards in a sector that historically has suffered from human rights abuses, according to Robeco Private Equity’s latest ESG engagement report.

The improvements follow years of campaigning by many different groups to improve working conditions for clothing chain workers, particularly in emerging markets. The apparel sector suffered its worst crisis in 2013 when the Rana Plaza factory in Bangladesh collapsed, killing 1,134 workers and injuring more than 2,500. The building's owners had ignored warnings to avoid using the building after cracks had appeared the day before, which meant its garment factories were packed when the building came down. “The apparel and retail sectors are highly exposed to violations of labor and human

Robeco QUARTERLY • #9 / SEPTEMBER 2018

rights in their supply chains, particularly in the developing countries,” the Robeco Private Equity ESG Engagement Report 2018 says. “According to the US Department of Labor, garments and cotton belong to the goods with the highest forced labor and child labor listings. The fact that the apparel industry is dominated by multi-tiered supplier relationships, a lack of traceability and fast market-driven changes only exacerbates the problems.”

Creating awareness The private equity team has engaged with the managers of holdings in its portfolios to discover how they deal with

human and labor rights issues affecting their apparel companies, and to ensure they operate in line with the relevant legislation. It’s not only about tackling work-related issues such as child or forced labor, discrimination, abuse of migrants or non-compliance with minimum wage laws. Apparel producers and retailers also face many environmental and governance risks such as hazardous chemicals, pollution, greenhouse gas emissions, bribery and corruption. Factors that can be breeding grounds for poor practices – particularly in ‘fast fashion’ – include having numerous and highly diversified product lines, cycles or seasons. These may contribute to human rights abuses such as forced or unpaid overtime to meet seasonal deadlines.

SUSTAINABILITY INVESTING

The volatility of a company’s relationship with its suppliers and sourcing from multiple countries can also cause problems.

High risk awareness Robeco Private Equity has exposure to apparel producers and retailers through 22 fund managers, 14 of whom are included in its ESG engagement program. The 39 apparel companies targeted ranged from Nordic diversified retailers to local specialized apparel brands in the US, with 18% based in emerging markets. “The level of awareness of human and labor rights risks with apparel companies is high, particularly when they source from high-risk

‘Responsible investors have also become more aware of the risks they face with apparel companies and their supply chains’ countries,” the team says. “Most apparel companies sell their private label, which gives them more control over their procurement and processes.” “The way that private equity fund managers assess the supply chain risks and human and labor rights-related risks in their due

diligence differs from one to another. Some of them include it in their ESG due diligence, some in operational, and others in legal due diligence. If there are any red flags, they devote additional attention to these issues. Generally, they do not extend their due diligence to the suppliers of their target companies. They apply the same due diligence process across all sectors.”

“Once invested, private equity fund managers apply different models of engagement with their apparel (or other) companies. The way they engage on human rights issues in supply chains beyond the general board representation largely depends on their overall investment and value creation approach, and their ESG governance model. Those with strong operations teams and ESG specialists in-house deal with these issues more directly and systematically than fund managers that don’t have these specialists in house.” “Overall, the fund managers are highly aware of risks related to labor conditions and human rights abuse in the supply chains of their apparel companies, particularly in high-risk countries. These issues are part of the day-to-day work of the procurement and ESG specialists from the portfolio companies and fund managers we spoke to.”

Challenges remain Discussions with these specialists highlighted a number of problems. In China, for example, record keeping and the tracking of workers is a big concern, while the country is suffering a labor shortage, which means overtime is prevalent. “Most of the effort at apparel/ retail companies in Asia goes towards improving the labor conditions and

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SUSTAINABILITY INVESTING

standards for its own labor force and less so for the suppliers,” the report says. Online retailers are a different concern: “We observed that pure online retailers typically do not have supplier codes in place, or otherwise have just started implementing their first sustainability initiatives. They rely on brands to take their responsibility to manage supply chains well, particularly when luxury and high-street brands are concerned.” Despite all these efforts and initiatives, transgressions regarding illegal child or migrant labor still take place occasionally. “Three apparel companies identified

‘The volatility of a company’s relationship with its suppliers and sourcing from multiple countries can also cause problems’ supplier factories employing children or refugees without proper documents over the last year, even though they had the relevant codes and audit systems in place,” the report says. The affected companies and their owners have been working

with their suppliers, the local authorities and specialized NGOs to remedy the situations and prevent them from recurring.

And there is still a need for investors to voice their concerns. “The genuine surprise shown by a Corporate Social Responsibility officer at a US-based apparel company about investors being interested in specific supply chain issues suggests that investors need to signal their concerns about ESG-related issues,” the report concludes.

Passive investing is incompatible with sustainability investing Sustainability investing requires active choices and so cannot be done purely passively, Robeco’s quant specialists say. David Blitz and Wilma de Groot argue that sustainability and passive investing are fundamentally irreconcilable investment philosophies, and investors must therefore choose one style or the other.

“One of the biggest investment trends over the past decades has been the shift from active to passive investing. The idea behind passive investing is that active management is a zero-sum game before costs, which implies that passively following the capitalization-weighted market portfolio at minimal costs should result in above-average performance,” says Blitz, co-head of Robeco Quantitative Research. “Another very popular trend among investors is to make serious work of integrating sustainability considerations, such as environmental, social and

Robeco QUARTERLY • #9 / SEPTEMBER 2018

governance (ESG) criteria, into the investment process. However, these twin desires are fundamentally at odds with each other: investors can have one or the other, but not both.”

Different incentives “Intuitively, it may seem that sustainability considerations may be integrated effectively into a passive investment approach. Specifically, passive investors can do active voting and engagement, they can exclude the stocks that are most problematic from a sustainability perspective, or they can choose to passively follow an ESG index,” adds De Groot, portfolio manager for

SUSTAINABILITY INVESTING

Robeco’s core quantitative equity team. “However, because comprehensive sustainability integration involves many active decisions, it requires active portfolio management, active risk management and active performance evaluation techniques. As a result, investors find themselves in the active management space, whether they like it or not. Passive investing and sustainability integration are very different investment philosophies, and therefore difficult to unite.” The authors say that while voting is possible for passive owners of shares, a recent study found that they sided with corporate management over 90% of the time. The business model of passive managers replicates the market index as closely as possible, and for that it does not matter if they vote or engage. Conversely, the main task of active managers is to generate added value,

and active voting and engagement can be a powerful instrument for doing so. They go on to argue that, apart from threatening firms with bad publicity, there is very little that passive managers can do if firms do not take their engagement efforts seriously. They cannot actually sell their positions in firms that only pay lip service to ESG issues because they are obliged to replicate the entire market portfolio.

Enhanced indices Still, passive managers can offer to track a broad market index but then

exclude the stocks that are most problematic from an ESG perspective. Popular targets for exclusion include ‘sin stocks’ such as tobacco and alcohol, or controversial companies such as cluster bomb makers. Increasingly, producers of thermal coal are being added to exclusion lists. Performance deviations are likely to be small as long as the number of excluded stocks is limited, but this approach becomes increasingly difficult to achieve as the exclusion list grows. And it is entirely negative screening, so it does not allow for positive screening using ESG criteria, where what you include is as important as what you exclude.

‘There is very little that passive managers can do if firms do not take their engagement efforts seriously’

Some passive investors believe that this issue can be solved by tracking an ESG index – one that consists only of stocks with the best ESG profiles. Although passive management techniques can be used to replicate the performance of such an index, it has all the characteristics of an active portfolio.

“Indeed, an ESG index is actually even more active than a normal one, because the ESG profiles of firms change over time, and because ESG criteria themselves are also subject to change: what was deemed sustainable 20 years ago might not pass scrutiny anymore,” says Blitz. “Like active strategies in general, ESG strategies require active portfolio management, active risk management and active performance evaluation techniques.”

Best of both worlds? What, then, about a compromise solution: using an active sustainable approach that stays close to the passive

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SUSTAINABILITY INVESTING

market index? Wouldn’t this achieve the best of both worlds? “At Robeco, we have extensive experience with efficiently integrating many kinds of sustainability requirements into investment portfolios, and the result does not have to be a very active portfolio,” says De Groot. “Even when individual stock weights are not allowed to deviate much from the capitalization-weighted index, it is

‘An ESG index is actually even more active than a normal one, because the ESG profiles of firms change over time’ still possible to achieve a portfolio with a strong sustainability profile. A good example is the Robeco QI Global Developed Sustainable Enhanced Index Equities fund,

which has an expected tracking error of just 1%. The aim of this strategy is to deliver higher net returns than the MSCI World index by tilting the portfolio towards stocks with strong scores on proven quantitative factors, such as value and momentum. At the same time, the strategy preserves the main benefits of passive investing, by offering a highly diversified portfolio at low costs.”

Robeco joins Brazilian engagement group Robeco has joined the Brazilian investor association AMEC in a move that will make it easier to engage with companies in the country. The Associação de Investidores no Mercado de Capitais is a group of 59 domestic and foreign investors with 400 billion reais (USD 97 billion) of assets on the Brazilian stock market.

The association aims to protect shareholder rights for minority investors and gain ESG improvements in the vibrant but sometimes turbulent South American nation. Robeco has about EUR 2 billion invested in Brazil through several strategies targeting emerging markets. Engagement has focused on securing improvements in corporate governance in several areas. A core aim is to develop stronger and more independent boards, implement risk and compliance systems, and improve disclosures. A history of poor governance and government interference is a particular risk that needs mitigation. Other material ESG issues include food safety, environmental risk management and anti-corruption controls in a nation that has struggled with food hygiene,

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deforestation and political scandals which saw the 2016 impeachment of President Dilma Rousseff for violating budget laws.

Positive changes “Even though Brazilian listed companies face many ESG issues, we also note some positive changes,” says Robeco engagement specialist Michiel van Esch. “The top-tier listing of the Brazilian stock exchange has recently changed several listing requirements for companies, especially related to corporate governance. One example is the dissolution of dual share structures that often allowed a large shareholder to control the voting rights in a company, sometimes to the detriment of minority shareholders.” “Other changes are requirements to develop and publish policies on various governance

topics, including director nomination, remuneration and so on. As many companies are struggling with the set-up of such polices, they are often keen to receive feedback from international investors, which creates an opportunity for engagement.” Daniela da Costa, who covers Brazil for Robeco’s Emerging Markets team, emphasizes the importance of having the right people on the board. “Managing a variety of (sometimes conflicting) interests requires people who are willing to stick out their neck, have the ability to remain independent and sufficiently understand the business,” she says. “To assess the quality of governance of Brazilian companies requires in-depth knowledge of the market and the various players. And that is where AMEC comes in. The network that AMEC provides allows us a better understanding of governance developments in the market, and promises to be a great platform for our engagement in Brazil.”

Lu Zhang

‘Most reported anomalies fail to hold up’ Great Minds

Lu Zhang is Professor of Finance and The John W. Galbreath Chair at the Fisher College of Business of The Ohio State University. For several years, together with fellow researchers Kewei Hou and Chen Xue, he has been digging deeper into the robustness of dozens of market anomalies reported in the academic literature. In our Great Minds series, a set of interviews with renowned academics and investment experts, we asked him about this work that involved thorough fact-checking reported equity market anomalies. More generally, we also asked him about factor investing and how investors should go about it.

Your recent research has focused on the replication of numerous academically-reported anomalies in equity markets. Could you explain how this idea came about and what led you to undertake this endeavor? “It took a long while. Kewei, Chen and I first documented some of the evidence when we were working on our q-factor paper back in 2014.1 At the time, we coded up about 80 anomaly variables, but only 35 were significant. In particular, 12 out of 13 liquidity variables failed to holdup. The editor of our article, Professor Geert Bekaert, deserves a huge amount of credit for guiding our q-factor paper and letting it see the light of day. While editing our work, Geert told us that he found our evidence that so many wellknown anomalies are insignificant very important, and wanted us to highlight it more. We did. But since the objective of that article was to establish a new workhorse factor model, we did not make the evidence the centerpiece of the article.” “Back in 2015, Eugene Fama and Kenneth French responded to our q-factor paper by incorporating two factors that resemble our investment and return on equity factors in the q-factor model into their three-factor model to form a five-factor model.2 And the Factors War was on. We quickly fired back with the working paper 1 K. Hou, C. Xue, and L. Zhang 2015, ‘Digesting anomalies: An investment approach,’ Review of Financial Studies 28, 650-705. 2 E. F. Fama, and K. R. French, 2015, ‘A five-factor asset pricing model,’ Journal of Financial Economics 116, 1-22. 3 K. Hou, C. Xue, and L. Zhang, 2014, ‘A comparison of new factor models,’ NBER Working Paper No. 20682, November 2014. 4 C. R. Harvey, Y. Liu, and H. Zhu, 2016, ‘... and the cross-section of expected returns,’ Review of Financial Studies 29, 5-68. C. R. Harvey, 2017, ‘Presidential address: The scientific outlook in financial economics,’ Journal of Finance 72, 1399-1440.

‘A comparison of new factor models’, which compares our q-factor model with their five-factor model on both conceptual and empirical grounds.3 Our key evidence is that the q-factors subsume their CMA and RMW factors, but their factors cannot subsume ours in factor spanning tests.” “Alas, that paper met with considerable resistance in the editorial process. Knowing very well what it takes to debate with Fama and French on their home turf, we set out to clear a higher hurdle with respect to incremental contribution, by replicating virtually all of the published literature about anomalies. Our initial thought was to compile the largest set of testing portfolios to test factor models, and to hold up our work against the competitive pressure from Fama and French.” “The tremendous amount of respect we have for Fama and French is borne out in the massive effort we put into ‘Replicating anomalies’. It is probably worthwhile pointing out that we did not set out to beat down the literature on anomalies. We were focusing on the right-hand, not the left-hand side of factor regressions. After three years of coding, it finally dawned on us that most anomalies fail to hold up, 64% to be precise. The evidence is undeniable.” “We were aware of Professor Campbell Harvey’s work with Yan Liu and Caroline Zhu, as well as Cam’s ‘Presidential address’.4 Looking at our evidence, we realized that Cam was right. We started to dig deeper into his work and the meta-science literature that he cited in his research. After that, the big picture became very clear to us.

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Lu Zhang is Professor of Finance and The John W. Galbreath Chair at the Fisher College of Business of The Ohio State University. He is also a Research Associate at the National Bureau of Economic Research and an Associate Editor of Journal of Financial Economics and Journal of Financial and Quantitative Analysis. He is Founding President of Macro Finance Society, an international academic society devoted to advancing and disseminating high-quality research at the intersection of financial economics and macroeconomics. Before joining Ohio State in 2010, he taught at Stephen M. Ross School of Business at University of Michigan and William E. Simon Graduate School of Business Administration at University of Rochester. Lu Zhang’s research focuses on asset pricing, in connection with macroeconomics, corporate finance, labor economics, and capital markets research in accounting. One of his major contributions is ‘The investment CAPM’, a unified, economics-based framework for understanding asset pricing anomalies. Lu Zhang has published extensively at leading academic journals. One chapter of his doctoral thesis ‘The value premium’ won the SmithBreeden Award for Best Paper for 2005 from American Finance Association (AFA) and Journal of Finance.

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Great Minds

‘Only 36% of the anomalies in our large universe withstood the replication tests. The survival rate is largely in line with those reported in other scientific disciplines such as psychology and oncology.’

Publication bias is real, and it affects everyone, ourselves included. We should all, as a profession, at least be aware of that danger.” The resulting paper5 considers almost 450 anomalies. Doing such an extensive groundwork must have required a lot of effort. Can you briefly tell us how you went about it? What were the main parameters you changed compared to the original studies and why? “Professor Chen Xue at the University of Cincinnati is the real hero behind our ‘Replicating anomalies’. I went through the published anomalies literature, and wrote a first draft of our data appendix. I knew a lot of the classic anomalies, but needed a refresher course on those documented in the past ten years, so it was not time-consuming for me. It was Chen who painstakingly coded up all 447 anomalies, one-by-one, making sure that we followed the variable definitions in the original studies, and when our replication results differed from those originally reported, making sure we understood why. Professor Kewei Hou went through Chen’s SAS programs to ensure that our empirical execution was of the highest possible quality.” “In our replication, we emphasized a reliable set of empirical procedures that use NYSE breakpoints and value-weighted portfolio returns. This set of procedures is more reliable because it better captures the economic importance of an anomaly. For comparison, in our June 2017 draft, we also reported results from NYSE-Amex-NASDAQ breakpoints and equal-weighted returns, a procedure that gives microcaps excessive weights. We are currently compiling results from a variety of additional procedures, including cross-sectional regressions.” And what are the main conclusions you would highlight? 5

K. Hou, C. Xue, and L. Zhang, ‘Replicating anomalies,’ NBER Working Paper No. 23394, May 2017.

“The main conclusion is that most anomalies fail to replicate. To be precise, only 36% of the anomalies in our large universe withstood the replication tests. The survival rate is largely in line with those reported in other scientific disciplines such as psychology and oncology.” Does that mean markets are not as inefficient as some suggest? “The short answer is yes. No answer is long enough for the efficient markets/behavioral finance debate. But in terms of the simplistic view that equates cross-sectional predictability with ‘free lunches’, our evidence does indicate that there are certainly fewer free lunches around in the marketplace.” Still, some factors appear to be significant and persistent enough. Would you consider the ‘anomaly glass’ half full or half empty? “Half full. Our replication did confirm the validity of many factors that investors have been loading on for a long time, such as value and momentum.”

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You argue that p-hacking is widespread in academic research. How would you suggest changing this? “We are dropping the p-hacking interpretation of our evidence. We are doing a major revision of ‘Replicating anomalies’. The next draft will just say: ‘most anomalies fail to replicate.’ When writing up the two first drafts, we were just using ‘p-hacking’ as a new name for ‘data-mining’, which has been around in the academic literature for a long time. Regardless of whether ‘p-hacking’ is mentioned in our article, we feel that data-mining is widespread. We don’t have a good answer to this problem.” “Oftentimes, the line between datamining and striving for good empirical performance is blurry. But it is healthy to at least be aware of the problem. Nowadays, for every working paper we circulate, we go through multiple rounds of internal replication, to control the quality of execution. We also routinely highlight evidence that goes against the tested hypotheses in our work.” You mention the fact that many academic studies overweight microcaps and the fact that due to the high trading costs associated with these stocks, anomalies in microcaps are too difficult to exploit in practice. What exactly do you mean by microcaps? Is this phenomenon constant over time? “We first read about microcaps in Fama and French’s 2008 article in Journal of Finance.6 Over the past 15 years, we have learned a lot from studying Fama and French’s articles, especially those from the 1990s. Microcaps are tiny stocks of which the market equity is below the 20th percentile of NYSE stocks. These stocks are not just small, they’re tiny. Fama and French showed that microcaps account for only 3% of the total market cap, but 60% of the names. In ‘Replicating anomalies’, we updated their evidence. As of December 2014, microcaps represented only 1.4% of the total market cap.”

E. F. Fama, and K. R. French, 2008, ‘Dissecting anomalies,’ Journal of Finance 63, 1653-1678. K. Hou, H. Mo, C. Xue, and L. Zhang, 2018, ‘q^5,’ working paper, The Ohio State University. Robeco, ‘The research culture is crucial for the success of an asset manager’, Quant Quarterly magazine, October 2017. 6 7

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“An example would be that the Fama-French five-factor model outperforms the q-factor model in explaining the value-minus-growth anomalies (but not by much).7 Finally, we try to take economic theory seriously, and use it to guide our empirical work. Otherwise, one is practicing applied statistics, not empirical economics.” In a recent interview with Robeco8, former president of the AFA, Campbell Harvey, advocated a concept called ‘registered reports’, where researchers would first pitch ideas to editors and these ideas would be peer-reviewed. If reviews were positive, editors would commit to publish the paper, no matter what results were found. What do you think? “The concept of ‘registered reports’ is new to me. I have not thought much about it. Cam has thought long and hard about related issues. He also has a wealth of editorial experience. I would defer to Cam in these matters. I do find the idea of ‘registered reports’ interesting and worthwhile to experiment with, starting out on a limited scale. I also think replication should be more routine in finance.”

Great Minds

Your findings deal a particularly severe blow to the academic literature around a purported liquidity factor. Could you explain bit more about them? “Sure. We certainly were not aiming at the liquidity literature. As mentioned, back in 2014, when working on the q-factor paper, we came across the evidence that 12 out of 13 liquidity variables are not significant. We took notice, but did not make a big deal out of it. We thought the set of 13 is too small.” “In ‘Replicating anomalies’, we have looked at a total of 102 variables broadly related to liquidity and trading frictions. We find that 95 of them, or 93%, fail to yield significant high-minus-low decile returns on average. The list of 95 includes many influential variables, such as short-term reversal, share turnover, absolute return-to-volume, idiosyncratic volatility, the number of zero trading days, and bid-ask spread.” Does this mean there is no such thing as a liquidity premium? To what extent should investors care about liquidity? “No, our findings do not mean that there is no such thing as the liquidity premium. However, they do say that in the valueweighted universe that accounts for 97% of total market cap, liquidity is just not that important. Before writing ‘Replicating anomalies’, I thought liquidity was as important as value and momentum, and probably more important than investment and profitability in the cross section, given the amount of the published literature. That was the impression I got from reading the published liquidity articles.” “But I was not even close to being right. Value and momentum can be found in value weights, but not liquidity. Investment and profitability also can be found in value weights, and are closely related to value and momentum. To what extent should investors care about liquidity? If one rebalances portfolios monthly, weekly, or even daily, trading costs become important. It is critical to develop a trading system that minimizes transaction costs to harvest factor premiums. If it’s done less frequently, such as quarterly or annually, liquidity becomes less important, as shown in our work.” So much for academic research. But would you say most research carried out by practitioners (mainly product providers) is just as biased? “Yes. There are many products in the marketplace, including some very popular ones, which are different from value and momentum. Even the ‘quality’ products come with a variety of different definitions, many of which failed to replicate in our study.”

Does all this mean that mean investors should disregard factor investing altogether and simply go for passive strategies? “Not at all. First, the line between active and passive strategies has blurred substantially in the past decade. In the old days, ‘passive’ literally meant holding the market portfolio, and ‘active’ meant everything else. Nowadays, ‘passive’ refers to predetermined algorithm-based strategies, and ‘active’ means there is more

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‘Our work does not discredit factor investing at all. On the contrary, we document reliable cross-sectional predictability in a universe in which frictions seem to play a negligible role.’

frictions seem to play a negligible role. When you take 36% of 447, you still get 161 significant anomalies even in value-weighted returns. We show that our latest factor models still leave as many as 46 anomalies unexplained. In short, the future of factor investing is bright! The challenge is to figure out which factors are the most relevant to forecast returns, and that’s the essence of the new ‘active’.” But then the obvious question is: which factors do you consider the most relevant for long-term investors? Why? “Value and momentum, which have already been adopted by many long-term investors. I am likely biased, but I would also say investment and return on equity underlying our q-factor model. Empirically, we have shown that the investment factor largely subsumes the value factor, and the return on equity factor largely subsumes the momentum factor. Theoretically, investment and profitability have a solid economic foundation, based on the net present value rule in corporate finance. I have been developing an asset pricing theory on this rule, which I dub ‘The investment CAPM’.”9

human involvement, I think. One may argue that factor investing built on the cross-sectional predictability in finance literature is passive in nature, according to the new definition.” “Regardless of the passive-active dichotomy, our work does not discredit factor investing at all. On the contrary, we document reliable cross-sectional predictability in a universe in which

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“We can debate what the best empirical measures of investment and profitability are. But the basic economic principles are not controversial at all. They have been taught in business schools for many decades. What remains controversial, however, is whether one can deduce asset prices from the net present value rule, while ignoring investor behavior. But the equations underlying the net present value rule and the investment CAPM are the same. Causality runs both ways from investment to the expected return, and back, meaning no causality. The same applies to risk and the expected return in the consumption CAPM, meaning no causality from risk to the expected return.” 9

L. Zhang, 2017, ‘The investment CAPM’, European Financial Management 23, 545-603.

The A-G of trends in fintech Investors looking for returns in fintech should focus on the A to G of developments, Robeco’s trends experts say. Their new white paper ‘Fintech 2.0: from trends to insights’ explains how financial technology is further revolutionizing how we conduct banking, consumer payments and financial services.

Speed read

Research

• White paper identifies seven key trends in financial technology • Focus ranges from artificial intelligence (A) to governance (G) • Transformation in the way that financial services are conducted

The research by Jeroen van Oerle and Patrick Lemmens identifies seven trends that now underpin developments in this vibrant sector. These form a neat A to G: “The first trend that is impacting the financial sector is artificial intelligence (AI),” the authors say. “Clearly starting from the technology side, AI is already finding its way into the financial sector in the form of models used within payments, consumer credit and robo-advice. Longer term it can stimulate the next innovation wave within payments in the form of invisible automatic payments.”

“Very closely related to AI is big data. The biggest use for it is in fraud reduction and improved risk management. Globally, around 500 billion transactions were performed in 2017. All these transactions are data points that can be used as input to improve risk models, better engage customers, comply with laws or make new products.” “Then there is core system replacement. Big technology companies replace their core systems every seven to eight years. When compared to the financial sector, it is obvious that replacement is long overdue. Rising interest rates, combined with stable regulatory requirements, are likely to lead the way to core system replacements in the coming years.” “The fourth trend that will continue to shape the discussions is distributed ledger technology (DLT), also known as blockchain. Its first use related to payments, but many other uses have been developed since, also outside the financial sector. We think of DLT as a new infrastructure layer, just like the internet.” “The fact that electronic payments are the most mature part of fintech does not imply there is a lack of growth opportunities. Cash is still growing at 1-2% per year globally, but this is much less than the growth of electronic payments in the form of card or mobile payments. This is especially true in emerging markets, where a lack of infrastructure requires people to leapfrog to mobile payments directly.” “Another important trend is financial inclusion. In many emerging market countries, the economics of the traditional bank branch model or insurance agency model do not work, due to limited density in rural areas in combination with a relatively low GDP per capita. Fintech has completely changed the picture. And in developed countries, fintech allows the bottom of the financial pyramid to be served in an economically viable way.” “Finally, there is governance. Despite the increase in financial regulation, many fintech solutions have been able to develop under a light/sandbox regime. The biggest question is if these start-ups can continue to grow fast enough to take the financial hit when they become as regulated as their traditional peers.”

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LAST BUT NOT LEAST

E is for e-commerce E-commerce is making logistics more complex. The last mile is a real challenge: expensive with inherently few economies of scale. For companies, this implies high capital spending requirements combined with limited opportunities for price increases. Warehouse location will become increasingly important while new technologies that aid warehouse automation will also play a key role in cutting labor costs and enhancing efficiency. Cloud platforms and crowd sharing will help make better use of free capacity and enhance efficiency, while automatically guided vehicles, drones and self-driving robots will help reduce labor costs. A plethora of new innovative tools and technologies are being developed to help connect the entire supply chain.

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The logistics of e-commerce: improving returns on delivery Vera Krückel and Folmer Pietersma, Robeco Trends Investing

E-commerce is booming, subjecting its logistics backbone to ever increasing costs. So the industry is looking for cheaper solutions. Highly automated state-of-the-art warehouses in prime locations, innovative tools such as robots with enhanced skills, artificial intelligence, drones and many other devices brought to us by Industry 4.0 will all play a major role in the transformation of this process. E-commerce currently accounts for 10% of global retail sales. So the only way is up. Statista expects e-commerce to grow around 19% per year and to make up 17.5% of overall commerce in 2021. But we think there is more potential upside. In China, for example, e-commerce penetration is already at 22%. Consumer confidence in online shopping has increased, both in terms of payment security and product quality. It is becoming an integral part of life for a large proportion of the population.

The last mile is the hardest This massive growth in e-commerce is having a significant impact on the underlying logistics support it requires and the supply chain is having to shoulder an increasingly heavy burden. Figure 1 shows a simplified diagram of a logistics set-up for e-commerce: goods are transported from a manufacturing facility to a centralized distribution center in what is called linehaul. This mode of transportation is generally still pretty efficient. From the distribution center, the goods move further along to fulfillment centers, which are closer to demand centers and therefore generally smaller. This set-up is known as a ‘hub and spoke’ model. From the fulfillment center, they are finally transported to consumers’ front doors, pickup points or stores, often in small delivery vans.

As one might expect, the further along the chain the goods travel, the lower the level of efficiency. And this is reflected in the costs. AT Kearney estimates that the last mile accounts for nearly half of total logistics costs. To compound the situation, consumers are becoming increasingly accustomed to free shipping and free returns. For logistics companies, this entails high capital spending requirements combined with limited opportunities for price increases and economies of scale. So the only option for the industry is to find cheaper solutions.

A-location warehouse owners benefit One beneficiary of the e-commerce boom is the industrial real estate owner. Warehouses in prime locations are enjoying the best market conditions in decades: e-commerce is three times as warehouse-intensive as traditional brick-and-mortar trade, and so this trend is set to continue. While, on the one hand, retail stores are being replaced with warehouses, on the other, inventory ratios are rising as retailers are duplicating their inventories to get them closer to the online consumer and shorten delivery times. More space is also required, as the shipping by retailers of smaller quantities or even individual items rather than pallets is making operations inherently less space-efficient. A well-positioned warehouse footprint is not only crucial from a cost equation perspective but also very important for service levels; in fact, it is often the only way to live up to delivery promises. This heightens the strategic importance of having

Figure 1 | E-commerce logistics flows Current level of efficiency

Pretty high: full trucks

Manufacturing facility

Truck/plane/ ship

High

Centralized distribution center

Moderate

Truck (plane, train)

Relatively low

Fulfillment center

Low

Small truck/ delivery van

Home, store, pick-up point

Source: Robeco

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‘Explosive growth in e-commerce is making logistics more complex’

a warehouse location as close to consumption centers as possible, shortens the expensive last mile and thus has a significant impact on the overall cost structure. While total warehouse costs – including labor and interior installations – can run up to 30% of total logistics costs, rental costs generally amount to only about 5% of the overall logistics bill. This implies that tenants will generally still be able to absorb quite a high degree of rent inflation before higher costs force them to move to B-locations. They will, however, want to think twice about doing this, as prime real estate is a scarce asset and there are few prospects for additional supply. For this reason, we expect owners of prime industrial real estate assets, often Real Estate Investment Trusts (REITs), to be major beneficiaries of the growth in e-commerce.

Vision technology – here come the robots One of our favorite ways to gain exposure to the e-commerce boom is through companies that are set to gain from warehouse automation. This is crucial to the success of any e-commerce

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venture. It comes in many forms and the complexity and breadth of solutions is as wide-ranging as the different functions – receiving, checking, counting, sorting, storing, palletizing and picking goods. One specific type of automation technology that will play a ground-breaking role in this process is vision technology. Once robots learn to see, they can move into the warehouse. To be able to work effectively in a warehouse, robots have to learn something new: the perception and recognition of objects. The ‘vision technology’ required for them to do this includes cameras, laser sensors, radio-frequency (RF) identification devices and barcode readers. These elements form part of a warehouse’s process chain and ensure that hardware can effectively signal to software, or the warehouse control system. The producers of these vision systems are some of the most interesting investment opportunities related to e-commerce growth. In warehouse automation, everything revolves around picking.

Currently, half of all labor time is spent on picking and packing, as 90% of the picks in a warehouse are still done by human hand. Moravec’s paradox basically concludes that it is very easy to teach robots ‘intelligent’ adult skills, but incredibly difficult to get them to perform tasks a two-year old can already master when it comes to mobility and perception. In the case of a warehouse environment, this could mean picking from a cluttered bin with overlapping items. Nevertheless, we are optimistic that this challenge can be overcome through a combination of machine 3D vision and deep learning.

Deep learning Machine vision is part of the larger vision technology market and refers to taking and automatically analyzing pictures and patterns. This would allow robots to be able to grab unknown objects in an unstructured environment. Deep learning is a technique that is useful in situations with a high degree of complexity and ambiguity – like those in a warehouse. It works through several hierarchical layers and, with the help of probabilities, it forms an ‘educated guess’ of what an object constitutes. Being able to identify objects is the first step; the robot then needs to determine how to best grasp the object. Equipped with a number of sensors, the robotic arm starts a feedback loop until the best strategy to pick an object is determined. The vision technology market was worth USD 15 billion in 2017 and is expected to enjoy a strong growth rate of around 15% over the next five years. From a customer perspective, the initial capital expenditure for vision technology is much lower and the payback period is much shorter than for other more ‘invasive’ types of automation. This makes adoption hurdles much easier to overcome.

both automation hardware and software to become more commonplace than mere equipment suppliers. In order to be able to partner their clients effectively, the larger automation players will need to go shopping to buy in the expertise they require.

Patchwork solution As the last mile is the biggest cost item, it is the main battleground for incumbents and start-ups alike. There won’t be a one-sizefits-all solution, and we think the last mile will become an ever more fragmented mix of innovative solutions working together in a patchwork. Start-up companies will bring technologies such as cloud platforms or crowd sharing to the logistics industry to make clever use of free capacity elsewhere. Incumbents will experiment with automatically guided vehicles (AGVs), drones, self-driving robots or even delivery tunnels. While many sound like and probably will be innovations of the future, others – or the earliest forms of them at least – will be with us quite soon.

‘The industry needs innovative solutions to increase efficiency and reduce costs’

Warehouse automation on a more general level is also an attractive investment area. The automation solutions in a warehouse are very wide-ranging and technological requirements are so advanced that players providing these solutions often operate in just one specialized area. This results in a relatively fragmented industry and one where we anticipate considerable consolidation. Automation gone wrong can create a lot of inflexibility in a warehouse and disrupt operations, so the planning and design process needs to be executed very carefully. With the exception of the very large warehouse operators, most customers cannot implement an automated warehouse without the support of integrators and process designers. We would, therefore, expect all-in solution or full-service providers offering

The logistics industry will probably be one of the first to employ self-driving vehicles on a large scale, which they will use to varying degrees and in varying forms. The implementation will probably start with platooning for linehaul trucks and self-driving forklifts inside warehouses or other fenced, internal, controlled and closed environments (for example, in storage yards, harbors and airports). As this is already feasible today from a technological perspective, these will probably be a very normal sight in just a few years from now. The most challenging part of distribution for autonomous vehicles is, of course, the last-mile delivery on public roads in very dynamic and congested inner-city environments. At the same time, this stage of the logistics flow would benefit most from the implementation of self-driving technology, in terms of cost reduction. Machine-to-person delivery on a large scale may still be some way off, but machine-to-parcel station handover is already achievable today. Whatever the solutions are, they all have one thing in common: they use an exceptionally large number of sensors and cameras. ‘Connected cars’ are many times more semiconductor intensive than ordinary vehicles. Producers of both connectivity solutions and chip producers will therefore see increased demand for their products. The last mile is also very fertile ground for innovative crowdsharing platforms, many revolving around the theme of converting existing spare capacity somewhere in the system into parcel delivery. A fascinating amount of clever innovation is taking place, and while there is a significant amount of entry (and exit), we think most individual solutions will only make a marginal

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contribution. Nevertheless, there is potential for interesting platforms to develop and their combined effect will make an impact.

Digital and physical infrastructures set to converge in the supply chain The supply chain is another prime example of how the digital and physical infrastructures of our worlds are converging. The usual buzzwords have finally arrived in the logistics industry; the internet of things (IoT), sharing economy, big data, artificial intelligence, cloud and crowd-sourcing will all contribute to a more efficient logistics system. They will bring end-to-end connectivity and visibility in real time, as well as advanced and anticipatory planning tools. All this will again be enabled by connectivity – in this context known as automated data capture devices (ADC). These include sensors, lasers, connectors, cameras and tags. Optimizing and digitizing the USD 4 trillion logistics market could unlock substantial hidden value. We think smart supply chains will not only help to reduce costs and error rates but also improve service levels through faster delivery. Goldman Sachs estimates that big data technologies can help save over USD 25 billion in operating costs across the logistics system. Streamlining operations to reduce costs can deliver significant value. Frost and Sullivan research shows that an astonishing one out of four truck miles in both the US and Europe are driven by empty trucks, and trucks that do carry goods are half-loaded. In addition, far too many expensive driver hours are lost; for example, as drivers wait at warehouses to unload freight. Figure 2 | Logistics becoming smart

Source: Zebra

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According to PWC, the transport sector is said to be responsible for 13% of global emissions. Clearly, reducing empty runs in ships, trucks and cargo planes through optimization technologies will substantially reduce emissions as well.

Track and trace Knowing where goods are situated in the supply chain and adjusting operations accordingly can help reduce costs. Connectivity has several advantages: it helps companies replenish inventory in a timely manner when necessary, but also reduces working capital through inventory reductions. Fewer delivery errors and early-detection mechanisms help reduce costs. Being able to track and trace products back to their origins is of crucial importance in the case of fresh food, for example, where contaminations can be more quickly detected, and countermeasures taken immediately and in a targeted manner. Similarly, for luxury goods, traceability helps to combat counterfeiting. Barcodes, RFID tags and lasers all generate and collect vast amounts of data, but this is worthless unless it is used to enhance decision-making. This is the domain of software companies offering enterprise software for supply chain management. Cloud solutions and artificial intelligence can help logistics become just-in-time and efficient. We have seen how much value can be created if the supply chain is vertically connected within a company’s own operations. This value creation will increase exponentially if supply chains are linked not only vertically to suppliers and customers but also horizontally to competitors and peers. We think therefore that the sharing economy will arrive in the logistics sector as sharing capacity with competitors can be mutually beneficial to facilitate real-time matching of loads and empties. We see risks for freight forwarders’ business models as the various parts of the supply chain become more effectively linked with each other. We think new online platforms will improve transparency in the system and in combination with the use of blockchain and other technologies, this will reduce their margins. On the other hand, the ability to more effectively match demand with surplus capacity will increase utilization rates for ship, truck and cargo plane owners – boosting their profit margins. E-commerce is changing the face of transportation and logistics. This creates both opportunities and threats for businesses that are involved in the supply chain and is providing an impetus for innovation in a broad range of areas – from warehouse automation, to self-driving vehicles and capacity management. The ability to improve efficiency, while keeping costs down will be the decisive factor. Companies that are able to do this and the innovators of the solutions that help them are set to benefit most.

Gilbert Van Hassel

‘The time is now for sustainability investing’ Interview

Sustainability is foremost in nearly every investor’s mind nowadays. This summer, The Big Book of SI was published, a Robeco/RobecoSAM publication addressing themes such as sustainability and the role of finance, megatrends shaping the world, and ESG & investment performance. We talked about it with Robeco CEO Gilbert Van Hassel.

The Big Book of SI was published this summer. Why now? “The timing is excellent. I strongly believe that we have reached an inflection point in terms of SI. There has been a change in thinking in the investment world, from avoiding companies that have a negative impact on the environment to investing in companies that have a positive one. The Sustainable Development Goals are a very important development in this context; they take sustainability to the next level by making it tangible and measurable.” “The shift in thinking that we are witnessing is in the interests of both society and our industry, and when these two are aligned, progress can be swift. Now more than ever, it is our intention to contribute to that shift and to play a leading role. With The Big Book of SI, we not only underscore RobecoSAM and Robeco's leadership in SI, but we have also created a reference point for our clients and ourselves.” There are many megatrends shaping the world we live in. How do they affect our industry? “We firmly believe in sustainability investing, and think all the stars are aligned for this investment discipline. From a bottomup perspective, sustainability is clearly changing markets. The environment in which companies operate is very different from 20 years ago. Climate change, resource scarcity, pollution and the working conditions in emerging countries are all trends that affect companies, as well as provide opportunities for new markets.” “However, they also present risks as they are changing the regulatory landscape, altering consumer behavior and, in many

cases, increasing costs. Moreover, clients are increasingly looking to create more sustainable portfolios to meet the demands of their sponsors, participants and regulators. And then there is the socioeconomic perspective and the many global challenges faced by our generation. While prioritizing growth above issues such as climate change risks may yield better returns in the short term, the long-term prospects for such a strategy may be less rosy.” Would you say Robeco and sustainability investing are a perfect match? “Sustainability investing is of strategic importance at Robeco. We started adopting it in the mid-90s and it has been at the core of our business since the mid-2000s, when Robeco acquired Sustainable Asset Management (now RobecoSAM). The acquisition of SAM gave us the knowledge and insight we needed to integrate sustainability in all aspects of our business.” “Our current joint sustainability strategy is built on four key aspects. We have a unique sustainability culture that has evolved over the last 20 years. This has led to extensive in-house expertise in research, analytics and investments. We have a truly integrated investment approach across the asset classes stemming from interaction between our SI researchers, financial analysts and engagement specialists and finally we have the ability to innovate quickly and offer clients bespoke solutions as sustainability investing evolves.” “Despite our clear vision on sustainability, we realize that there is no one size fits all, so we offer many different products and solutions for many different clients across the globe. At the time of writing, we manage EUR 100 billion of integrated sustainability assets in equity, fixed income and private equity. We believe that

Robeco QUARTERLY • #9 / SEPTEMBER 2018

‘We firmly believe in sustainability investing, and think all the stars are aligned for this investment discipline’

the investment industry will move from creating only wealth to creating wealth and well-being, and it is our intention to contribute to that shift. It is in the interests of both society and our industry, and when these two are aligned progress can be swift.” As CEO, you get to meet the bigger clients. Do you feel sustainability investing is on every investor’s mind right now? “The topic of sustainability arises within minutes of talking with clients. I believe that we have reached an inflection point. It is already clear that taking a sustainable approach does not detract from performance. We believe that using financially material ESG information leads to better-informed investment decisions and benefits society.”

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“The Sustainable Development Goals are a very important development in this context that take sustainability to the next level by making it tangible and measurable. There has been a change in thinking in the asset management world, from avoiding companies that have a negative impact on the environment to investing in companies that have a positive one.” “Investors can embark on sustainability investing in small steps. What we see at Robeco is that, as knowledge and experience in sustainability investing increase across the organization, so too does conviction. I hope that this Big Book of SI will help investors find their way in the fascinating, multi-dimensional world of sustainability investing.”

Column

Excessive It looks unlikely that Italy’s new populist government will seek confrontation with Brussels about its budget for 2019 after all. Although, the threat of an excessive deficit procedure that could culminate in a fine worth 0.5% of GDP is probably not what tipped the balance. It is more plausible that they have developed a healthy respect for the influence of the bond market. The ten-year yield differential between Italy and Germany has risen more than 150 basis points since the radical 5-Star/League came into power. Budgetary developments in the US would tempt observers to conclude that the oncefamous ‘bond vigilantes’ have been in a state of induced coma, but in the case of Italy they appear to be alive and kicking. Mobilizing financial markets against a member state can force it into a budgetary straightjacket, imposing a modest fine cannot. Such a fine has to be framed in terms of billions to disguise the fact that in economic terms what it actually boils down to is peanuts. Modest fines which offer little incentive are not limited to EU budget rules. Fortunately, European leaders are aware that macroeconomics involves more than just fussing about sovereign debt, budget deficits and the overriding importance of price stability. One of the few good things

to come out of the Great Depression is the introduction of the Macroeconomic Imbalance Procedure, a surveillance mechanism that can also result in a fine – in this case of a negligible 0.1% of GDP. The aim of the procedure is to identify potential macroeconomic imbalances early on, and this year the only country deemed to be without imbalances was Slovenia. It was also noted that the current account surplus of the Eurozone was rising rapidly and is set to reach 3% of GDP in 2019. A lack of aggregate demand is one of the causes. Well, we don’t have to worry that Italy will boost aggregate demand. What about virtuous Germany and the Netherlands? One of the most striking macroeconomic imbalances involves underinvestment in Germany, in both the public sector (try taking a train to or from Berlin) and the private sector. Over the past three years, frugality in both countries has led to an average current account surplus of more than 8%. The threshold is strangely asymmetric (+6% GDP and -4% GDP), which suggests a bias towards a greater tolerance for such surpluses. This, what I believe to be, already excessive 6% threshold was determined on the basis of Germany’s average GDP (just below 6%) in the three years before the procedure was introduced. It is ironic that the European Commission speaks of an “imbalance” for both countries, rather than an “excessive imbalance”. Can countries live with surpluses forever? In the years before Bretton Woods, John Maynard Keynes observed that surplus countries are not forced to reverse their situation and deficit countries cannot be financed forever. Therefore, his proposal to rebalance the world economy was to introduce a tax for countries that run current account surpluses. But he was thinking more along the lines of confiscating overdrafts than imposing a paltry fine of 0.1% GDP. There is no chance that EU leaders will make their sanctions for such imbalances much heavier. The financial markets won’t be of much help either. The Eurozone will continue to display a dangerous deflationary bias.

Léon Cornelissen, Chief Economist

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Additional Information for investors with residence or seat in Singapore This document has not been registered with the Monetary Authority of Singapore (“MAS”). Accordingly, this document may not be circulated or distributed directly or indirectly to persons in Singapore other than (i) to an institutional investor under Section 304 of the SFA, (ii) to a relevant person pursuant to Section 305(1), or any

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