Time2Read - december edition 2015 by Robeco

TIME2READ

TIME Selection of Robeco’s best read articles

2READ Important information Robeco Institutional Asset Management B.V., hereafter Robeco, has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. Without further explanation this publication cannot be considered complete. It is intended to provide the professional investor with general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. All rights relating to the information in this presentation are and will remain the property of Robeco. No part of this publication may be reproduced, saved in an automated data file or published in any form or by any means, either electronically, mechanically, by photocopy, recording or in any other way, without Robeco’s prior written permission. The information contained in this publication is not intended for users from other countries, such as US citizens and residents, where the offering of foreign financial services is not permitted, or where Robeco’s services are not available. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at www.robeco.com.

Including the best of the Robeco World Investment Forum in Hong Kong

DECEMBER EDITION 2015

This document is solely intended for professional investors

FOREWORD

Embracing a Slow Growth World As the year draws to a close we are delighted to publish our latest edition of Time2Read highlighting our best stories from the second half of 2015. And what a year it has been. We devote a special section in this edition of Time2Read to the speakers who graced our annual Robeco World Investment Forum in Hong Kong. The theme was ‘Hidden opportunities in a Slow Growth World’, and we feature stories by Robeco’s local specialists Victoria Mio and Arnout van Rijn on how these can be found. Of the external speakers, economist Linda Yueh describes how China is a land of contradictions, while historian Niall Ferguson says the real threat to growth is the resumption of conflicts since the end of the Cold War. We also ran a special series on alternative investments, including a story advising investors to ‘beware the super-cycle in commodities’ and another warning that in the ‘world of hedge funds, not all streets are paved with gold’. In the mainstream asset class of equities, our Global Consumer Trends Equities fund has gone from strength to strength, so we looked at top brands and the ‘double-edged sword of tech innovation’ among other themes. Elsewhere, Robeco has long been a pioneer of sustainability investing, and as corporate governance becomes increasingly important, we asked the question ‘how good are your directors?’ We also looked at sustainability in another field we have pioneered – quantitative investing. We answered ten key questions about factor investing, and in another significant number, 25 years of specialism in quant is commemorated by Head of Equities Peter Ferket. We hope you will enjoy reading our magazine and wish you happy investing in 2016! Hester Borrie, Board Member and Head of Distribution and Marketing Robeco

Contents Brand relevance: Mind the generation gap!

Not all hedge fund streets are paved with gold

Do strong brands make strong investments? Some do.

The added value of hedge funds for institutional investors.

38 Ten key questions on factor investing Head of Factor Investing Research Joop Huij answers questions from pension funds.

32 Changing technology

Fifty shades of China

Start-ups will remain important, when their products are deflationary or challenge established players.

China is not a black and white story. Opportunities lie in the gray areas.

CONTENTS

Foreword

Brand relevance: Mind the generation gap!

The Forum in Hong Kong Best of the Robeco World Investment Forum in Hong Kong: Hidden opportunities in a Slow Growth World.

72 – 102

Fama-French five-factor model: Why more is not always better

Beware the economic ‘super-cycle’ in commodities

Getting back on our feet and soldiering on

What to expect when you don’t know what to expect

Top of the league for decades and still hungry for more

How good are your directors?

The double-edged sword of changing technology

Ten key questions on factor investing

Why China will dominate the emerging middle class

Not all hedge fund streets are paved with gold

A quantitative approach to sustainability investing

Manager selection is key when investing in illiquid assets

Data and research are the key to success in volatile markets

A critical eye and patience are crucial in low vol

Fifty shades of China

Sustainability criteria complete the investment puzzle

Factor investing for credits: From research paper to fund

A good strategy starts with a good design

Equities set to lead returns over the next five years

Robeco World Investment Forum

Return to conflict is an inflation threat

Better corporate governance could re-rate Asia

Robotics will change society and possibly even humans

Factor investing: The flipside of following the index

Demography: A dividend or a disturbance?

E-commerce continues to lead Chinese investment opportunities

China is a unique place of contradictions

102

The art of Face Changing

EQUITIES

Brand relevance: Mind the generation gap! Strong brands is one of the trends Robeco Global Consumer Trends Equities capitalizes on. Fund manager Jack Neele discusses the latest Interbrand 100 most valuable brands, focusing on the most relevant names and the ones that missed the boat.

“It is more interesting to rank the 100 most valuable brands in terms of how their value has increased or decreased. This reveals trends relating to the products consumers are using and how they perceive companies and brands,” says Jack Neele, Manager of Robeco Global Consumer Trends Equities, referring to Interbrand’s annual list of the 100 most valuable brands.

What strikes you about the brands that have become more valuable?

This brand consultancy has calculated not only the value of the brands, but also whether this value has risen or fallen. Eight of the ten largest positions in the Robeco Global Consumer Trends Equities portfolio are in the top 100.

What can be said about the brands that have declined most in value?

Top 10 holdings Robeco Global Consumer Trends Equities Company

Weight in portfolio (%) Position top 100* Brand value USD mln*

Facebook

3.88

22,029

Google

3.61

120,314

Nike

2.78

23,070

Starbucks

2.51

6,266

Apple

2.50

170,276

Visa

2.46

6,870

Mastercard

2.42

5,551

Nestlé

2.38

8,632

Tencent

2.36

L Brands

2.23

Portfolio details at 30 September 2015. * = Interbrand Best Global Brands Report.

“Consumers are attracted to brand products. This has always been the case, and it always will be. And this applies not only to consumers in developed economies, but also to consumers in emerging markets. Increasing wealth means the demand for Western luxury products is on the rise in these countries,” Neele explains. In addition to strong brands, the digital consumer and the emerging market consumer are other trends in which Neele’s fund is invested. “Strong brands have also developed in our digital world of smartphones and tablets, software, apps, search engines and online shopping in recent years.”

“The strong rise in technology brands. The three biggest climbers are all technology companies: Facebook, Apple and Amazon. The technology sector is strongly represented and a third of the 100 most valuable brands are tech brands.”

“A division is emerging between new generation brands and those favored by the previous generation. The top ten includes Coca-Cola, IBM and McDonald’s – companies whose value has been falling slowly for years. Coca-Cola and McDonald’s are struggling in the wake of healthy eating trends and IBM is old technology.”

Technology dinosaur Microsoft is in the top ten and actually saw its brand value increase? “This I find hard to fathom. Microsoft is really active in cloud services, but has had very little success in the mobile phone market. My perception is that Microsoft’s strength is waning.”

A generation gap is emerging in brand land. But traditional luxury brand Hermès is one of the biggest climbers. How is this possible? “Hermès is a brand that moves with the times, knows how to stay relevant and responds to consumer preferences. An example of this is the Apple Watch Hermès, for which the fashion label developed the clock face and handmade leather strap. This enables Hermès to position itself alongside a trendy brand like Apple, while for Apple the fact that a luxury brand like Hermès is supporting its watch is a status enhancer.”

Are there more examples of brands in the top 100 that are managing to stay relevant? “I think Nike and Starbucks are good examples. Nike produces apps that allow people to share their sports performances through social media. And at Starbucks you can use your mobile phone to order and pay for products. These companies are embracing new technologies and using

JACK NEELE Portfolio Manager Robeco Global Consumer Trends Equities

‘McDonald’s and KFC are brands favored by the previous generation’ them to their advantage. Consumers appreciate this, which translates into an ongoing increase in brand value.”

Noteworthy: there are 14 car makers among the 100 most valuable brands.

Under Armour isn’t in the top 100, but is in your fund. Nike and Adidas are on the list, but you only have Nike in the portfolio. Why? “Nike is more successful at penetrating the markets in which Adidas was traditionally strong, like football, but the reverse does not apply to the same extent. Under Armour is bigger than Adidas in the US – it is also a brand that is favored by the new generation and sponsors young talent like Memphis Depay and Jordan Spieth.”

After Huawei, Lenovo is now the second Chinese brand in the top 100. Can we expect more strong brands from emerging markets?

“Many Western car makers have been working on their brand value for over half a century and Japanese and South Korean car makers for several decades. I don’t see Tesla.”

“I believe that Alibaba is among the 100 most valuable brands, but it’s not on the list. The top ten are extremely Western, with mainly US and European brands and a sprinkling of Japanese and South Korean ones. While many Chinese brands compete on price, this is not a characteristic of a strong brand.”

Volkswagen is the only car maker that has seen its brand value decline. Can the company repair its dieselgatedamaged image?

Are there any other strong brands missing from the top 100?

“Consumer confidence takes a long time to build but can evaporate overnight. Volkswagen’s reputation has been driven off a cliff and regaining consumer confidence will take years.”

McDonald’s and KFC are in the top 100, but not in your fund’s portfolio. While Chipotle is not on the list and you have bought this company. Why? “Like McDonald’s, KFC is a brand that was favored by the previous generation. Chipotle is the new generation’s preferred choice. It’s not fast food, but is referred to as fast casual – a combination of fast and personal, with better-quality ingredients. Customers can choose what they want in their burrito, which is then prepared in front of them. This freedom of choice appeals to modern consumers. It’s totally different from hamburgers that are pre-made and served at a counter. The concept of customization is perhaps even more important than the Mexican food. I expect Chipotle will make it onto the list of most valuable brands in the coming years.”

“Uber, Victoria’s Secret, Twitter and Instagram to name but a few. I can imagine that it is difficult to determine the brand value of an unlisted company like Uber. This also applies to brands that are part of a larger company like lingerie retailer Victoria’s Secret, a subsidiary of L Brands, and Instagram, which is owned by Facebook.” “Manufacturers that can use the strength of their brands to generate consumer loyalty, to exert pricing power and to stay relevant over time are an interesting investment opportunity for Robeco Global Consumer Trends Equities.”

This publication is intended to provide investors with general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products.

QUANT INVESTING

| 11

Fama-French five-factor model: Why more is not always better Nobel laureate Eugene Fama and Kenneth French have expanded their original three-factor model by adding two factors. What do we think about this?

Three Robeco experts on empirical asset pricing give their views. They acknowledge the major contributions Fama and French have made to the literature in the past and so studied this new research with great interest. However, the debate is set to continue – they take a critical view of this newly proposed model. Fama and French have created a five-factor model1 to describe stock returns by adding two new factors to their classic (1993) three-factor model2. This three-factor model consists of market risk, size and value. The size effect is that stocks with a small market cap earn higher returns than stocks with a large market cap, and was found to exist in the 1963-1990 period. The value effect is the superior performance of

stocks with a low price to book compared with stocks with a high price to book. Fama and French have now added profitability (stocks with a high operating profitability perform better) and an investment factor (stocks of companies with high total asset growth have below average returns). Both new factors are concrete examples of what are popularly known as quality factors. The paper ‘A five-factor asset pricing model’ was published in the Journal of Financial Economics in April 2015. Pim van Vliet, Portfolio Manager Conservative Equities, David Blitz, Head of Quantitative Equity Research, and Matthias Hanauer, Quantitative Researcher, discuss the implications.

Adding more factors has drawbacks

Surprising omissions

Van Vliet sees the addition of two more quality factors as a big change from the old model. ”If you exclude market risk, the new model effectively doubles the number of factors to four. All these factors interact, which makes it more difficult to summarize the cross section of stock returns.”

Van Vliet is more surprised by the factors they did not include. “The new model still ignores momentum, while this factor is widely accepted within academia and has been around for 20 years.”

David Blitz is also critical about the way the empirical research has been approached. “This approach can even be considered a form of tautology, because they use five factors to explain the returns of those same five factors.” The two new factors (profitability and investment) are thus used to explain their own performance. I would prefer it if they showed that just a handful of factors can be used to explain the performance of the numerous factors found in the literature. They do this in the follow-up paper, but it should form the basis for their study.

They also omitted the low-volatility factor, although for Blitz this is not such a big surprise. “There is a practical reason for excluding it, because it is not easy to combine with the market risk factor in the three factor model,” he says. “The market factor, which is similar to the beta factor of the capital asset pricing model, still assumes higher returns for higher risk, while a low-volatility factor would assume the opposite. An alternative approach would be to scrap the market factor altogether, but they did not choose this more radical step.” Blitz argues that Fama and French have been too quick to add the two factors. “The two new

‘The paper does fill a gap in the literature’ factors they have added are relatively recent discoveries and the research on these factors in different markets and time periods is still limited.” Hanauer says a different definition of two factors related to quality might be more appropriate. “They have added the two factors but it is unclear why they have chosen these precise definitions,” he says. “In my opinion, the definition of gross profitability given by Robert Novy-Marx3 would have been a natural choice.” Adding two factors is a big step, but in some way it is only a modest step, thinks Blitz. “In the AQR paper ‘Quality minus junk’ twenty underlying quality variables are used, only two of which are

EUGENE FAMA (left) KENNETH FRENCH (right)

selected by Fama and French. Why two instead of twenty? Why those two in particular? A lot of questions remain unanswered.” Don’t get me wrong, he adds. “I am not against these two extra variables, but why have they given them a special status by putting them in a model, when there is a range of other variables available?” According to Hanauer, the two quality factors contradict earlier findings by Fama and French. “In their 2008 paper ‘Dissecting Anomalies’4, they stated that the asset growth and profitability anomalies are less robust. However, in their five-factor model they use exactly this same asset growth variable in their investment factor.”

Divided opinions on implications The three experts are divided on what the main implications of the five-factor model will be. Blitz suggests that Fama and French may have distanced themselves from their previously

steadfast belief in efficient markets, where the relation between risk and return is linear and positive. “The three-factor model still fitted this belief, because they saw size and value as risk factors, just like market risk in the capital asset pricing model. But now they don’t even bother to explain how the two new quality factors fit into their old framework, or whether there are behavioral explanations for these factors.” Hanauer does see a bright side to the new model. “Despite all the criticism, the paper does fill a gap in the literature on these two quality factors.” Van Vliet says that Fama and French did a great job with their original 1993 model in reducing the number of factors that were proposed in various different papers in the 1980s. “And now they have added two more. These additional factors will give quite some food for thought in the coming years.”

1. Fama, E., and K. French. “A Five-Factor Asset Pricing Model.” Journal of Financial Economics, 116 (2015), pp. 1-22. http://www.sciencedirect.com/science/article/pii/ S0304405X14002323. Working Paper (September 2014) available at SSRN (free download): http://ssrn.com/ abstract=2287202 2. Fama, E., and K. French. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), pp. 3-56. http://rady.ucsd.edu/faculty/directory/valkanov/pub/ classes/mfe/docs/fama_french_jfe_1993.pdf 3. Novy-Marx, R. “The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics 108(1), 2013, 1-28. http://rnm.simon.rochester.edu/research/OSoV.pdf 4. Fama, E., and K. French. “Dissecting Anomalies.” Journal of Finance, (August 2008), pp. 1653-1678.

14 |

OPINION

Beware the economic ‘super-cycle’ in commodities A market strategist once said that “if you buy commodities, you are betting against the ingenuity of people.” When natural resources become too expensive, human resources step in to find alternatives, says CIO Investment Solutions Lukas Daalder.

‘Solar is set to become a serious competitor for oil’

“Most asset classes have a cycle: equities go up in times when the economy is booming and down in a recession, and so on,” says Daalder. “Commodities have a super-cycle. They start off with a normal cycle, do well in the early stages of a recovery as people start to build things again, and then go down when the cycle ends. The super-cycle is a much wider, bigger and longer phenomenon which is driven by scarcity and investments.” “The oil price, for example, goes up in the recovery cycle, but at some point it becomes so expensive that it triggers the use of alternatives such as solar energy, which then become economically viable to tap into. And this takes time: you need to invest in new projects, and conduct R&D, etc. So it creates a super-cycle where if oil gets too expensive, people will look for cheaper alternatives.” “It means that you are betting against the ingenuity of people. Basically, if you think that people are smart and will solve everything in the end, they will always find a replacement for commodities. Therefore,

Commodity price growth may be peaking

they will always ultimately decline in price. If you take a basket of ten commodities, in ten years from now its value will probably be lower. Ingenuity means people get smarter and find alternatives in the supercycle outside the normal economic cycle.”

Oil remains the kingpin A major issue with commodities is that there are so many different types with different characteristics, from ‘hard’ materials such as metals to ‘soft’ agricultural products. But there is one elephant in the room: oil. “Commodity prices are dominated by the sheer size of the oil market, so people will normally just ask where we are in the stage of the oil supercycle,” says Daalder. “Since 2014, there has been a dramatic decline in the oil price, which is related to the rise of US shale oil. And it doesn’t feel like we’ve hit the bottom yet, even though oil prices have recovered somewhat, because fracking is still in development and has not yet peaked.” Source: Business Insider

‘If you can make a correct call on the super-cycle, you can beat equities’

How solar power prices have fallen 80 70 60 50 40 30 20 10 0 77

Price of crystalline-silicon photovoltaic cells. USD per watt Source: The Economist via Bloomberg

“Added to shale, it is clear that solar energy is becoming more competitive as the costs have been driven down immensely. Solar is set to become a serious competitor for oil, so we’re not yet at the bottom of the super-cycle for oil.”

Risk not always matched by return Buying into commodities can therefore be a riskier investment than other asset classes, but without necessarily getting the returns needed to justify the extra risk, says Daalder. “The risk profile of commodities is a bit like equities, but the volatility is higher, while the return profile is lower. Over the past 25 years, depending on which index you look at, commodities have yielded returns somewhat in excess of (risk-free) US Treasury bills, but at much higher volatility. Equities on the other hand have offered superior results over time. Part of this weak return is linked to the fact that you continuously need to roll over futures contracts when investing in commodities, which is a costly exercise.” “You may wonder why you want to invest in commodities, in that case. Traditionally, there are two arguments: diversification and timing. The diversification argument used to be that commodities added returns at times that equities didn’t. However, this argument has lost a lot of its shine

over the past couple of years, as stocks and commodities became much more correlated during the 2009 crisis. The other argument is timing: as long as you are able to make a correct call on the super-cycle, you can beat equities. But you need to have the knack of spotting the start of this cycle.” The market can also suffer from liquidity problems, where it may be difficult for an investor to exit if things turn sour. “Liquidity depends on each commodity. The oil market is very liquid, and it’s easy to get in and out. However, if you move into natural gas, you will see some strange price moves at times, which is partly a result of liquidity problems, as well as transport and storage costs,” says Daalder.

At the mercy of the weather This lack of liquidity in some areas can also translate into lower transparency, he says. “Given the illiquid nature of some commodities and the fact that many are linked to the weather, where one bad summer can badly affect production and prices, returns are unpredictable. So it may be a transparent market on the whole, but some of these commodities are pretty erratic, and go up and down quite heavily according to certain events,” he says. “Commodities do tend to be a good inflation hedge, but there is a question here of causation and correlation. The two major inflation shocks that we have had over the past 60 years have been due to oil prices, and were therefore the cause of the inflation. Commodities became a hedge against the inflation that they had created.” Subsequently, commodity investing has fallen off the radar, and is no longer offered by Robeco. “The trend overall in the last five years has been for people to be less inclined to be invested in commodities. Added to that is the fact that the longer-term returns are not that interesting,” says Daalder.

OPINION

| 17

Getting back on our feet and soldiering on In terms of global economic growth, 2015 was not much to write home about and Robeco’s Chief Economist Léon Cornelissen expects 2016 to be at best only marginally better.

LÉON CORNELISSEN Chief Economist Robeco

‘A Brexit would be a huge blow for Europe and an even bigger one for the UK economy’

The economic heavyweights – the US, Europe and China – are each facing their own set of problems. However, Cornelissen doesn’t share some economists’ fear that the markets will lose confidence in the key central banks if their quantitative easing policies don’t deliver tangible results. “It’s still too early for a crisis of confidence.” Many eyes will remain fixed on Europe in 2016 – a logical consequence of the growing migration problem. In economic terms, Cornelissen thinks this situation will mainly be beneficial. “It could prove to be a blessing in disguise. Europe is now hampered by restrictions imposed by the Treaty of Maastricht, which leave little room for further fiscal stimulus. However, the European Central Bank is an advocate of this and now that Europe is awash with refugees, some of these restrictions could simply be lifted. Recently, Pierre Moscovici (European Commissioner in the Juncker Commission) remarked that government deficits would be taken less seriously.”

Europe: “Wir schaffen das schon” After all the problem needs to be dealt with, says Cornelissen, even if certain countries are still in denial. There needs to be a more central approach. “Europe is pandering to Turkey now, which is logical because it needs strong controls along its borders. The fact that this comes at a price is logical.” As yet Cornelissen is less concerned about the right-wing shift currently taking place in various EU countries, although “the lack of enthusiasm for solidarity

in France and the growing strength of the National Front may undermine stability there.” “As the Germans say: ‘Wir schaffen das schon.’ The flow of immigrants may have a positive impact on economic growth in Germany. Initial estimates are 0.2%, but the real effect will be significantly greater. Helping these refugees into work is the best solution, even though this will increase pressure at the bottom end of the labor market, of course.” Cornelissen is more worried about the UK’s in/out referendum. “Cameron will likely want to hold this in the spring of 2016 – to be well ahead of the Bundestag elections in Germany and the French presidential elections.“ The impending mid-term blues (reduced momentum for the governing party once it has been in power for two years) are already looming, so speed is of the essence. A Brexit would be a huge blow for Europe and an even bigger one for the UK economy. It would cut itself off from the world’s largest market – ‘selfdwarfing’ as the Frankfurter Allgemeine calls it. The Scots will in turn also demand a new referendum, bringing the threat of a ‘Scoxit’.

China will be fine too The Chinese government has made mistakes in recent years in its rush to devalue the yuan. But it still has enough instruments at its disposal to kick-start the country’s spluttering growth engine. The fact that the Chinese currency is soon to be included in the IMF’s SDR (Special Drawing Rights: a basket of reserve currencies) is perhaps not strictly by the book, says

Cornelissen, but it may give China a boost. “The new Five Year Plan will be presented next year too. It’s the same old song: structurally lower long-term growth, further implementation of the economic transition, but it works.” At any rate Cornelissen is ruling out a further sharp depreciation of the yuan for the next six months. After this, there may well be room for further devaluation, if only to stem the further outflow of capital.

And Japan? It’s soldiering on Three new Abe arrows have been unveiled – before the first three have even been shot. “These are intended to stimulate nominal GDP growth. But there is no time frame or details of how it is supposed to work. In the meantime pressure on the Bank of Japan is rapidly increasing.” So far Abenomics has been very disappointing and the only solution Japan has for this is even more Abenomics. The IMF’s claim that the country is ‘relying too heavily on monetary policy’ in the absence of any better alternative is also dampening sentiment. What’s more, there is no credible opposition in the country and the next elections are not anticipated until 2018. It will be just more of the same in Japan for the time being, Cornelissen fears.

US: Forever number 1 Things are not all that rosy in the US either. Renewed political deadlock between the president and his Congress seems to be on the cards, the government’s job creation plans are bearing little fruit and the low oil price means that the shale revolution is also losing steam.

Yet of all the economic powers, the US is still the ‘convincing’ winner, thinks Cornelissen. “The country is much better equipped to absorb external shocks.” The skirmishes surrounding the late-2016 presidential elections are already in full swing. Cornelissen thinks that a Democratic president is the most obvious outcome. He or she will probably have to deal with a Republican-flavored Congress though – a combination that promises little in terms of stimulus for the US economy. However, history has proven often enough that this country’s economic resourcefulness and resilience should never be underestimated.

Deflation hysteria ebbing away All in all, the outlook for the global economy is not much to write home about. “Toil is perhaps the right word,” says Cornelissen, who nevertheless thinks we should be careful about excessive pessimism. “But the patient isn’t ready to get out of bed and start swinging from the chandeliers yet. In fact, he isn’t even off the drip.” And this, seven years after the collapse of Lehman Brothers, isn’t a particularly uplifting observation. But there is hope. “To get out of debt, you need real growth and real inflation. Now that the oil price is stabilizing at a low level (between USD 40 and USD 60), the deflationary pressure it exerts on inflation is ebbing away. This will silence the deflation hysteria.” Which is good news for central banks and eventually also for the global economy.

‘The stabilizing oil price will silence the deflation hysteria’

20 |

OPINION

WHAT TO EXPECT WHEN YOU DON’T KNOW WHAT TO EXPECT What do investors expect for 2016 when it comes to returns on investments or economic growth? We asked the twitterati and they – as a group – don’t really seem to have a clear vision. We do, however.

22 |

QUANT INVESTING

Top of the league for decades and still hungry for more xxxxxx

PETER FERKET Head of Equities

Robeco has been carrying out quantitative research for over 25 years. In the rapidly growing world of quant investing, the company is a pioneer and one of the leading players in this field. We talk to Peter Ferket, Head of Equities and the driving force behind quant investing at Robeco.

Robeco offers a myriad of products. How did it all start? “We began in around 1990 with our first quantitative study – into strategic asset allocation. That was real top-down allocation research. Based on risk profiles, we sought to find the best investment mix for retail clients. Shortly after we began researching factors – for both stocks and bonds.” “The first real investment models were introduced in 1994, with a quantitative ranking for developed market equities based on the factors momentum and value. For bonds, we had the duration allocation model for the US, Germany and Japan. These models were used as input for the fundamental investment teams to aid decision-making.”

The first real quant product wasn’t introduced until later… “Yes, Lux-o-rente was the first real quant fund. Launched back in 1994, it became a fully quantitative fund in 1998, with a completely active duration policy. The investment model has however evolved over the years. Just like a flesh-and-blood portfolio manager, models have to keep developing too. There’s also an increasing amount of data available and more and more markets to be exploited. So you continue to tweak your model. The Lux-o-rente model is better now than in 2005. And it was already good then, as its track record shows.”

How unique is Robeco’s quant strategy within the global asset management industry? “Quantitative investing in itself is not unique, but our approach is. There are three key elements: the quality of our internal quant research, the extensive investing experience we have within Robeco and our ability to translate that expertise into specific solutions for clients. There are players with larger research teams and there are providers with more general investment experience, but it’s the combination of these three facets that other parties don’t have. That makes us unique.”

Is quant is the best choice when it comes to creating tailored solutions for clients – more so perhaps than fundamental products? “In a certain respect, yes. Quant has a modular structure by definition and it’s rules-based. It’s easy to change the universe. If a quantitative model works in Europe, it’s easy to quickly establish whether it will work worldwide as well. And it takes no time at all to implement the strategy in another universe. This is quite a bit more complicated for fundamental strategies.”

in the portfolio. However, quant models don’t work as well with fewer positions, because company-specific risks weigh more heavily.”

How much competition is there in quant investing, from both passive providers with smart beta ETFs and active players? “There is serious competition, but we’re in the Champions League when it comes to quant investing. We’re among the top five, together with ‘pure’ quant firms like AQR and DFA. We are the thought leaders in this ballpark.”

How difficult is it to maintain this pole position? “You’re never safe out at the front – it’s hard to maintain your lead. You have to keep investing in research. And you have to do even more than you did in the past. There competition is fiercer, so you have to run faster. That’s why we have expanded our research and portfolio management teams. Worldwide allocation to quant is growing, so our asset base is growing too. We have doubled the size of the quantitative research team over the past four years (from 15 to 30) and our Quant Equity headcount has increased from five to ten in the past two years.” “We have expanded the product range from Multi Factor Equity to Multi Factor Credit. The next step is Multi Factor Multi Asset. Stand still and in two years you’re on the back foot. High standards continue to be a key focus in our research and we’re highly critical of new variables and factors. The force behind all of this is the intrinsic motivation of the team itself. We are driven by curiosity and the desire to keep improving ourselves.”

What risks do you see ahead for quant investing? “The rise of quant and passive investing has led us to modify our fundamentally managed funds in recent years. These funds have become more high-conviction, for example with less than 100 names

“If everyone turns to quant investing, it will lose its effect. But this is purely a hypothetical risk. I do notice an increase in the number of providers though, some of which are inferior and have the potential to

tarnish the concept’s good name and push down the average returns of quant providers. That’s exactly what happened with hedge funds when they gained in popularity – the market became awash with players that lacked the right skills.”

Where do you expect to see further growth? “Our strategic plan Accelerated Growth 2014-2018 includes a target of EUR 50 billion in assets under management for Quant Equity. The tally currently stands at EUR 26 billion. This target is based on four pillars: Quant Emerging Markets, Conservative Equities, Multi Factor Equities and alternatives for passive investing (enhanced indexing, but also Quant Sustainable Global Equities).” “We also see enormous potential for Multi Factor Credits. Credits still constitute a larger part of the portfolio than stocks for institutional parties. We also believe in the potential of our quantitative absolute return fund Global Tactical Asset Allocation (GTAA), on account of its liquid nature and low correlation with stocks and bonds. Given the low expected returns for these asset classes, the tide has turned in this fund’s favor – certainly in view of its positive performance in more volatile markets.”

What position will quant investing as a whole occupy in 20 years and Robeco’s quant strategy in particular? “One thing is certain: in 20 years Robeco will be much bigger than it is now. And quant will still be a very important pillar. Quant currently accounts for over 10% of the total assets under management. Although new pillars will come and go, quant will definitely not diminish. At any rate, in 20 years it will have proven that it wasn’t just a fad. Quant is here to stay and by that time Robeco will still be one of the top players in this market.”

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OPINION

How good are your directors? Having top-quality board members who can take a long-term view is critical for strong corporate governance, say leading business figures.

Sustainability investors often bang the drum for longer-term thinking. But how realistic is this, given that all directors – and fund managers – must preside over quarterly reporting? Many board members also have tenures that may last only a few years, and most portfolio managers have mandates that are reviewed annually. The issue was hotly debated at the International Corporate Governance Network’s 2015 summer conference.

“I think the biggest issue we face is the whole long-termism versus short-termism issue,” says Wendy Lane, a director of the US insurer Willis Group Holdings. “Clearly there has been a big rise in short-termism, particularly in the US, and even long-term investors have short-term reporting pressures of their own. The biggest help for directors facing this issue is to ask themselves: is what you are doing in the longterm best interests of the company?”

She said that while she was a director of a US healthcare company during a boom period, “all we heard from shareholders was ‘you’ve got to repurchase shares, leverage up … we want cash back’. But we wanted to keep our powder dry.” The company eventually used its spare cash to buy a competitor and its share price went up. “We say to shareholders: we hear you, we see your pressures for value creation; but if you know what your long-term responsibility is, you can balance things out pretty well.”

Short-term vs. long-term conundrum Annell Bay, a director of US oil and gas group Apache, says the short-term pressures can outrank the longer-term vision if the company goes through a bad patch. “If you have consistently poor results, quarter after quarter, something’s got to change. You have to show the shareholders that the plans you have laid out can still achieve long-term success.” Michael Harland, Assistant Comptroller for ESG for New York City, says director tenure offers a classic example of mismatched timespans. “The management driving the ship has at most a three or five-year time horizon. If they’re making an investment that may actually save the company 10 or 20 years down the road, the current management is not going to be paid for it, so where’s the incentive? Nor are they going to be held accountable if their decisions which are focused on the short term end up blowing up further down the road, because they’ll be long gone.”

And investors have the same problem. “What’s material over your 50-year time horizon may not be in five,” says Donna Anderson, Head of Global Corporate Governance at US asset manager T. Rowe Price. “Climate change for us, with our two- to ten-year time horizon in a typical fund, is much harder to get our arms around, and much harder to try to provide expertise on.”

Quality of the chairman Good governance comes down from the top, so a good chairman is key, says Simon Walker, Director General of the UK Institute of Directors. “It starts with the chairman, who needs to demonstrate the highest standards of integrity and probity and set clear expectations about the company’s culture, values and behavior,” he says. “That then needs to permeate through the company as a whole. One thing we saw in the financial crisis was how that had not been applied at banks; it was a profound cultural problem.”

‘What’s material over your 50-year time horizon may not be in five’ One senior investment banker who navigated the financial crisis agrees about culture. James Bardrick, Chief Executive of Citigroup Global Markets, says he changed the meaning of the

CCO acronym which describes his job as Chief Country Officer for the UK to read as Chief Culture Officer. “We can’t regulate for a lot of things. We can’t regulate for conduct, we can’t regulate for behavior – only against the consequences of it,” he says. “So how do we get the results to be better? If the culture at both a personal level and an institutional level is incorrect, it doesn’t matter how good your governance or planning is; the outcome won’t be right.”

You’re fired! Changing of the guard Sometimes it may be necessary to fire directors, Bay says. “Every member of the board forms part of the culture, so if you refresh the board and bring new people in, those new people will change the culture of the board, because someone with fresh eyes has the right to say: why are we doing it this way?” Boards that cannot keep up with rapidly changing events present another problem, says lawyer Holly Gregory, Chair of the American Bar Association’s Committee on Corporate Governance. “It’s always struck me as strange that the pace of business change is remarkably rapid, but the pace of board turnover is very, very slow,” she says. “It seems to me that if a business is changing fast, you have to be looking every year to see whether the skills sets on the board are keeping up with the direction in which the company is going. It’s hard to ask someone to leave a board, but maybe that’s part of the culture we need to change.”

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OPINION

The double-edged sword of changing technology Changing technology presents a double-edged sword for the global economy. Disruptive start-ups will probably remain important, particularly if new products are deflationary or challenge established players.

“The emergence of all kinds of new technologies, such as the development of increasingly powerful computer chips and the advance of the internet as a distribution channel, is dividing the world into two camps,” says Lukas Daalder, Chief Investment Officer of Robeco Investment Solutions. “On the one hand, there are those who believe the combination of these trends will provide a solution to all our economic and climatic problems. The people that believe in this scenario are the advocates of the school of exponential growth, who extend every growth rate into infinity.” “At the other end of the spectrum, there are those who have serious doubts about the potential that these new technologies offer. They point to the loss of jobs associated with the ongoing growth of robotics and automation, and the emergence of ‘disruptive businesses’ is doing more harm than good, leading only to economic chaos. Reality probably lies somewhere in between.”

LUKAS DAALDER Chief Investment Officer Robeco Investment Solutions

‘Disruptive start-ups could be bad for the shares of established companies’

Change at the speed of light Daalder says the rise of smartphones, from a niche product five years ago to a mainstream device today, is a case in point. However, development of the smartphone was led by the mighty Apple and other tech giants. Future innovation is more likely to come from disruptive start-ups, he says. And the speed at which innovation can take hold still has the power to surprise. It took 75 years for the telephone to come into general use, whereas Facebook went from founder Mark Zuckerberg’s university dorm room to one of the world’s largest companies in less than five years. Meanwhile, the much-admired ‘Moore’s Law’, in which the capacity of new microchips doubles every two years while their price halves, is becoming redundant with the advent of quantum technology. “As a result, the ‘old’ economy has too little time to adapt to these changes, which could have major social consequences. Examples are students being trained for jobs that may no longer exist in four years’ time, or pension funds being confronted with a sudden drying up of capital inflows,” he says. “In the case of the self-driving car, it is difficult to see what professional drivers and insurance companies will do if it is introduced on a large scale.” Daalder says a side-effect of new technology is that it is deflationary, which would encourage central banks to keep interest rates low, which means bond yields would remain low. For equities, disruptive start-ups

could be negative for established companies, but it would depend on final demand. Productivity gains from innovation and any economic growth associated with new technology would however be more positive for equity markets generally. The wider impact on the economy and financial markets could be either positive or negative – the double-edged sword – as shown in the table on the right. “There are more negative than positive points, but much depends on the weight given to the different elements,” says Daalder. “For instance, a true techno-optimist will hold that new breakthroughs will be all-decisive, tipping the scales to the positive side.”

The economic effects of the technological revolution Negative

Positive

Lower employment

Productivity gains

Lower (measured) GDP growth

New breakthroughs

Emergence of disruptive industries

More purchasing power as a result of deflation

Lower profits Emergence of sharing economy (less final demand)

Improved consumer surplus

Weakening governments Source: Robeco

Being a ‘techno-realist’ The likely impact of innovation, detailed in a special section of the FiveYear Expected Returns 2016-2020, entitled ‘The economic effects of the technological revolution’, builds on a previous examination of the future, in which Daalder described himself as a ‘techno-realist.’ “If you ask me whether the next 20 years will be boring and marked by stagnation or vibrant with highs and lows, I would definitely go for the second scenario,” he commented in the July 2015 article. “Yes, there are sectors that will be damaged by technological developments such as publishers and the music industry. But at the same time there is a revolution underway that for the most part has gone under the radar of the traditional calculations used to measure economic growth. The value of all that digitization in those sectors simply cannot be ‘zero’.”

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FACTOR INVESTING

Ten key questions on factor investing Investors are increasingly becoming aware of the advantages that factor investing has to offer and are starting to implement its lessons. They regard the concept not just as an afterthought but also as an element of their overall investment strategy.

Pension funds face two major challenges. They need to increase returns. The majority of pension funds have a coverage ratio that is only just above the minimum requirement. However, at the same time they have less appetite for risk, because they cannot afford to let this ratio fall further. Is factor investing the solution for meeting these seemingly conflicting challenges? Head of Factor Investing Research Joop Huij specializes in empirical asset pricing and equity strategies and answers ten questions from pension funds.

What are the benefits of using factor investing for institutional investors?

“The benefits are reduced risk and enhanced returns in the portfolio over longer periods. Furthermore, factor investing helps asset owners gain a better understanding of the underlying factors relating to risk and return. This enables them to construct robust portfolios designed to withstand shocks. Institutional investors also appreciate factor investing’s academic basis. The demand for hard evidence that an investment style actually works has increased as a result of the crisis. Investing without clear rational reasons is a thing of the past.”

JOOP HUIJ Head of Factor Investing Research

When does a factor really work?

“Many studies on new factors are based on past returns and make a lot of assumptions. For example, that there are no trading costs, that you can trade just as easily in small caps as in large caps and that there are no taxes. In practice, many of these new factors

simply do not work. Therefore institutional investors should be skeptical when considering incorporating new factors into their investment strategy.”

‘Many are based on past returns and make a lot of assumptions’

“However, having said that, I do not dismiss quality as a factor entirely. There is empirical evidence for some new quality variables. But more evidence is still required for it to be fully acknowledged as a factor.” “We do not consider size or market capitalization to be distinct factors, although there is some empirical evidence for these. At the same time, we advise institutional investors to work with a universe that also includes smaller caps when implementing factor investing strategies for equities.”

“The factors that do work have two things in common: there is ample empirical evidence supporting their existence and there is an economic rationale for it. I was one of the authors of a study that looked into the performance of mutual funds that were exposed to factors. We found that the most well-known factors, value, momentum and low volatility worked best, while the more exotic factors did not.”

“But I do not expect this to happen. While large institutional investors are embracing it and allocating large sums of money to factors, many other investors are unable to engage in factor investing strategies because of organizational barriers. If you wish to adopt factor investing you would typically have to make substantial changes in your organizational setup, responsibilities and in the alignment of interests.”

What about the quality and size factors?

“Quality has become a very popular factor. However, it is often not completely clear what quality means. The definitions used by investors and researchers vary and often include many different variables. For a variable such as return on equity there is very little academic evidence. What we see is that this variable is sometimes augmented by low volatility or value to increase performance. In reality it is then just another factor in a different package.”

Do you expect premiums to disappear if more investors embrace factor investing?

“In theory, if more investors were to embrace the concept, it would push up asset prices in the most attractive segment of the market. So future returns would go down and the premiums would disappear.”

What is the difference between factor investing and risk premium investing?

“Investing in risk premiums and smart beta investing are frequently used terms that both refer to the same idea as factor investing: strategically allocating to factors. I prefer to avoid these terms, because both specifically indicate that factors are compensation for taking risk. However, there is very little empirical evidence to suggest that you actually need to take this risk to generate returns.” “There are alternative interpretations other than risk to explain the existence of these premiums. Take for example the behavioral biases of investors that can distort asset prices. Robeco believes that factor premiums are related to rational behavior such as the career concerns of portfolio managers. Their career prospects might be jeopardized if they significantly underperform for a considerable period of time after deviating too much from the benchmark.” “For us it is very important to know more about the reasons why factor premiums exist. A more in-depth understanding can enable you to gain a better exposure to them.”

What is the best approach if you wish to capture factor premiums?

“Factor investing is the right choice, but the degree of success depends on proper implementation. Factor investing works, even with a generic or index approach. But it is

possible to capture factor premiums more efficiently by setting up a high conviction approach. If you implement factor strategies well, you can earn higher returns, reduce risk and cut trading costs. A good factor strategy avoids three things: unrewarded risk, going against other factor premiums and unnecessary turnover.”

Should you time factors by changing the weights to the individual factors?

“First and foremost you can add value by diversifying across factors. Moreover, we found that it is very difficult to time them. The academic literature on the subject is not conclusive, although there are some studies showing the role of the business cycle on factor returns, and the impact of factor momentum. There are two important obstacles in timing factors.”

‘It is very important to know why factor premiums exist’ “First, timing factors typically leads to higher transactions costs, which can have a large impact on total returns. Second, there are only a limited number of investment choices to be made. This phenomenon is called limited market breadth.”

“You need to be very skilled, i.e. have a high level of accuracy, to implement a strategy effectively if there are only a limited number of investment possibilities. The problem with timing is that you only have a handful of factors to select: if you time these, you make a small number of decisions that can have a large impact on performance. This is not attractive from a risk/reward perspective. We do allow for deviations from the strategically chosen factor mix, but these are relatively small.” “Instead of trying to time factors, we advocate a diversified approach. In addition to diversifying, investors should also have a long time horizon to absorb these periods of underperformance. This is not only the case for equities but also for credits.”

How can factors be optimally mixed?

“The optimal mix is client-specific for two reasons. First, it should take into account your preferences. These preferences depend on the type of investor. Low-volatility stocks lose less in down markets resulting in a more stable funding ratio for pension funds while maintaining exposure to the equity premium. On the other hand, value and momentum can be more attractive for sovereign wealth funds, because these are often more interested in maximizing returns. Second, it should take into account the portfolio’s current exposures in the integration of a factor solution.”

Do currencies have an effect when constructing a factor portfolio?

“Currencies can have an impact on total returns, but this is less than the factors themselves. They can also be hedged according to investor preference. There are many ways of dealing with currencies and we can create tailor-made solutions. We do not advocate the use of factor strategies on currencies as a separate asset class, for instance by applying a momentum strategy to currencies.”

Does a momentum strategy still work after you have taken the transaction costs into account? “It is true that generic momentum strategies are inefficient because of the associated trading costs. Most research on momentum strategies has serious shortcomings and many studies do not take these costs into account. When you do, a considerable proportion of the returns disappear. Many generic strategies sell a stock as soon as it falls out of the top 10% of the universe.” “However, it is possible to set up a more efficient momentum strategy and significantly reduce portfolio turnover by around 50%. In an efficient momentum strategy there is a tradeoff between the strength of the signal and the trading costs. And you should only engage in a trade if the signal is strong enough.”

OPINION

| 35

Why China will dominate the emerging middle class The Chinese middle class will dominate the ranks of emerging consumers in the next five to ten years while predictions about India are too optimistic, says Robeco trend analyst Steef Bergakker. Where will the shoppers of the future be from? The emerging consumer is an important investment theme that emerged during and directly after the financial crisis. At the time, the US consumer was switching into a lower gear, while growth in emerging economies was still strong. Homi Kharas, from the OECD Development Centre, wrote an influential paper on the subject in 2010, in which he predicted that the global middle class would double by 2020 and triple by 2030. Most of the growth would take place in China and India. The prospect of hundreds of millions of new consumers spending on more than just the basic necessities could lead to an accelerated demand for discretionary consumer goods. Bergakker started to investigate whether the assumptions behind the model were valid, especially after growth in some emerging markets began to taper off. He wanted to find out whether this was still an interesting investment theme and where to find the best opportunities. Bergakker found China offers the best prospects. â&#x20AC;&#x153;Investors often talk about the global middle class. But in terms of opportunity, size and relevant investment horizon, this really only means China.â&#x20AC;?

Overly optimistic predictions for India But what about the predictions for growth in India? The OECD paper assumed that India would be on a higher growth trajectory and that it would become the biggest consumer economy in 2030. India currently only represents 2% of global consumption, while it makes up 18% of the world population. The model predicts that India’s share of global consumption will increase to 11% in 2020 and 23% in 2030. Bergakker feels that this is unlikely. “This timing for India is too optimistic. It still remains to be seen whether they will even become dominant at all.” Bergakker thinks that the biggest challenge for India is to find jobs for its increasing working population. The Chinese development model is not an option. “The Chinese formula for development was simple: bring farmers to factories. China put a lot of people to work in industry, a more productive environment than the countryside. The advantage of this policy was that it caused incomes to rise quickly. And exports helped to sustain the growth.” But this economic model is not possible for India. “India’s industrial base is simply too small. It accounts for less than 15% of GDP.”

‘The biggest challenge for India is to find jobs’ An alternative model is job growth in services. If China is the factory of the world, could India possibly become the service center of the world? Bergakker is skeptical. ”India is known for a few high-profile outsourcing companies that provide call center and IT services. But the number of jobs these industries would create is negligible in relative terms and they require a reasonable level of education.” He adds: “India has the reputation of a having large, well-educated population. But the reality is different. It will take at least a generation to achieve the level of education required to provide large pools of highly skilled service employees.” He predicts that jobs now are more likely to come in low-skilled services (taxi driver, handyman and construction worker) where productivity is lower.

Bergakker says India still has a long way to go. “The country needs to improve the quality of its education system and physical infrastructure such as roads and bridges.” Until now progress has been slow.” Modi has taken some steps in the right direction, but you can’t expect one man to be able to change such a large country in a short period of time,” he says. “Around a quarter of the population is illiterate. There is a lot of red tape. It will take at least five years before you see any impact.” “There are many structural barriers to overcome before India has a middle class that has an impact on the global economy,” concludes Bergakker. “The growth of the middle class in India is beyond any reasonable investment horizon.”

Much better case for China China is in a much better position to make the transition to middle class income levels, predicts Bergakker. “The outlook for the next five to ten years is strong.” And he gives three reasons why the Chinese economy and middle class will continue to grow in the next five years. “First, the increased level of urbanization,” he says. “Salaries in the city are three times higher than in the countryside. Urbanization is expected to increase from 54% now to 60% in 2020. Second, young people in China earn more than the older generation because they have received a better education. This is unusual, because normally older people earn more on account of their experience. As the older less well educated retire and younger employees climb the corporate ladder in the coming years, average incomes will increase. Third, there is an increase in the female labor force participation rate and the income gap between men and woman is expected to shrink.” Bergakker warns that despite the positive medium term outlook, there are long-term challenges to overcome. “At some point the old formula of shifting farmers into factories will no longer work. Countries such as Vietnam can do the same, but at a much lower cost.” The Chinese government understands the need for reform and is taking measures to increase the quality of its economic growth.

Not many countries have successfully made the huge leap required to join the high income group – Bergakker regards it as a daunting task. “To avoid the middle income trap they need to make institutional reforms and change their mentality. Brazil also had an enormous demographic dividend, but could not extricate itself from the middle income trap. Only a few countries have succeeded and South Korea is one of them.”

Companies that solve such problems are favored by the Chinese government, which is a critical success factor. ”It is essential to have a good relationship with the Chinese authorities,” says Bergakker. “And e-commerce fits into their vision of transition from an economy driven by investments to one that is consumer-driven. The Chinese state also supports e-commerce by building distribution centers.”

Chinese growth in consumer discretionary and e-commerce

Investing in Western companies to ‘play’ the Chinese middle class investment theme is difficult. “There are Western companies with a large presence in China, but these are mainly luxury goods players,” says Bergakker. “For the mass market it is more difficult. For example, Unilever – the Anglo-Dutch company that manufactures nutrition, hygiene and personal care products – has achieved some success in China. But there will be fierce competition with domestic brands and China will still account for a relatively small portion of total turnover. For an investor it makes more sense to invest in companies focused primarily on the Chinese domestic market.”

Chinese annual GDP per capita is already at the point where spending on discretionary goods is taking off, says Bergakker. “Empirically this point is between USD 6,000 and USD 10,000.” So which segments will grow most strongly in China? Consumer surveys and historical patterns from countries that have followed the same path suggest affordable discretionary consumption will increase the most in volume terms. “The sectors with high prospects are education, healthcare, consumer credit, beauty products and tourism. Average growth is predicted for cars and PCs and low growth for food and apparel.”

‘At some point the old formula of shifting farmers into factories will no longer work’ Bergakker has an interesting addition to this list: e-commerce, which has only a few dominant players in China such as Alibaba, Tencent and Baidu. These companies can help to overcome some of the problems caused by a lack of physical retail infrastructure. “One of the big problems in China is the lack of good retail infrastructure and logistics outside the major cities,” he says.” It is difficult to reach consumers outside these cities. E-commerce makes it possible to circumvent these problems with platforms like Tmall and Taobao, Alibaba’s online shopping market places. Physical delivery is still a problem, but a large percentage of the population can be reached like this.”

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OPINION

Not all hedge fund streets are paved with gold Hedge funds are surrounded by a certain mystique. There is something secretive about the way they operate. They are regarded as products that can make a profit irrespective of market direction. But are they really appropriate for an institutional portfolio?

Robeco Portfolio Strategist and Researcher Roderick Molenaar has studied the added value of hedge funds for institutional investors. Together with Thijs Markwat and Rolf Hermans, he looked into their performance and compared their risk and return characteristics with those of other asset classes. â&#x20AC;&#x153;Investors should be skeptical when looking at the performance of hedge funds,â&#x20AC;? he says. Hedge funds form a broad and diverse group of products that invests in other asset classes without a lot of restrictions. They can be long-only, short-only or long-short strategies, and sometimes leverage is used to increase performance. The funds can invest in a

combination of equities, bonds, currencies and commodities. Often they invest in sometimes exotic derivatives on these asset classes. There are many different strategies, but the researchers focused on global macro, equity market neutral and managed futures. Global macro takes both long and short positions in global financial markets, e.g. stock, bond and currency markets. Equity market neutral strategies can go long and short and use stockpicking techniques, while trying to retain a net neutral position to the aggregate stock market. Finally, managed futures use forward contracts on mostly commodities and currencies.

Historical performance is lower “I estimate historical performance to be around 6% per annum when corrected for biases,” says Molenaar. His estimate is considerably lower than the figures in the hedge fund databases, which collect performance data. Hedge fund index performance in the databases is around 9%, equity market neutral is 6%, managed futures 6% and global macro around 11%.

There is also the ‘backfill bias’, says Molenaar. “Funds build up a track record, but don’t necessarily report it until it’s a good track record – and then they include the good years from the past. This bias has an estimated positive effect of 2% on the results. There have been attempts in the last few years to improve data quality and it has recently become more reliable, but it is a slow process.”

Sharpe ratios over-reported Companies can choose whether or not to submit performance figures for the databases. “In general, the historical hedge fund performance is overstated. There was too much room for bias and this distorts the figures,” says Molenaar: “First, there is survivorship bias. Some funds close down because they have taken on too much risk or as a result of redemptions. They can just exit the databases and their performance records are removed. Survivorship bias has around a 3% effect on performance. In some rare cases, the reverse is true. Some funds exit the databases because their performance is very strong and they have reached full capacity. They no longer need new money and do not want to be in the databases as part of their marketing efforts.”

‘In general, historical hedge fund performance is overstated’

Another major issue for investors is the risk/ return profile of hedge funds. Investors should be careful when using the Sharpe ratio (measured as the return above the risk-free rate divided by volatility) to assess hedge funds, warns Molenaar. “Without adjustment the Sharpe ratio is 0.6 – higher than for equities (0.5) and bonds (0.5), but with corrections this ratio is lower. Again, biases play a role here and generally lead to inflated Sharpe ratios. When you adjust for biases, most hedge fund Sharpe ratios are lower than those for equities and bonds.” A major problem when assessing Sharpe ratios is the absence of a transparent price for the assets in portfolio, argues Molenaar. “The prices that are reported are more stable than in reality. This underreported volatility has a positive impact on the Sharpe ratio. Underreporting can be caused by investments in somewhat illiquid assets like convertible bonds, for which daily pricing data isn’t always available.”

Less liquidity Hedge funds prefer sticky money, says Molenaar. “That’s why hedge funds are less liquid than other asset classes. They are not always that easy to exit.” He explains how hedge funds operate: “In many cases there is a lock-up period (during which you cannot sell) of three to six months. And there is also the notice period. This means you have to give advance warning of your intention to sell in order for the fund to unwind existing positions. And if you want to exit earlier you sometimes have to pay a redemption fee.” Sticky money is especially important in implementing less liquid strategies, says Molenaar. “It helps to protect the existing investors. For example, a convertible arbitrage position – buying a convertible bond and shorting the stock – is very difficult to unwind. But for other strategies, such as managed futures, it is easier to unwind trades.”

Correlation with equities and bonds The correlation with equities and bonds is an important consideration for investors who want to create a diversified portfolio. However, at least as important is how hedge funds behave in different market conditions. The researchers looked at the performance of hedge funds in a range of equity markets. “In bull markets, most hedge funds perform well – with the exception of dedicated short strategies, which involve shorting stocks.” “The correlation with equities depends on the type of strategy, and the performance is

very diverse. Managed futures did well when equities performed poorly. In down markets, equity market neutral strategies did badly, while global macro had a break-even record.”

‘Managed futures do well when equities perform poorly’

equities, and is negative during times of crisis. “Again, it depends on the type of strategy.” Besides the relatively high correlations with equities and bonds, it is also worth mentioning that as much as 80 to 90% of overall hedge fund index performance can be explained by the returns of commonly used risk factors such as equities, bonds, factor investing and various option strategies.

Low transparency The correlation of hedge funds with equities is not constant; it fluctuates, says Molenaar. “On average, the correlation of the overall hedge fund market is between 60 and 80%. In terms of diversification this is not very good. But for global macro and managed futures it is less than 40%, which is more suitable for diversification. After the collapse of Lehman Brothers in 2008, the correlation of global macro and equity market neutral with equities rose, while the correlation of managed futures fell. In other words, during this crisis managed futures offered better protection.” He also looked at how hedge funds performed when interest rates fell, because this is very important for pension funds. “Like bonds, some hedge fund strategies tend to do well when interest rates are falling,” says Molenaar. “Global macro and managed futures perform well in these circumstances, but equity market neutral lags behind.” In general, falling interest rates have a negative effect on coverage ratios and a positive effect on bonds. “Generally speaking, the correlation is lower for bonds than for

Hedge funds are secretive by nature, says Molenaar. “There is secrecy about what they invest in and who their clients are.” There are practical reasons for this secrecy. “If they are short a stock and this is well-known in the market, it can make it more expensive to unwind a trade. There are exceptions and some funds actively seek media attention in order to put pressure on companies.” This lack of transparency is an issue for pension funds, says Molenaar. ”The regulators require them to be in control. They need to know what they are investing in and to understand the investment strategy. These demands are sometimes in conflict with the world of hedge funds.” Another issue for pension funds is the question of whether they can act as a hedge against inflation. Molenaar says that inflation protection should not be the primary reason for investing in hedge funds. “Their strategies focus on absolute return, and inflation protection is not their primary goal.”

Costs are key The 2% management costs and 20% performance fee charged by hedge funds are still normal, says Molenaar. “Good hedge funds with strong track records are still in a position to demand high fees.” But he sees some small changes. “There is pressure from pension funds to reduce costs. Some are divesting. For example, Calpers, often considered a leader in the industry, announced that it would withdraw USD 4 billion from hedge funds because of high fees and the complexity.” ”Some Dutch institutional investors no longer want to invest in hedge funds because of the costs, regulatory demands, or because they no longer see the diversification benefits. But other institutional investors still believe in hedge funds.” He ends with some advice for pension funds: “When allocating to hedge funds, the key is to choose the right fund. You have to be able to select a good manager, because you can’t buy a hedge fund index tracker and there are large differences in performance. If you select a bad manager, it can have a significant negative impact on performance.”

42 |

SUSTAINABLE INVESTING

‘Improve the sustainability while limiting deviations from the benchmark’

MACHIEL ZWANENBURG Portfolio Manager RobecoSAM Quant Sustainable Global Equities (QSGE)

‘A quantitative approach to sustainability investing’

Asset owners want to integrate sustainability in their equity investments, but the question is how?

“We wanted to create an alternative to the existing active and passive ESG solutions.” Portfolio manager Machiel Zwanenburg manages RobecoSAM Quant Sustainable Global Equities (QSGE) together with Peter Ferket. One-and-a-half years after its launch in October 2013, this enhanced-indexing strategy passed the EUR 100 million assets under management mark. The strategy is managed on a purely quantitative basis, ranking stocks on sustainability (80%), valuation (10%) and momentum (10%). We interview him to find out more about the strategy.

What are the features of the strategy and characteristics of the portfolio? “The QSGE strategy offers investors access to global equity market returns with a superior sustainability profile. To achieve this, we developed the strategy in close cooperation with RobecoSAM, Robeco Quantitative Research and Robeco Quant Equities. The main question w e asked ourselves before starting this process was: how can we improve the sustainability profile of a portfolio while limiting deviations from the benchmark? The answer: an integrated inclusion approach proved to be superior to one that relies on exclusion.” “Combining the two requirements – corporate sustainability and equity market exposure – is not as straightforward as it seems. After all, the more environmental, social and governance (ESG) factors are integrated, the more a portfolio tends to deviate from the benchmark. We solved this dilemma with a quantitative approach.”

“The model-driven stock-selection strategy is based to a large extent (80%) on sustainability information from RobecoSAM, the investment specialist focused exclusively on this field and owned by Robeco. The remaining 20% is based equally on valuation and momentum factors, in order to add extra alpha.” “This approach provides the right balance between relative performance and sustainability. The strategy invests in an average of 500 stocks and the active share is about 35%.”

How does the investment process work? “The starting point of the investment process is an in-depth assessment of the corporate sustainability performance of every stock in the benchmark. RobecoSAM invites the world’s largest 3,400 publicly traded companies to participate in its annual Corporate Sustainability Assessment (CSA), the basis for which is an industry-specific questionnaire featuring between 80 and 120 questions.” “Each company’s relative score within its industry is the key determining factor in the composition of the portfolio. Currently more than 95% of the securities in the universe have a sustainability score.” “In the second part of the investment process, each stock in the benchmark is assessed and scored on the basis of valuation and momentum factors, which generate above-average investment returns in the long run. In the third step, we combine both parts of the investment process to produce the stock ranking and construct the portfolio. Stocks with attractive sustainability and quantitative characteristics are overweighted relative to the benchmark, while companies with less attractive profiles are underweighted.”

Is it easy to customize strategies? “The strategy is characterized by its flexibility and can be tailored to meet client needs. This includes the use of different universes or an exclusion list, based on the client’s sustainability investing strategy. Furthermore, the portfolio construction process is flexible enough to allow for different tracking error levels.”

How does the strategy fit client needs? “We wanted to create an alternative to the existing active and passive sustainable solutions that help pension funds face four major challenges: – – – –

a meaningful ESG integration in their investment policies a focus on low cost solutions simplicity and transparency a regulatory environment that discourages high tracking errors”

“The QSGE strategy addresses these challenges. Sustainability is the starting point for the strategy and it is integrated into the investment process. The cost structure is competitive with passive solutions. The strategy offers transparency on the scores of the various ESG criteria. As to deviating from the benchmark, the active risk is in line with that of a passive index like the MSCI World ESG Index or the Dow Jones Sustainability World Diversified Index. We see that we are able to outperform an investment in passive (ESG) solutions after costs.” “There is also interest in the QSGE strategy from parties considering quantitative solutions that are positive on the ESG side. It is inspiring to see how we have moved forward from client need to research project, and finally to a successful strategy.”

OPINION

Manager selection is key when investing in illiquid assets

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In their search for higher returns and diversification, institutional investors often opt for illiquid investments. But do these asset classes really offer the right return characteristics? Robecoâ&#x20AC;&#x2122;s conclusion is that manager selection is crucial.

Together with portfolio strategist Jaap Hoek, Robeco researchers Thijs Markwat and Roderick Molenaar have written a white paper called ‘The ins and outs of investing in illiquid assets’, based on an extensive literature study. Markwat and Molenaar explain the key findings of their research in an interview.

What factors make investments illiquid? “There are four factors that limit the liquidity of investments,” says Molenaar. “The first is the external costs incurred through transactions. These are generally higher for hedge funds, real estate, private equity and infrastructure than for listed stocks and bonds – for instance, because such transactions involve legal specialists. A second factor is that market makers are needed to make the trade possible and they have to maintain supply. The market makers must be compensated for the risk that they may temporarily be unable to find a counterparty.” “Illiquidity also arises when the buyers and sellers don’t have the same information. The less well-informed party will want compensation for the risk of potentially not trading at the right price. That makes it more complex and reduces the liquidity. The fourth factor is ‘search friction’, when it’s difficult to match up supply and demand. That happens when there’s no centralized market, for instance. A small market with few parties can result in wide spreads between bid and offer prices. These various sources of illiquidity overlap too and thus reinforce each other.” Pension funds and other institutional parties are investing more and more in illiquid asset classes. But are they being sufficiently rewarded for the lack of liquidity? “Their long investment horizons mean that pension funds are in a good position to invest in illiquid assets,” says Molenaar. “They are less likely to experience reduced tradability as a drawback than investors with a short-term horizon. But they can benefit from the compensation that the market demands. They’re also less affected by the high transaction costs.” “On theoretical grounds, you might expect there to be some kind of liquidity premium,” says Markwat. “But the results of academic research are mixed. Within some asset classes, illiquid investments offer better

‘There’s little or no empirical evidence for a yield differential between liquid and illiquid asset classes’ yields than liquid investments do. So a liquidity premium exists in such cases. But there’s little or no empirical evidence for a yield differential between liquid and illiquid asset classes. You can’t say that there’s no liquidity premium between asset classes, but it is certainly very difficult to demonstrate that it exists.” “For many illiquid investments, there often isn’t a market value available,” says Molenaar, “so you have to work with book values that are intrinsically of a lower quality. For some people, it’s a fundamental principle of investing that you should receive a premium for investing in illiquid assets.”

‘You should invest in illiquid asset classes for the alpha, rather than for the risk premium’ Are illiquid assets actually attractive enough to invest in? “Whatever the illiquid asset class, it’s important that you pick good fund managers,” says Molenaar. “The managers and their funds must always be in the top quartile. David Swensen, Chief Investment Officer at Yale University and the architect of the endowment investment strategy, agrees. In his study ‘Pioneering Portfolio Management’, he says that you shouldn’t invest in illiquid asset classes for the risk premium, but rather for the alpha you can generate. It’s not always possible to establish

whether good returns are the result of a manager’s added value or perhaps because there’s a premium for illiquidity. But you do get an additional return, and that’s a combination of factors that you can’t put your finger on.” “Swensen argues that there are more opportunities to generate alpha because it’s more difficult to gather and process the correct information about investments in illiquid markets. That’s in contrast to public markets, where the investors have all the information.”

How can the liquidity premium vary so widely for different investors? “A study by Tilburg professors Frank de Jong and Joost Driessen shows that investors with a longer-term investment horizon are able to ask – and get – a higher liquidity premium,” says Markwat. “Because they can hold investments for longer and therefore have to trade less often, long-term investors have lower transaction costs. But because they won’t be satisfied with a lower gross return, the premium they receive has to be higher.”

‘Liquidity premiums are higher in times of crisis’ “Predicting a crisis is pretty much impossible,” says Markwat, “so anticipating one isn’t an option. It’s true that you can buy illiquid assets at low prices during a crisis, but the timing’s still awkward. You never know if the crisis is going to deepen. On top of that, your own situation is important. If you have a solid position, you’ll be more capable of benefiting from the discounts than if you’re affected by the crisis too.” “There are examples of parties who got into trouble by investing too heavily in illiquid investments,” adds Molenaar. “Think of the Harvard University endowment case. The university fund got into big trouble during the crisis in 2008.”

Illiquid investments also offer diversification opportunities. What are they? “These investments can offer exposure to specific characteristics,” says Molenaar. “Take inflation, for instance. By investing in infrastructure, you can acquire inflation exposure (in the Netherlands, at least). Or, if we’re talking real estate, investments in rental housing offer different characteristics – more defensive ones, perhaps – to quoted commercial real estate.” “A second benefit of diversification comes from the fact that the prices of liquid and illiquid investments don’t respond at the same time to market developments. That’s because the prices of illiquid investments are based on valuations. There’s a delay in their response to developments on the stock market, for example. Because of that timing difference, the value of the portfolio as a whole is less volatile. In itself this is just an exercise on paper of applying accounting rules, but it can still be a benefit from the portfolio management point of view.”

What is the key message that investors should take from your white paper? “That the returns on illiquid investments are largely determined by the managers you select,” says Molenaar. “If you’re an investor who wants to invest in illiquid asset categories, you should always ensure you have the necessary skills to select the right managers.”

48 |

OPINION

HANS RADEMAKER Chief Investment Officer Robeco

Data and research are the key to success in volatile markets This year has really kept investors on their toes. Central banks set the tone again, but geopolitical developments also played a role. Volatility has increased and shows no sign of disappearing as we move into 2016. But this does not mean that investors should be pessimistic about the coming year. We talk to Hans Rademaker, Robeco’s Chief Investment Officer and Member of the Group Management Board.

Unrest on the financial markets seems to have increased during 2015. What has caused this? “After 2014, which was a good year for investors, we expected more volatility in 2015. And that is exactly what we got. In the first few months of the year, everything still appeared calm; but the effects of having large economic blocs in different phases of monetary policy soon became apparent. Volatility increased sharply for three main reasons: the stagnation of economic growth in China, lower commodity prices and the ongoing discussions about the US central bank’s first interest-rate hike.” “China was moving into bubble territory. Stagnating growth and the devaluation of the yuan by 3% caused anxiety to spread. Commodity prices fell due to the lack of demand from China and this had a negative impact on economic growth in emerging markets and commodity economies such as Australia and Canada. Needless to say, mining companies were hit the hardest.”

At the same time, investors are concerned about the effects of the Fed’s first rate hike... “The discussion about whether the Federal Reserve will raise interest rates and when is of course on investors’ minds, but above all the question of who is really calling the shots. Is it the central bank or do the financial markets ultimately determine monetary policy? If the latter is the case, then we could end up with a scenario where the Fed is ‘behind the curve’ and has to act retroactively. Tranquility appears to

have returned on this front for the time being and the Fed, the ECB and the Bank of China have supplied the market with sufficient liquidity. Their approach has worked for now.” “However, that does not alter the fact that these blocs are at different stages in their monetary policy and so volatility will remain on the menu in 2016 as well. The US is still on the brink of its first interest-rate hike, whereas Europe is still on course for more monetary easing.”

What does this mean in terms of expectations for the financial markets in 2016? “In the longer term, we expect to see normalization in the bond markets, with negative total returns, as we discussed in our Expected Returns 2016-2020 publication. This will happen sooner or later, although the central banks have been able to postpone it. We are banking on a positive market environment certainly in the first months of 2016 as the Fed is reluctant to nip the economic recovery in the bud. This means capital will continue to cost almost nothing for the time being. Ultimately, this is, of course, not a solution, but merely a postponement.”

“At Robeco, we are able to identify anomalies in the market and to capitalize on these. We have a long track record of academic research and efficient implementation of investment models. And I’m not just referring to our quant solutions; this applies to our team of fundamental investors too. Clients do not pay us to stick close to the index. They opt either for passive solutions or for a proven active strategy. In both cases, they are looking for value for money. Taking risk is not an objective in itself, but we identify opportunities and position ourselves to take advantage of them.”

Passive investing is growing rapidly and further consolidation within the asset-management industry is expected. What will 2016 bring in this context? “There will be still more polarization between truly passive and truly active in the asset management industry. I believe the midfield (in terms of assets under management) will not disappear overnight, because there is still no real commercial necessity for this. The difference between institutional investors and wholesale distribution will gradually disappear. Also within wholesale, a shift from funds to mandates – a business which has a different service and price level – is evident.”

Will the refugee crisis push Europe further back?

Is this shift towards mandates a positive development?

“No. The refugee problem has a social and a political impact, but less of an economic one. However, Europe does have a less flexible labor market than the US. You see this reflected in the degree of economic recovery. But the economy is definitely now gaining momentum, also in Europe.”

“If you can focus on that as an asset manager then it is. The very large distributors still need strong brands with a wide range of products and services. They do not want a different provider for every type of fund and this has led to the creation of guided architecture. So you have to offer a wider range of funds, while still ensuring that you are best-in-class. Distributors are looking for global players and niche players. Our investment results are good and I have complete confidence that they will remain solid in the future. The challenge for Robeco lies more in global distribution.”

Where are the best opportunities for investors in the coming year, given the stages of the economic cycle the major economic power blocs have now reached? “It is good that the economic systems diverge. Under these circumstances, diversification proves its added value and robust results are possible. In any case, it is better than a ‘risk off – risk on’ environment, where everything moves up and down at the same time. The current scenario offers a good opportunity for active investors to apply diversification.”

Robeco is increasingly portrayed as a quant investor. Is that justified? “Robeco has a lot more to offer than just that. At Boston Partners, the emphasis lies on value investing. On the fixed-income side, we are strong in credit analysis and increasingly add value by integrating sustainability into both equity and bond products. Yes, in RIAM we do have a real quant product champion in house, but don’t forget that we also have more

than EUR 12 billion invested fundamentally in emerging market equities. In addition, we focus increasingly on integrating ESG criteria in our funds – both in equity and in bond products. And Robeco is still successfully catering to growing institutional demand, where the emphasis lies less on products and more on solutions (outcome-oriented solutions).”

One of the growth markets in which Robeco is not really a big player is absolute return. Are there ambitions to play a bigger role in this area? “Absolute return is obviously a bit of a catchall term. We actually have several products in this area – Transtrend, Boston Partners’ long/ short products, and RIAM’s Global Tactical Asset Allocation (GTAA) and new Carry fund. In fact, Lux-o-rente and Flex-o-rente are also a type of absolute return product. They are scalable and less dependent on the people managing them. I don’t really see us suddenly offering macrohedge funds with one or two gurus as fund managers. These types of funds are often very volatile with extreme ups and downs. And that is not Robeco’s style.” “For that matter, hedge funds as a group are going through a particularly difficult period with large outflows, disappointing results and pressure on fees. There are positive exceptions, but as a group they are having a tough time.”

Finally, what is the main reason why investors should invest with Robeco in 2016? “Next year, we will also be confronted with a complex and volatile market. Robeco is in an excellent position to identify opportunities and to capitalize on these in a responsible way. As research and data analysis have been the building blocks of our approach for over 85 years. Our focus is on academic research and facts and not on subjective assumptions. The results over those 85 years show that our approach works pretty well.”

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EQUITIES

Not all low-volatility stocks are equal. What to watch out for when selecting products.

A critical eye and patience are crucial in low vol The growing interest in low-volatility equity products is increasing supply. It should come as no surprise that products with (virtually) the same description may be different. Investors don’t like large price fluctuations and that is part of the reason why volatility and risk are often referred to in the same breath. But the two are not synonymous. The real risk that investors run is the chance of permanent losses, not the hiccups along the way. Many risk-averse investors are turning to low-volatility products to reduce the volatility of their equity investments. Demand has increased since the Global Financial Crisis, and so too has supply. And even though the decision to opt for low volatility is often made from a risk perspective, it is also a good step in terms of returns. While low volatility can often be more volatile than expected in the short term, the lowvolatility feature of these strategies is most

visible during down and/or relatively turbulent markets. In addition, historical data shows that returns from low-volatility stocks are almost invariably better than returns from the wider market. The only requirement for investors is to use a horizon that includes a market cycle of both highs and lows.

Extra returns Robeco research based on data from 19262010 has demonstrated that the chance of a passive low-vol strategy underperforming the wider stock market over a period of three years is just 10%. And for enhanced low volatility, as used by Robeco in its Conservative Equities strategies, this rate is much lower still: 2%. The

data since 2006 – when the first Conservative Equity strategy was launched – corresponds with these research results, says Pim van Vliet, portfolio manager of Conservative Equities. Robeco’s Conservative Equities doesn’t just take account of historical low volatility; it also factors in momentum and value. Interestingly enough, including these two extra factors in the longterm calculations doesn’t produce a higher risk than the pure low-vol strategies. “Yet since 2006 this approach has been doing around 2% better each year than a pure low-vol approach. Global Conservative Equities has achieved returns of 8% a year since inception. Min Vol has achieved 5.9% and the market 5.2%.”

Probability of underperformance during down markets 1 month

3 months

1 year

3 years

Low Vol

17%

16%

11%

10%

Low Vol enhanced

21%

14%

Source: Robeco Quantitative Research. Sample period 1926-2010 US stock market

‘The risk with passive Minimum Volatility lies in the fact that only historical data is used’

This too corresponds with the data that the research over the 84 years leading up to 2010 produced, says Van Vliet. The key reason for this is the addition of momentum and value. “The risk with passive Minimum Volatility lies in the fact that only historical data is used,” he adds.

Advantages of an enhanced approach “We also look at companies’ balance sheets in order to map out the possibility of financial distress – the chance that they will get into difficulties. A company can have low historical volatility, but have inflated its balance sheet with loans capital. This can cause volatility to increase sharply. A second advantage of the enhanced approach is the portfolio’s lower turnover rate. “For some minimum-volatility products, this can be well above 30%, meaning

that performance can be reduced due to transaction costs. The average turnover rate for our Global Conservative Equities is around 25% – therefore a stock stays in your portfolio for an average of four years.” “Another difference is that the Conservative Equities funds are not allowed to deviate from the index weight by more than 10% when it comes to diversification over regions, countries and sectors. This gives the funds room to maneuver, but prevents them from for example running an enormous exposure in a limited number of sectors, points out Van Vliet. “For a number of years, the S&P Low Vol Index had a concentration of almost 60% in just two sectors: utilities and consumer staples. Then when these sectors fall out of favor you get huge ‘style drifts’, with all the associated risks.”

Vast volatility reductions Performance and volatility of Global Conservative Equities versus the market 40%

40% Volatility reduction Min-Max: 9-44% Average: 26%

30% 30%

20% 10%

20%

0% -10%

10%

-20%

Stocks in the Conservative Equities strategies are selected for their low volatility, but value and momentum are also taken into account – stocks that are attractively valued or in demand among investors. “Over the course of the cycle the volatility reductions compared to the market since 2006 have averaged out at 26%, with a peak of 44% in 2008 – the year that Lehman Brothers collapsed. The higher the volatility of the markets, the more the strategy usually succeeds in keeping volatility in check.

-30% -40% 06Q4 07

Conservative Equities - Global Source: Robeco

MSCI World

0% Oct-07 Feb-09

Jun-10 Oct-11

Feb-13

Jun-14

During bull markets, the volatility of a low-vol investment can even be higher than that of the market, especially over shorter periods – something that has also come to attention

of financial regulators. The Dutch financial watchdog, the Authority for the Financial Markets (AFM), recently warned investors that the volatility of many products is higher than their name suggests.

Concerns of the regulator The European regulator, ESMA, is also investigating the matter. The AFM has given passive low-vol products as a pertinent example and spoken to sellers of products with a noticeably high level of volatility about their provision of information. This mainly concerns the information they provide to buyers on how volatility is measured. It’s a familiar picture for Van Vliet. “The crux of low volatility is that you lose less than the market in bear markets, but at the same time retain the ability to avoid falling too far behind when the tide turns, which means that you can achieve returns that match or are better than the market over a cycle of highs and lows.” “Reductions in volatility are usually visible over longer periods. The advantages become quite evident when you compare Conservative Equities strategies with the market over a period of at least one cycle.”

Afraid of increasing rates? The reduction in volatility has been visible since the inception of Global Conservative Equities. The data however is from a period of ever-decreasing rates. Could a longer period of rising rates create a different, rose-tinted picture? Van Vliet acknowledges that low

Probability of higher volatility than the market 1-year volatility

Low Vol Low Vol enhanced

3-year volatility

All

Down

All

Down

4.8%

3.4%

1.4%

0.3%

0.0%

21.3%

18.4%

2.9%

8.9%

0.0%

Source: Robeco Quantitative Research. Sample period 1926-2010 US monthly returns

volatility may be sensitive to increasing rates. The enhanced approach can also prove its worth in such a market climate. “Passive low vol is especially sensitive. This can be counteracted somewhat by adding value and momentum, generally leaving the strategy less sensitive to rate increases,” explains Van Vliet.

Check list for low-vol selection The many preferences and rapidly growing range of products are causing investors to ask what they should watch out for when selecting low-volatility products. Van Vliet lists five points: – A multi-dimensional risk perspective: not only past low volatility counts, but also future risks. It’s better to tackle this problem with an active approach to low vol. – Performance in bull markets: limiting losses in bear markets shouldn’t be too much at the expense of upward potential when the markets pick up again. – Turnover rate: a low portfolio turnover rate means low transaction costs and higher net returns.

– Concentration risk: using historical volatility as the only selection criteria could lead to significant imbalances at, for example, sector level. – Can every position be explained: can every position in the portfolio be explained on the basis of the stock’s low-volatility nature or not? This last point seems obvious, yet it’s anything but. Many sellers of low-vol products use ‘optimizers’ in their portfolio construction. This usually involves examining the correlations within a basket of stocks. Selecting stock X because it has a low correlation with stock Y can result in a lower volatility in the portfolio as a whole, but can also lead to the inclusion of stocks in the portfolio that have high volatility in themselves. Van Vliet: “Products built with optimizers don’t necessarily perform worse and don’t by definition have a higher volatility, but the way they work is harder to explain. What you get is a kind of black box. And furthermore, correlations over time are not stable, making it necessary to adjust the portfolio – with higher transaction costs as a consequence.”

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OPINION

Fifty shades of China “This is not a black and white story. The opportunities lie in the gray areas.” Portfolio manager Fabiana Fedeli has returned from a trip on which she spoke with a number of political, financial and economic experts on China.

Yes, there are challenges ahead and Fedeli did notice heightened anxiety and a reluctance to be outspoken among Chinese officials. The anti-corruption campaign launched by president Xi Jinping has resulted in a more limited freedom of expression and opinion, Fedeli thinks. That is the darker side of an approach that also has its advantages. “It does enable the central government to push reforms at local government level more effectively.” Recently investors have shied away from Chinese stocks due to worries about the country’s future growth. The IMF has lowered growth expectations to just below 7%, but, according to what Fedeli heard on her trip, growth is currently closer to 5% and it could fall further

‘There is still significant demand for buildings in Tier 1 and 2 cities’ unless the Chinese government intervenes with a more comprehensive stimulus program. This implies that the Chinese government will have to rely also on the old means of stimulus, using fixed-asset investment (FAI). In the past growth was triggered by FAI, and this has created overcapacity in some areas. We have all heard the stories of ‘roads to nowhere’ and ‘ghost towns’. However, in recent years the country has been trying to find a more sustainable growth path, de-emphasizing FAIs and promoting services and consumption, says Fedeli. In itself, 5% growth is not a bad thing – Western countries can only dream of such figures – and it would be fine if that 5% growth was the result of less FAI-driven growth with a higher contribution from services and consumption. However, manufacturing has dropped faster than the government would have liked, and although growth in services and consumption has been healthy, it has not risen as much as was hoped for. More FAI is the obvious way to stimulate growth, but it will mean taking a step back in terms of economic transition. “More stimulus is not necessarily a bad thing. We live in an era of government stimulus around the globe. Just look at the Federal Reserve, the ECB and the Bank of Japan. Although until recently, China has been

in more of a tightening mode. But the key question is: where are the FAIs made?” Fedeli says. She is optimistic on this point though. “Xi seems to have enough control to determine where the assets go. There is still a need for metro lines, links between city hubs, hospitals and schools.”

Lessons learned That does sound a bit optimistic for anyone who has seen images of the ghost cities all over China. But this is exactly the area where Xi can now make a difference, Fedeli thinks. “In recent years money has not been effectively channeled by local governments, who sold land to developers wherever they could, triggering a real estate bubble in some cities. But there is significant demand for buildings in Tier 1 and 2 cities, and even in the centers of Tier 3 cities. Location and facilities are key, things that were overlooked in the big boom after 2009. But lessons have been learned.” After speaking to many experts on China, what does Fedeli consider to be the biggest common misunderstanding on the country’s economy? “The first thing is definitely the idea that China has no need for any further FAI because it has over-built and over-invested. This is not necessarily true for all regions. The transportation in and between cities

FABIANA FEDELI Portfolio Manager Emerging Markets Equities

‘In recent years money has not been effectively channeled by local governments’ leaves room for improvement and there are still opportunities in real estate.” The second misunderstanding, according to Fedeli, is the idea that the potential of urbanization has run its course. “There is still a sea of migrants from the countryside who work in the cities, but have no residential rights there. The result is that they don’t build a life with their families in the cities, so they don’t spend in the cities. These people are city dwellers on loan from the countryside.” But things are expected to change here too, with the Hukou (house registration) reforms. These new reforms will give these immigrants residential rights in the cities where they work. “We are talking about around 100 million people and there could be as much as CNY 4 trillion (approx. USD 630 billion) involved in the related reforms, equaling the total economic stimulus in 2009.”

Force to be reckoned with Going back to the old ways is not without risk, though. ”The main risk is how the FAI will be implemented,” Fedeli believes. “In the old days local governments inflated their balance sheets in order to finance stimulus programs. But today this cannot be done to the same extent.” That leaves two other options. “The central government can increase local government

tax revenues to create sufficient cash flow to finance the reforms, or alleviate some of the debt burden on local governments’ balance sheets. They may do a combination of the two. And then it’s a matter of not just selling land to anyone, as was the case after 2009.” At the moment Fedeli thinks the risk-reward balance looks fine – the rewards are greater than the risks. “China is still a country with huge consumption potential. It is still a force to be reckoned with. In 20 years from now, it will be the biggest economy in the world, on a PPP basis. There’s no way we can ignore that and the country offers investors an excellent pool of companies to choose from.” Does recent volatility on the stock market not scare Fedeli? “Yes, Chinese stocks may be more vulnerable to market volatility – that comes with the territory. It could take another ten years or more before China is a sophisticated market with a more stable pool of domestic institutional investors and less retail-driven market volatility.” But recent volatility does not mean that the sentiment is right. This may create great opportunities, Fedeli thinks. “During times of panic the correlation tends to go to 1, but that gives investors the chance to pick up really solid

stocks at a cheaper price.” And in the longer run, the opening up of the Chinese financial markets will offer great opportunities, she thinks. “They are still in their infancy and still a long way from being in line with the size of the economy. Of course there’s been a lot of distortion, we have seen a real estate bubble and the boom and bust of onshore stocks, but that’s mainly due to a lack of alternatives for Chinese investors,” says Fedeli. That will change in the future. Fedeli believes that the Chinese government will open the markets further, even if it leads to capital outflows. “The challenge is to do so gradually. That is easier in theory than in practice.”

A tale of two Chinas For now the main thing is to watch the central government’s reforms and stimulus plans. “We need to monitor that very closely,” Fedeli says. “Once we understand what they are going to do and how, we can adjust our stock selection accordingly.” As said, the opportunities lie in the gray areas of a story that is often sketched in black and white. “We see two Chinas: the new and sustainable one, and the bad one ridden with excess capacity. And then there is the gray area – an area where stock selection is even more crucial, but one that can still deliver alpha.”

60 |

SUSTAINABILITY INVESTING

Sustainability criteria complete the investment puzzle According to Edith Siermann, Chief Investment Officer Fixed Income, the active way in which Robeco navigates changing market conditions and its leading position in the area of sustainability are a perfect illustration of what sets it apart.

In Siermann’s opinion, it is more important than ever for a bond investor to have a distinct view. “The rise of passive investing is causing clients to look more critically at how much added value active management really offers. What’s more, interest rates are very low at the moment. This means that some parties, such as pension funds, would benefit greatly from extra returns.” But higher returns are not always better, adds Siermann quickly. “Of course, returns need to be seen in the context of a certain risk framework.”

do make a difference. And you also have to demonstrate you have enough expertise and experience and are thus a credible supplier.” One recent example of such a product launch is the Global Multi-Factor Credits fund: “We have years of experience in factor investing in equities, and have built a solid reputation. We are now using that expertise and image to our advantage in the corporate-bond market.”

Strong in sustainability

“In other words, risk-corrected returns need to be as high as possible,” says Siermann. “After the crisis of 2008, the industry became more aware of how important effective risk management is. Parties look beyond the level of returns to the way in which these returns are generated. This is why the combination of active strategies and advanced risk models used by Robeco Fixed Income is in such high demand.”

Another area in which Robeco Fixed Income stands out is Sustainability Investing. In July 2015, Fixed Income was awarded the highest possible rating of A+ based on the United Nations’ guidelines for CSR investing (UNPRI). “Sustainability Investing focuses mostly on the equities segment, as engagement and voting at shareholder meetings are what form the basis,” says Siermann. “We also see that the average UNPRI score of fixed-income investments is clearly lower than for equities.”

“You need to be a pioneer, as nobody notices ‘me-too’ products,” explains Siermann. “Clients are looking for solutions that really

“You often see parties that have made a decision at management level to make sustainability a permanent element in their

‘We consider the degree to which sustainability information has an impact’

investment policy,” says Siermann. “Then they look for an asset manager with a good track record in this field. I see that our approach and the fact that we are a real trendsetter appeals to our clients. It’s not our most important sales argument – that’s the investment results of our products. But it does tip the scales in our favor if another party can offer comparable investment performance.” “We can create a more complete picture of the contextual factors that affect a country or company if we take sustainability and social criteria, as well as financial factors into account,” says Siermann. “It is an increasingly important piece of information you need to complete the puzzle. We analyze to what degree sustainability information has a financial impact for the country or company concerned and whether it increases upward potential or downside risk.”

The client’s interests Currently bond investors focus mainly on the rate hikes that are likely to take place later this year in the US. This is a typical environment

in which some areas of the bond market are not interesting, while others could generate attractive returns. In Siermann’s opinion, this development constitutes an extra argument for active management. “We are able to take positions in interesting parts of the market while avoiding others,” she explains. “That is more in the clients’ interests than using a passive solution to buy all the bonds in the index in one go and totally overlooking the return potential of the various subsectors.”

Reliable investing the easy way “Investing is our core activity and compared to other parties, Robeco invests a great deal in research,” says Siermann. “A really good example of this is the expertise we have acquired through our research in the field of quantitative investing. One difference between us and very large asset managers is that we can get new ideas working very quickly. This rapid transition from theory to practice makes it really great to work for Robeco.”

EDITH SIERMANN Head of Fixed Income

“Since I joined Robeco in 1989, the world of bonds has changed enormously,” Siermann reflects. “In those days, transactions were for most part still processed by hand. These days, transaction processing and trading is almost entirely digital. The bond market has also developed rapidly. The volume of investment instruments and markets has increased hugely. Despite all these changes, the way in which Robeco approaches the market has remained largely the same.” ‘Reliable investing the easy way’ encapsulates what Robeco’s basic principles have been since 1929. “And that still applies,” says Siermann. “We don’t go for fast profits. Solid, fundamental analyses form the basis of our investment policy. Thanks to this approach, we weathered the difficult period following the collapse of Lehman Brothers in 2008. Our portfolios were not immune to poor market sentiment, but they survived the crisis without operational problems. We did not suffer any disproportionally large losses. And I can confidently say that this was no accident.”

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FACTOR INVESTING

For optimal efficiency we look at multiple factors

Factor investing for credits: From research paper to fund

The Robeco Global Multi-Factor Credits Fund was launched on 15 June 2015. This fund, which invests worldwide in investment-grade bonds, enables institutional investors to take advantage of four factors: LowRisk, Value, Momentum and Size. Low-Risk selects low-risk bonds of low-risk companies, Value selects bonds that are cheap relative to their risk and Momentum selects recent winners. In addition to these three factors that Robeco uses in its equity factor strategies, Robeco Global Multi-Factor Credits takes the Size factor into account. Amongst other things, this also enables the strategy to take advantage of the liquidity premium, which plays a more significant role in less liquid markets such as the credit market than it does for equities. Patrick Houweling manages the fund and since 2012 has also been portfolio manager of the Conservative Credits strategy, which implements the Low Risk factor for corporate bonds. In 2014, together with quantitative researcher Jeroen van Zundert, Houweling wrote a research paper titled ‘Factor investing in the corporate bond market’. In this study they show that factor investing can also be successfully applied to credits. Their research demonstrates that multi-factor credit portfolios achieved attractive Sharpe ratios and information ratios in the period from 1994 to 2013.

Where does the interest for this fund come from?

Most academic studies on factor investing focus on equities. Patrick Houweling and Jeroen van Zundert show that factor investing also works for bonds. Read

“Mostly from institutional investors that do not want to use factor investing just for equities – they want to apply factor investing to their entire portfolio and are interested in the prospect of a higher Sharpe ratio and higher returns.”

how their research paper was used to create a fund.

‘An alternative to passive investing’

“Realistic historical simulations that take into account liquidity and transaction costs show that the Global Multi-Factor Credits fund has a significantly higher Sharpe ratio than the Barclays Global Investment Grade Index. One of the advantages of a multi-factor portfolio compared to a single-factor one is the effective diversification of relative risk, in other words the likelihood of lagging the index. Weak years for one factor are often mitigated by strong years for others. This results in a more stable outperformance relative to the market than the individual factors produce.”

‘This academic research was driven by questions from clients’

What led you to write the research paper on factors in the bond markets? “This academic research was driven by questions from clients. Robeco already has factor strategies for equities. Many institutional investors apply factor investing to stocks, or have decided to do so. They asked us how factor investing could be used for corporate bonds, so we documented our work on this subject in an academic research paper.” “It is no surprise that investors start with equities, because the market for factor investing in stocks is more developed. There are more asset managers offering this style of investment and more has been published about it than is the case for bonds.” PATRICK HOUWELING Portfolio Manager Robeco Global Multi-Factor Credits Fund

“Apart from institutional investors that use factor investing as an alternative to their actively managed portfolio, there are also investors who see it as an alternative for passive investing and are considering using it to replace their index portfolios.” “The fact that there is interest in both camps doesn’t surprise us because factor investing is an intermediate strategy that falls between passive and active investing: active due to the high tracking error, focus on outperformance and more concentrated portfolios; passive on account of the more mechanical and systematic approach to investing.”

How much exposure is there to factors in clients’ existing bond portfolios? “Active bond portfolios often have a fundamental management style and not a quantitative approach, which is why they cannot be termed real factor portfolios. We always offer to analyze clients’ portfolios to establish their factor exposures. For example, if a manager expresses a preference for Low Risk, how strong is that exposure and what is the degree of exposure to the other factors? It is important that clients are aware of what their portfolio actually contains.”

What were the focus points in your research in terms of finding workable strategies? “It is important to make research into factor strategies as realistic as possible: transaction costs and liquidity are essential focus points. Certain bonds are more expensive to trade in than others, depending on their liquidity. For example, recent issues are more liquid than older ones.

Limited liquidity also means you cannot buy all the bonds you would like to. This is why we have developed a model that calculates how likely it is that you will be able to buy or sell a bond, given its characteristics.” “Another element is portfolio construction. Academic research usually assumes an investment horizon of twelve months. But this evaluation is too rigid – sometimes too long and sometimes too short. In the actual strategy, we constantly evaluate a bond’s attractiveness. As long as it remains attractive you don’t need to sell it. Our strategy’s turnover is dynamic and differs from one bond to another. This helps keep down transaction costs. The result is an average investment horizon of two years; longer than in the academic methodology, which also helps minimize transaction costs.” “The integration of the various factors in a portfolio is another major focus point. How do we achieve balance in the model so that, on average, you achieve equal factor exposure? We want to maintain a welldiversified exposure to all four factors.”

Which factor was the most difficult to implement? “Momentum, because this changes so fast. Bond rankings change quickly over time, which means that the turnover rate is higher than for the other factors. This makes it difficult to set up a pure momentum strategy for bonds at the current time. The challenge is to maintain a good exposure to this factor without trading too much.” “But because we combine the Momentum factor with other factors we can keep turnover down; for example, if two bonds score the same on Value, it is better to buy the one that scores best on Momentum. It is important to incorporate this in a multi-factor strategy. The Momentum factor combined with the others improves diversification and generates a higher Sharpe ratio than a multi-factor portfolio without Momentum.”

Does the Size factor cause liquidity risks? “If we were to select directly on the basis of the Size factor, liquidity would be a risk as the portfolio would be almost entirely made up of bonds issued by smaller companies. But our indirect approach helps limit the possible risks.”

“We position ourselves for the Size factor indirectly, by choosing a broad universe that also includes smaller names. Furthermore, we construct a well-diversified portfolio with a large number of issues. We strive to achieve equal weighting in the portfolio: relative to the benchmark we underweight large companies and overweight the smaller ones. We do not need to take any large positions, because we hold a wide range of issues in the portfolio. This approach ensures that the factor exposure for Size is almost the same as for Value, Momentum and Low Risk.”

Have your experiences with Conservative Credits helped you establish this strategy? “We have used many parts of the Conservative Credits investment policy. We follow the same five steps used in the Low Risk strategy. We start with a broad universe, filter that universe, rank the remaining bonds, carry out analyses and finally construct the portfolio.” “But there are important differences too. We use much stronger restrictions on risk characteristics such as maturity for our Conservative Credits strategy, because this is predominantly a Low Risk strategy. We also have other factor weights in the multi-factor model, because the factors are equally weighted, while in Conservative Credits the emphasis is of course on the Low Risk factor.”

Why have you opted for a global universe? “For a quantitative strategy, we want to have the largest possible universe in order to make a good selection and construct a portfolio. You need effective diversification and factor exposure to do this.” “The fund’s universe comprises more than 14,000 investment-grade corporate bonds from more than 3,000 companies worldwide. The portfolio contains 150-200 issuers – more than a typical active corporate bond portfolio. Many of our clients also want to have a global investment universe and Robeco Global Multi-Factor Credits allows us to fulfil this demand.”

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QUANT INVESTING

A good strategy

starts with a good design David Blitz discusses research to improve existing strategies and explains how he designs new ones. “Our mission is to make good strategies even better and to design the next generation.”

Head of Quantitative Equity Research David Blitz has been at the forefront of quant investing since 1995 and is responsible for coordinating all quantitative equity research. Some of the key tools he has helped to develop are proprietary stock-selection models and portfolio-optimization algorithms. He has also published numerous papers in peer-reviewed academic journals.

What do you see as your mission at Robeco? “You could call researchers the architects of our quantitative investment strategies. Our mission is to make the good strategies already in place even better, and to design the next generation of quantitative strategies based on entirely new ideas. A good strategy starts with a good design.”

How do you look back at your time as a quantitative researcher? “It gives me great satisfaction to see how our ideas have blossomed over the years. In the early 90s we developed the first generation of quantitative stock-selection models based on value and momentum, which were developed as a decision-support tool to generate investment ideas for our fundamental portfolio managers. It was from these humble beginnings that quant started.” “We found that the real-life performance of the stock rankings was good. A Dutch institutional investor was impressed by the track records and asked us to create an investment strategy that was based solely on a quantitative stock-selection model. The next challenge was to construct

‘We have been most successful in strategies that differ from those of the competition’ portfolios based on stock rankings. Therefore we developed portfolioconstruction algorithms to convert the ranking signals into buy and sell decisions for portfolios.” “After this first step, we added more capabilities such as low volatility, and also quant emerging markets because we saw that our models worked well in these markets too. Our assets under management have grown substantially along the way.”

What is your explanation for the rise? “Good stories are not sufficient. The track records are the driving force. Asset owners want to see evidence that you can actually deliver, and rightly so.”

“So there are many hurdles to overcome before a new strategy becomes successful. That’s why internal education is very important. Moreover, educating our sales colleagues and account managers helps ensure that we explain the concept behind these strategies to our clients and prospects properly.” “We have been most successful in strategies that differ from those of the competition. We call them ‘blue ocean strategies’1. These strategies help to fulfill a particular client need. Our organization has shown the ability to systematically create and capture these ‘blue oceans’ – examples of which include Quant Emerging Markets Equities, Conservative Equities and Conservative Credits.”

What research is done for existing strategies? “Another reason behind the rise is that a new generation of decision makers has come to the fore. For them, it is not such a big step to embed quant in their long-term investment strategy; they are already familiar with concepts such as value and momentum because of their university finance courses and the CFA curriculum.”

Do you face any hurdles when developing new strategies? “We have always been given the opportunity to develop new strategies internally. Quant has created a lot of goodwill, at the top of the organization as well.” “But there is also skepticism whenever we want to create new strategies. The question is always whether there is a market for it. This is difficult to answer when there is no peer group, there are no existing customers, and we need to sell a concept that is less well known in the industry.”

“We continue to look at our existing factors. How can we best harvest them? Can we take out any risks that don’t lead to higher returns? Can we define our variables better?” “Another focus area is smart trading for the portfolio. What are the costs of a particular trade? What is the best way to execute a transaction? This will become more important as our assets under management grow. We want to offer capacity for new clients, while protecting our existing clients.” “We will also look at adding new factors, but won’t be chasing the latest factor fads. Our decisions are based on extensive evidence over long periods of time and in different markets.”

‘Good stories are not sufficient. The track records are the driving force’ What is the focus of your fundamental research? “We focus on the main research question: Why do factors exist? We know that certain factors work, because there has been a lot of empirical evidence. But there is little academic consensus on why factors work. Is it because of behavioral mistakes, or institutional reasons such as reward structures or how the asset management industry is organized? These explanations are highly important to investors. Knowing why certain factors work can help you understand how best to harvest them.” “Looking at explanations of why factors occur is not an easy path to take for a researcher. For example, Pim van Vliet, Eric Falkenstein and I looked at 12 possible explanations for the low-volatility effect. You can imagine how difficult it is to distinguish between the consequences of these explanations.” “Still, I expect that we will make progress in this area in the coming years. My team is ready to meet new challenges and we have expanded our pool of junior researchers. Furthermore, we have stepped up the work we do with universities, with two of our researchers writing their PhD theses here.” “We are the place to be for quant investing. We see this in our ability to attract top talent, the feedback from our clients, and the fact that we compete successfully with the large quant houses in the US. There aren’t many European asset managers that can say that. I am proud of what we have achieved.” DAVID BLITZ Head of Quantitative Equity Research

1. Named after the book ‘Blue Ocean Strategy’ by INSEAD professors W. Chan Kim and Mauborgne.

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OPINION

Equities set to lead returns over the next five years Equities will earn 5.5% annually for investors over the next five years, while returns on German government bonds are forecasted to fall to -3%. These are the core predictions of Robeco Investment Solutions’ latest Expected Returns Outlook 2016-2020.

‘Higher growth and the return of inflation are the key elements’

Factored into the planning will be the return of inflation and the first US rate rise after eight years as the global economy continues to return to normal. The chance of gradual economic normalization continuing following the financial crisis is seen at 70%, though a mix of surprise headwinds may threaten the growing stability. The return of constraints such as inflation that haven’t been seen for many years – indeed, the bigger threat has been deflation – is termed as a ‘behind the curve’ scenario in which prospects for normal growth levels may be impeded. US inflation is seen peaking at 3% while European price rises should level out at 2.5%.

“We believe that economic normalization is becoming more likely, including the return of inflation and rising interest rates,” says Lukas Daalder, Chief Investment Officer of Robeco Investment Solutions. “Compared to last year’s outlook we have raised the odds of our central scenario taking place from 60 to 70%, at the expense of a reduced likelihood of either a positive or negative adverse scenario from 30 to 20%. It is a logical update on the central scenario presented last year. At that time we expected to see a ‘gradual normalization’ of the world economy, with growth and inflation slowly returning to normal. We still believe this to be the most likely scenario.” “But as the leading economies in the world have moved closer to the point where constraints start to resurface, we have also moved into a more mature economic scenario. This scenario is called ‘behind the curve’. Higher growth, and yes, the return of inflation are the key elements.”

Inflation? Remind us what that was…

Asset prices still inflated

Daalder says what may take investors, central bank planners and the wider public most by surprise is the return of something that everyone thought had been abolished – inflation.

While there are plenty of returns to be had out there, investors should not believe that bull markets will last forever. “As we stressed last year, most of the asset classes are expensive, which means that we should not get our hopes up that we are heading for strong returns in the next five years,” Daalder warns.

“To think of inflation as something that simply falls out of the sky once a central bank expands its balance sheet has always struck us as peculiar,” he says. “Inflation is a process of firms raising prices, or labor demanding higher wages: processes that have no direct link with quantitative easing. In the following five years, strengthening demand will cause economies to run into capacity constraints again, which will trigger the re-emergence of inflation.” “We expect US inflation rates to peak at around 3%, while European inflation will not exceed 2.5%. As such, this ‘behind the curve’ scenario is a logical follow-up to our ‘gradual normalization’ base scenario of last year: we have moved a year further into the recovery phase.”

“The most striking element in this year’s forecast is the -3% average annual return we expect for German sovereign bonds. This sounds gruesome for sure. However, it is simply the mathematical result of combining low starting yields with a gradual return of the inflation scenario. The very low bond yields offer no protection for the negative price adjustment that we expect.” It means that equities are once again the preferred asset class in terms of likely returns. “We expect the price of normalization for equities to be less painful, which is reflected in the fact that we have kept our return estimate

unchanged at 5.5%,” says Daalder. “There are a number of forces tugging in opposite directions.” “On the negative side, we see high valuation, especially in the US, and margin pressures related to rising labor and interest rate costs, pulling potential returns lower. The downside however is capped by the dividend yield of 2.5%, which represents a buffer comparable to that of bond yields, although with a lower guarantee. Additionally, equities will be supported by steady earnings growth, linked to our positive growth outlook.” To sum up, Daalder says: “We are more bullish than bearish, though the nature of risk and return will change as the world economy continues to recover. But there are challenges, some of which will be just as disruptive as the unprecedented economic and monetary conditions we have witnessed in the past five years. We remain cautiously optimistic.”

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ROBECO WORLD INVESTMENT FORUM

Hidden opportunities in a Slow Growth World

THE FORUM IN HONG KONG The Robeco World Investment Forum (RWIF) was held in Hong Kong this year. It was an appropriate city for such a venue, because Hong Kong is a place full of energy, with a focus on making money. This year’s theme was ‘Finding hidden opportunities in a Slow Growth World’. Robeco’s own experts and an impressive line-up of external speakers including historian Niall Ferguson explored this theme in many dimensions: the role of China, the influence of demographics, and how innovation can rejuvenate long-term world growth. I hope the articles on all the speakers in this Time2Read will give you new investment insights. Todd Benjamin, Moderator

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ROBECO WORLD INVESTMENT FORUM

‘There has been a fourfold increase in fatalities from armed conflicts per year’

NIALL FERGUSON Historian

RETURN TO CONFLICT IS AN INFLATION THREAT A return to conflict following decades of stability after the end of the Cold War is a major threat to world inflation, says historian Niall Ferguson.

The resumption of war in the Middle East and Afghanistan and the rise of Islamic State have the potential to return the world to high inflation, Ferguson told the Robeco World Investment Forum in Hong Kong. “The biggest risk the world faces is escalating conflict, not just in the Middle East, but across North Africa and in Afghanistan,” says Ferguson, Professor of History at Harvard University. “Since the Arab Spring there has been a fourfold increase in fatalities from armed conflict per year, and roughly the same increase in deaths caused by terrorism. This is a change in direction from the 20 years of relative peace that followed the end of the Cold War.” “If Islamic State consolidates and becomes a credible caliphate, then that would have very serious implications. Suppose it is able to take over Saudi Arabia? That’s not inconceivable, because that’s what they want to do; that’s where Islam’s most holy places are, and it’s also where the oil is. So one has to think that this could get a lot worse before it gets any better; in fact I see no reason why there shouldn’t be even more violence in the Middle East next year than there has been this year.”

Low inflation was a peace dividend Ferguson believes that the collapse of the Soviet Union in 1991 and the subsequent peace dividend does not get enough credit for ushering in the low inflation world we have today. “The end of the Cold War did a number of things which have gone unnoticed by economists, because they don’t tend to think about war much,” he says.

“It made the world a much more peaceful place. There was a dramatic decline in conflicts nearly everywhere; the number of battlefield fatalities in the 2000s was one-tenth of what it was in the 1970s. The Cold War caused and sustained civil wars around the world as both superpowers chose to arm opposing sides.” “A relatively peaceful world is bound to be a relatively low inflation world, because historically, war has been the main driver of inflation, partly by disrupting production and partly by the effect it has on the money-printing policies required to finance it. So part of what we’ve seen post-Cold War has been a global decline in inflation associated with the decline in conflict.” He says the end of decades of hostility between the nuclear-armed United States and Soviet Union is also partly responsible for lower risk premiums in financial markets. “Something interesting is happening with interest rates in that regard,” he says. “During the Cold War we all lived under the threat of a nuclear Armageddon, and that really disappeared in the period after 1991 – most of us stopped thinking about the possibility of an apocalyptic superpower conflict. So a couple of

‘We’re not seeing a slow growth world; we’re seeing slower growth in parts of the world’

things that have largely been ignored by economists help us understand why the world in recent times has experienced a combination of low inflation and low risk premiums.” “And you can’t fully answer the question of why we are in a low inflation, low rates world without talking about the financial crisis. It was the financial crisis that really brought the world to the brink of deflation, because we had a near-Depression experience. So you have to include this in any explanation of zero interest rates and very low inflation, as it was only the very aggressive action by central banks led by the Fed that prevented a re-run of the 1930s. Now we have low inflation and low rates, but that sure beats the alternative scenario of deflation that we faced after 2008.”

No slow growth world Despite his gloomy outlook on armed conflict and inflation, Ferguson disputes the notion that the world is seeing slow growth when put into an historical context. “The idea that we’re in a slow growth world has become conventional wisdom, with talk about ‘secular stagnation’, but as an historian I am skeptical about this,” he says.

“If you take the data back to 1980, this doesn’t stand up as a period of exceptionally slow growth in the world as a whole; the early 1980s were worse. If you take an even longer timeframe and go back 100 years, again you come to the conclusion that this is much ado about nothing.” “We’re not seeing a slow growth world; we’re seeing slower growth in parts of the world. Europe for example is clearly underperforming, and this may explain why Europeans think they are in a slow growth world. But here in Hong Kong, you can’t say the same thing; China has been the biggest economic miracle of the past 100 years. And although China’s growth rate has slowed, it’s still fast growth historically.” Ferguson says the state of the global economy is actually more akin to late 19th century America. “There’s an old saying that history doesn’t repeat itself, but it does rhyme, and some previous eras do help us to understand our own time. If you go back to the late 19th century, what you had then was low inflation and falling prices, but also rapid growth in certain economies, particularly the US. I think it’s a little like the late 19th century now; a low inflation world, but it’s not a depression. We’re seeing impressive growth in Asia and also in Africa.”

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ROBECO WORLD INVESTMENT FORUM

BETTER CORPORATE GOVERNANCE COULD RE-RATE ASIA Corporate governance improvements in Asia could lead to a massive re-rating of stocks, says Robeco’s Chief Investment Officer for the region, Arnout van Rijn.

The poor record of companies on Environmental, Social and Governance (ESG) issues has led to Asian companies’ market multiples being lower than those of their global peers. This however is changing, partly thanks to governance improvements initiated by Japan that are slowly being adopted by other nations such as South Korea, Van Rijn says. “Corporate governance is an area where we have seen a lot of improvements in Asia, and it’s one of the reasons for us to be constructive on the outlook for the region,” Van Rijn said at the Robeco World Investment Forum in Hong Kong. “It began in Japan with the introduction of the Stewardship Code and the Corporate Governance Code. Companies have really started to put them into practice, and you can see already that the level of stock buybacks and the numbers of independent directors appointed to boards have increased quite dramatically in Japan. The momentum for this is quite strong, so we will see a further re-rating of the Japanese equity market.” “The other major market where it will make a big impact is South Korea, where the big chaebol (business conglomerate) Samsung Electronics has started to make improvements, introducing share buybacks and other things that are really in the interests of minority shareholders. These companies are also appointing more independent people to their boards who will look at the company from the minority shareholder’s point of view.”

Genie is out of the bottle: ‘Korean discount will probably diminish’

ARNOUT VAN RIJN Chief Investment Officer Robeco Asia Pacific

He believes this should create trickle-down benefits if the biggest companies continue to set a good example. “Because Samsung is such a large conglomerate, it will probably lead the way for other companies in South Korea. In the long run it means that the ‘Korean discount’ which has been around for decades will probably diminish as corporate governance improves. It will never be a straight line, but I think we have turned the corner now also in South Korea, which is following in the footsteps of Japan. So these two countries are showing good improvements in corporate governance, and this should lead to an upward drift in South Korean and Japanese stock market valuations.”

Environmental and social improvements So much for improving the ‘G’ in ESG… but what about the ‘E’ and the ‘S’? “On the environmental and social responsibility side in Asia the developments are somewhat slower,” says Van Rijn. “But there is quite a lot of hope, particularly in China, where environmental problems have come to the fore with a public outcry over the level of air pollution in Chinese cities. Enforcement was always the issue, and there is now much more enforcement of environmental rules in China than there ever was before. So China is really the one place where things have been progressing quite nicely.”

“On the social responsibility side we have spent quite a lot of time engaging with companies in Asia, for instance with Hon Hai on labor relations, because they were producing iPhones and other gadgets in Chinese factories under sometimes quite dreadful working conditions. It’s quite clear that our engagement has resulted in improvements in labor relations. It’s never going to be a one-off – you have to continue to engage – but if this is done in a constructive way, companies in Asia are quite willing to listen to you.”

‘My recommendation is to be quite constructive on Asia’

Positive on property In terms of sectors, Van Rijn particularly likes real estate, infrastructure and industrials. “Sector-wise we are looking at Asian property, assuming that this is one of the few regions where interest rates can still be cut. That is generally a good thing for property valuations, so it’s a sector we are still quite keen on. There are interesting opportunities on the industrial side, particularly in the big roads project that China has embarked upon, and also in the fact that you see a lot of innovation coming from Japan and South Korea, and more so from China itself. Some of these industrial companies are really quite interesting, so we have some positions in these too.” And there are other reasons to be positive on Asia, Van Rijn says. A lowgrowth environment makes companies more cash conscious, which feeds through into stock prices eventually, and the region is coming up from a low base.

Defying the slow growth scenario Van Rijn believes that improving ESG can act as a catalyst for share price growth amid worries that slowing global growth will subdue markets, particularly if China does not meet its high profile GDP expectations. “The slow growth world is also evident in Asia, so stock market valuations have come down quite a bit,” says Van Rijn, who is also portfolio manager of Robeco Asia Pacific Equities and picks stocks from across the region. “But we think that the Chinese growth slowdown has now come to an end, which sets the tone for a better environment for equity investors in the region. We see that stock market valuations in Asia are on average 20-30% lower than elsewhere in the world, and that in itself creates a value opportunity.”

“My recommendation is to be quite constructive on Asia after the dramatic fall that we saw in the summer of 2015,” he says. “We are reaching levels which are quite appealing and earnings growth is still pretty OK in the region, particularly in Japan and South Korea. So that means the most obvious opportunities are in these countries.” “I seriously think Japan is still a bull market and will continue to re-rate, though it may not be so much driven by earnings growth anymore. And because companies are becoming more efficient in their balance sheet management, I think their stocks can still move higher. For investors, it is encouraging to note that corporate governance is now high on the agenda in Asia.”

“When you look at individual countries, South Korea stands out as an opportunity, as it has decent earnings growth and extremely low valuations. China is the second area where, following the correction, things are looking relatively cheap. Thirdly, a lot of stocks in Japan are still trading below book value, so you’ll see a fair representation of Japanese stocks in our portfolio too.” This publication is intended to provide investors with general information on Robeco’s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products.

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ROBECO WORLD INVESTMENT FORUM

‘For every bit of technology you introduce, you actually create new jobs’ PIPPA MALMGREN Advisor to President Bush

ROBOTICS WILL CHANGE SOCIETY AND POSSIBLY EVEN HUMANS Robotics may alter the composition of the humans who invent them, says former Presidential advisor and technology specialist Pippa Malmgren.

The benefits of advancing technology will outweigh the drawbacks, creating new industries and improving the global economy, Malmgren told the Robeco World Investment Forum in Hong Kong. “We worry about robotics, but we don’t understand that we will become partial robots ourselves,” she says. “Soon we will have robotic joints or organs, or organs that have been grown in a test tube; even 3D-printed organs. This will change the definition of what a human being actually is.” “A lot of people are afraid of robotics because they think it’s going to bring mass unemployment. “I think that for every bit of technology you introduce, you actually create new jobs, but they will be in new areas. Instead of in manual labor, for example, robotics will create new positions in the legal, creative, advertising and distribution parts of the business – all these aspects will become more important.” “And so the critical question is: do you want to have human beings doing things like heavy lifting? We’d have a better world economy if we didn’t and if we devoted their talents and energy to other endeavors. We are going to need to raise education levels for this, but we’re going to have to do that anyway.”

Keeping up with events Developments in technology make it important for investors to keep up with events, says Malmgren, a former advisor to US President George Bush and a current advisor to the world-renowned Massachusetts Institute of Technology. She said it was ironic that most investors would read a financial magazine such as The Economist but not a technology magazine like Wired, believing such publications to be for younger people. “This is insane, because most of the people who control the biggest pools of capital in the world are over 35, and how can you invest if you don’t understand what is happening at the cutting edge of technology? This becomes a high priority issue; it’s not tangential for investors. They need to devote more of their time to understanding what is already possible,” she says. “People say to me ‘that’s such a nice necklace’ and I’ll say ‘it’s not a necklace, it’s a LG 900 Bluetooth device that lets me listen to my phone calls’. People need to get more savvy about what already exists, not to mention what’s going to exist. You can’t isolate any specific field. Every field of endeavor is undergoing a technological revolution right now.”

‘It’s a mistake to think that the future Googles will only come out of Silicon Valley’

Lettuce progress… Aside from robotics, Malmgren cites food production as a major innovational trend. “The fact that we can now produce a lettuce inside a dark room with no sunlight or soil, almost no water, virtually no electricity or fertilizer, and produce it with a higher nutritional content much faster than in the real environment, is a game changer for the world,” she says. “And the speed at which drone manufacture is moving is incredible. In areas like building surveying, most companies hire a guy on the ground to walk around a building with a pair of binoculars. Now you can have a drone that is pre-programmed sending real-time, live data back to headquarters to show what’s going on.” So what to invest in? Malmgren says investors should not lose sight of traditional industries that embrace technology to become more efficient. “In energy, we see innovation in everything to do with extraction technology which means being able to drill in difficult and awkward places,” she says. “Refining technology is going to allow us to convert raw oil, gas and coal into refined materials that can be used for power, and so much is happening in the realm of solar power; the sky’s the limit.”

“Everybody wants to know where the next Google is, but there is such a technological revolution going on out there, that it’s like a democratization movement. The amount of computing power an iPad now has is greater than there used to be in a defense lab. So that means anybody with an iPad can innovate, and anybody can create a company out of absolutely nothing. Apple describes itself as a roof over the heads of a bunch of tiny little companies – that’s where innovation comes from.” “So it’s a mistake to think that the future Googles will only come out of one place, out of Silicon Valley. We’re probably going to see some extraordinary IPOs coming to market in the next decade. We should watch out for these and even if we can only invest in the publically listed stocks, these IPOs are going to tell us where the next interesting, investible tech play will be.”

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FACTOR INVESTING:

Investing in market-cap weighted indexes and factor indexes has serious disadvantages, according to Han Dieperink and Joop Huij. An active approach to factor investing works better.

“A slow-growth world is also a low-return world. So how can investors still get decent returns?” This was the key question that Han Dieperink, CIO of Rabobank Retail & Private Banking, asked the audience of wholesale and institutional investors at the Robeco World Investment Forum in Hong Kong. Dieperink implemented factor investing into his clients’ equity portfolios this year. Together with Robeco’s Head of Factor Investing Research, Joop Huij, he discussed how it can best be implemented, and just as importantly, what should be avoided.

The challenges of index investing “Private clients face the challenge of getting decent future returns from their bond and equity portfolios. And index investing is one way to gain exposure to the equity market,” says Dieperink. “One advantage of these index-based products, such as ETFs, is their low costs, but there are also challenges. ETFs have been known to cause flash crashes, and then there is the issue of illiquidity.” ”Another disadvantage of the market-cap weighted index products is that they do not always reflect the exposure you want to have in sectors and regions. Indexes can reflect boom and bust cycles. For example, at the end of the 1980s during the height of the Japanese property bubble, the weight of Japan in the MSCI World was more than 40%.”

THE FLIPSIDE OF FOLLOWING THE INDEX

‘Front-running and overcrowding are serious concerns when rebalancing portfolios’

HAN DIEPERINK CIO of Rabobank Retail & Private Banking

‘Would you feel comfortable if you knew that your trades would be made public?’

“So index investing has issues, and that was one of the reasons why we decided to also allocate to factor investing,” says Dieperink. He sums up the others. “Factor investing enables us to optimize how we use our risk budget; its rules-based approach takes effective advantage of behavioral biases, and it offers a better risk-return portfolio.” He warns: “The factor premiums are attractive, but to fully reap the potential benefits, the strategy has to be implemented well.”

Generic factor investing indexes exposed to front-running and overcrowding Factor investing can be implemented by using generic factor indexes. Although Joop Huij acknowledges the transparency of this approach, he points out serious disadvantages. “Like market-cap investing, there is plenty of information available on the index constituents, and on pending changes. This is an attractive feature, because it gives a lot of insight into performance. But this transparency also has serious disadvantages. It can lead to front-running by hedge funds before announced index changes can be applied to the portfolio. It can also lead to overcrowding because large numbers of market participants buy and sell at the same time.” Huij continued his presentation by asking the audience two questions on their investment strategies: “Would you feel comfortable if you knew that the trades of your strategy would be made public and that

other market participants were able to exploit this knowledge by front running? Or with the idea that other asset owners were engaging in exactly the same trades on the same day?” Front-running and overcrowding are serious concerns when rebalancing portfolios, but there had never been any research into this subject. At least not until Huij initiated a study with Georgi Kyosev in order to fill the gaps in the literature. “If you look at new inclusions, these stocks already start to increase in price five days before rebalancing,” says Huij. “On the sell side the results show the opposite – prices go down prior to exclusion. These effects can be seen in the graph below: ‘i’ is when the index is rebalanced.”

Outperformance before and after factor index inclusions1 1.20

New inclusions (buys)

1.00 0.80 Outperformance (%)

“Passive investing guarantees that an investor will experience all of the losses along with the market index, when a bubble in a particular sector or country bursts. Another issue is that the world economic center of gravity is constantly changing, and an index does not always reflect these changes.”

0.60 0.40 0.20 0.00 -0.20 i-7

i-6

i-5

i-4

i-3

i-2

Source: Thomson Reuters Datastream, OECD

i-1

i+1 i+2 i+3 i+4 i+5 i+6

“It would require a completely new generation of factor investing investment vehicles that offer investors transparency without sharing sensitive information with the public,” says Huij.

It helps to select stocks in a different way Moreover, the way in which Robeco selects stocks is different, which helps to avoid overcrowding. “It is possible to capture factor premiums more efficiently by setting up a high-conviction approach, says Huij. “If you implement factor strategies well, you can earn higher returns, reduce risk and cut trading costs. A good factor strategy avoids three pitfalls: unrewarded risk, negative exposure to other factor premiums and unnecessary trading costs.” “Factor investing in itself is not the Holy Grail, because implementation is so important,” concludes Dieperink. “And front-running and overcrowding are key considerations for me.”

1. Source: Huij and Kyosev, 2015, working paper. The results are calculated for MSCI World Minimum Volatility USD Index over the sample period (Sep 2010-Dec 2014). Returns are in USD. The graphs show cumulative outperformance of new buys/new sells over all constituents in the MSCI Minimum Volatility Index at the relevant point in time. Between i-1 and i is when the index is rebalanced and a stock is included in/excluded from the index. i-7 is 7 days before rebalancing, etc. The graphs show returns averaged over all rebalancing periods from Sep 2010-Dec 2014.

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‘Technology will enable older people to work longer than they used to do’

HAMISH McRAE Economic commentator, futurist

DEMOGRAPHY: A DIVIDEND OR A DISTURBANCE? Rising populations will only drive economic growth if working-age people are properly educated and trained, says demographics expert Hamish McRae.

As the global population continues to rise, the problem is not so much the increasing numbers, but rather how well both developed and emerging companies utilize the workforce, McRae told the Robeco World Investment Forum in Hong Kong. “Demography is slow moving; it shifts just that tiny bit each year, whereas markets move at the speed of light,” says McRae. Over a longer investment horizon, demographics have a profound impact on asset returns, but population growth in itself does not automatically lead to higher economic growth, he says. “Population growth is only a driver of economic growth if that population is educated and trained, and usefully employed,” he adds. “If you have a lot of angry young people without jobs, you have social instability, and that is the potential catastrophe for some areas of the world, including much of North Africa and the Middle East.”

Technology a key driver Another key driver of economic growth is technology. McRae is optimistic about its influence in the coming decades: “An older world can be a successful world because technology will enable people who are older to work longer than they used to do. If you are heaving things around on a building site, then you want to be under 40. But if you’re standing in front of people serving them, it doesn’t matter if you’re older. Using the skills of these people will actually become very important.”

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DON’T LOOK TO JAPAN Demography can have a profound effect on financial markets in the long term, Hamish McRae told the audience at the Robeco World Investment Forum. In the discussion on its effects, Japan is often seen as a harbinger, because it was the first country that had to cope with a rapidly aging population. So should we look to Japan for answers? Certainly not: the country is not a model for the rest of the world, for three reasons. First is the lack of immigration compared to Europe and the US. Immigration can have a major impact on population projections, as we see with Germany. Increasing migration to Germany caused by the Syrian refugee crisis means it may remain the most populous country in Western Europe, despite UN predictions that it will be surpassed by the UK – also owing to mass immigration. This means higher nominal GDP growth and higher long-term interest rates in the largest Eurozone economy. Second are the specific circumstances that caused deflation in Japan. The Japanese have huge amounts of foreign assets, some of which they have sold to fund their aging population. This repatriation of capital has put upward pressure on the yen, making imports cheaper and keeping a lid on inflation. But most countries don’t have the luxury of such vast financial means. A recent study by the Bank for International Settlements confirmed the link between aging and inflation. It found that a larger share of dependents is correlated with higher inflation. This makes sense because dependents consume more goods and services than they produce, exerting inflationary pressures through excess demand. Third is that low interest rates in the country are not caused by the aging population. The opposite is true: the aging population will bring an end to the current savings glut. McRae cites a report written by Charles Goodhart for Morgan Stanley in which he warns that a rapidly aging population will lead to higher interest rates, because the current savings glut across the world will come to an end. Real rates of interest will reverse from their present decline, and rise. When it comes to the impact of aging on an economy, Japan should not be seen as a blueprint. Léon Cornelissen, Chief Economist

And he thinks that the IT revolution which has seen advances from smartphone technology to electric cars is far from over. “I feel the IT revolution is still in its early stages; it will actually be a driver of growth in both the developed world and emerging markets, for a generation to come,” he says. “We haven’t yet reaped the full benefits. There will be gaps though; growth is more likely to occur in the emerging world.” “The key issue is what happens in China, India and the US. If things come good in these three countries and they also manage to solve environmental concerns as well as purely economic ones, then the world economy will prosper over the next 50 years. If they go wrong, then we will be in trouble.”

Nothing new about China and India McRae says China and India have been at the forefront of demographic and economic growth for centuries, with the US a relatively new kid on the block. “At the time of Christ, the Roman Empire was actually only the third-largest empire in the world in terms of economics. The largest was India and the second-largest was China.” “Looking at the world in 1820, when the Industrial Revolution had just got underway, the most populous countries were the big economies – dominated by China and India. The world economy was completely transformed over the subsequent 200 years with Europe and then the US leaping ahead.” For population growth, “it looks as though the world will level off at about 10-11 billion people,” he says. “Europe and Japan are aging fast; North America remains young. There are differences within the developed world, with some countries getting older, and some remaining young.” “Within the emerging world, the age advantage will move from China to India. India will pass China in around 2020 to become the world’s most populous country. In Africa, the population growth is continuing to boom, and that raises key questions about whether a growing

population is actually a positive or a negative – and the short answer is it is a positive, providing those people are trained and educated.”

Urbanization is positive McRae says urbanization is a boon, rather than a curse, as it becomes easier to service the rising population from cities. “There’s no question that until 2050 the world’s population will carry on rising. That raises questions about whether we can feed them. Most of these additional people will live in cities, and this is a big positive; it is easier to feed people in cities and provide them with services. Anyone who sees urbanization as a catastrophe is wrong.” He believes another phenomenon that will help is the fertility rate, as couples have smaller families, leading to a lower ‘replacement rate’: the number of babies born to replace parents who die. “Fertility rates everywhere are plunging, even in Africa,” he says. “The replacement rate in the developed world is 2.1 babies per mother: in North America it is a fraction lower; while in Europe we are well below this, with only France and the UK approaching a replacement rate of two.” “The big growth is still in Africa, where in countries such as Niger each woman has an average of 6.5 babies. Singapore has the lowest replacement rate in the world, and there is virtually a voluntary one-child policy in Macau and Hong Kong, with 1.1 per mother. So will the end of the one-child policy change things much in China? Maybe not. Maybe there is a voluntary fertility rate in China of below 2; in fact, I expect there is.”

“It is a slow growth and slow return world, but it is a reasonable proposition that looking further ahead, it will not be a slow growth world. Although it may well be the case that growth in the emerging world will drive the global economy.”

Emerging markets set to grow faster For future economic growth, McRae sees most of it coming from emerging markets, and all of it at a faster pace in this decade than in the previous one. “We may well see faster growth from 2010 to 2020 than in the period from 2000-2010, because there won’t be anything in the coming five years that is nearly as awful at the 2008 financial collapse,” he says.

“The absolute key is that if there are a lot more people in the world, then we must use them effectively, and in the investment world, one looks at where real education is actually improving the quality of human capital. I think the countries and enterprises that succeed in this area will prosper. It’s not so much a case of follow the money, as follow the clever people.”

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E-COMMERCE CONTINUES TO LEAD CHINESE INVESTMENT OPPORTUNITIES

VICTORIA MIO CIO China and Portfolio Manager Robeco Chinese Equities

‘Now is the time to start positioning for a recovery’

Investment opportunities in China will be led by e-commerce, healthcare and the drive to combat pollution, says Victoria Mio, CIO China and Portfolio Manager of Robeco Chinese Equities.

The country’s stock market took a battering this year after rising to unsustainable levels on the back of a retail investment boom, falling as much as 40% when the bubble burst. However, fundamentals remain strong, and changing demographics along with China’s reorientation towards consumer-led growth all bode well for stocks, she says. “The Chinese stock market went through a boom and bust cycle in the first half of 2015, but now is the time to start positioning for a recovery,” Mio said at the Robeco World Investment Forum in her home town of Hong Kong. “Now most of the bad news has been priced in and there are several positive catalysts, such as the announcement of China’s 13th Five Year Plan and the recovery of growth, led by consumers. The internet sector, e-commerce and increased consumer spending are the key drivers going forward.”

‘Demand for healthcare goods and services is changing’

“And there are plenty of opportunities. In the internet space, mobile penetration has already reached 95% – to the surprise of many investors – and internet penetration is now 48%. Online advertising growth is set to reach 40% in 2015 and e-commerce growth 22%. Internet companies listed in both Hong Kong and the US have outperformed the MSCI China Index in the longer term.”

She says e-commerce is being driven by multiple factors. “The first is growth in the number of internet or mobile phone users, and how many of these can be converted into internet shoppers. How well internet companies can boost their growth over the long term depends on increasing the number of users, the value of the baskets of goods that these users buy, and the number of categories available to buyers.”

No correlation with GDP growth

Mio says changing demographics, led by an aging population and the adoption of Western wellness habits such as gym membership and having medical conditions treated privately, is the second major investment opportunity.

Mio says the slowdown in growth in the Chinese economy which has worried investors globally has no correlation with the e-commerce sector. China has been gradually moving away from an export-led economy as the ‘factory of the world’ towards a greater reliance on domestic consumption. “The GDP growth slowdown has been mainly caused by weakness in the industrial sector, whereas consumption is the main growth driver,” says Mio. “The growth in e-commerce is mainly being driven by the increased penetration of the internet and smartphones, and the use of computers for online shopping. There is no correlation between the GDP growth and e-commerce.” “However, the e-commerce sector does have a high level of volatility, partly due to misplaced expectations, and also due to competition within this space. Our position as an investor is based on a scenario where e-commerce continues to grow at a very fast pace. The key thing is to find the best companies to benefit from this growth; those which are positioned to fend off competition over the long term.”

“It is projected that the Chinese working population will peak this year, while the number of senior citizens will grow over the next few decades. This backdrop provides an opportunity for companies to capitalize on the growth in demand for healthcare services and products for the aging population,” Mio says.

Healthcare opportunities are rising “The demand for healthcare goods and services is changing; people want better hospitals and clinics, and there is also an emphasis on wellness. This is evidenced by the popularity of running marathons and the increase in the number of health clubs in major cities – all of these are indicators of changing consumer behavior.” After e-commerce and healthcare, a third exciting area is combatting China’s notorious pollution, she says. On some days, smog levels in

major cities such as Beijing or Shanghai are so high it is impossible to see from one side of the road to the other. “The air and water pollution situation in China does provide a lot of investment opportunities. Air purification equipment companies along with waste water treatment and equipment companies have outperformed the MSCI China Index in the past few years,” she says. And combatting the influence of the notorious Chinese retail investor is also on the agenda. Many ordinary Chinese people bought blindly into stocks, believing that what goes up does not go down, with many losing all their money in the subsequent crash. “The Chinese stock market has been dominated by retail investors, many of whom are first-time investors: very unsophisticated and untrained in financial markets, with only limited experience,” says Mio. “Since this boom and bust cycle, the government has started some programs for investor education; in the past there were close to none. So these are very welcome.”

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‘China is the most significant source of uncertainty in the world economy’

LINDA YUEH Economist and the BBC’s Chief Global Business Correspondent

CHINA IS A UNIQUE PLACE OF CONTRADICTIONS China is a unique place of contradictions and risks that will continue to perplex the world as it continues to transform, says economist Linda Yueh.

Investors often cite the slowdown in Chinese growth as their biggest concern for the world economy, when they should understand that the existing growth path and transition is already unprecedented, Yueh told the Robeco World Investment Forum in Hong Kong. “What’s happening in China is the most significant source of uncertainty in the world economy at the moment,” says Yueh, an economist who is also the BBC’s Global Chief Business Correspondent. “The world’s secondbiggest economy is as an unusual exception – a unique place.” “It is a place with average incomes of less than USD 8,000 per annum. It has a single (Communist) party and it is a transitioning economy; a developing country which accounts for one-fifth of the world’s population. You cannot really use any analogies for China; existing models don’t work. We don’t have a model to fully understand it.”

Boom, bust, or both? Yueh cites the recent boom-to-bust Chinese stock market as an example of how the country exhibits both mayhem and confidence in equal measure. “One view is that China’s markets are in meltdown: it’s the next Lehman crisis. This is going to shake the world; that’s what we heard this summer,” she says. “And now in the past week, we’ve heard that China is a bull market, and the 13th Five Year Plan is going to put everything on the right path. Both of those statements are true; China has always been a place full of contradictions.”

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“China has a really unusual stock market. Chinese investors are predominantly retail, there is a huge number of state-controlled entities, and it’s a closed market. So it’s not a market that foreign investors can invest in directly, except for a few institutions. It’s a country with capital controls and that kind of volatility of course has consequences and repercussions, but predominantly within China itself. And that’s the biggest difference between a Chinese market decline and what happened within America’s financial system, which is integrated with the rest of the world.” She said like so many other things about China, the stock market has its own special kind of volatility, and yet is still making money for domestic investors. “Despite all this volatility in the Chinese market, if you had bought your shares a year ago, you would still be up,” she says. There was a bit of what you might call ‘profit taking’.”

“But because of the market having more than doubled in the past year, falling 40% in the summer, and now having risen by over 20% since then, this volatility is probably what has made everybody sit up and take notice. It’s unheard of for the world’s second-biggest economy, but perfectly normal for an emerging market that still has institutional capital controls and capped savings.”

The real market to look at But she warned investors who are fixated on wobbly Chinese stocks: “This is not the market you should really be focused on. There is really a deeper question of whether China can continue to grow well for another 30 years. It’s been a remarkable growth rate so far.” “China has had a tremendously impressive transition – better than any of the former Soviet Union republics, for instance. But it’s facing a massive

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challenge, and many question whether China can really achieve what it wants – making 1.35 billion people prosperous. That has never been done, and if it happens, it would be completely transformative.” “So, Chinese leaders are trying to overcome the ‘middle-income question’. Within a decade, China hopes to become a proper middleincome country, achieving something that only 17 countries in the postwar period have managed to do.” She says a sense of context is necessary to understand the real Chinese growth story. “A lot of people say ‘China has slowed down so much, it was growing at nearly 10% and now it’s only like 7%’. Of course that’s a big drop, but at 10% growth its economy was doubling in size every seven years; at 7% it will still be doubling in size within a decade. When we come to Europe, which is growing at 1%, you’ll start thinking ‘I need to do a bit more business out here in China’.”

Innovation, not imitation Future Chinese growth will not mirror the techniques used to get the country this far, Yueh says. She told delegates that the average annual growth rate since 1978 is 9.6%, of which about 60-70% is ‘factor accumulation’ – simply adding workers and capital. The rest came from Total Factor Productivity (TFP) – through technological and productivity. “That’s a very standard way of growing for a developing country, and that’s why when China needs a very fast stimulus it goes for investment,” she says. “But the downside is, if you’re not investing efficiently, it can drive up debts in the system, which can become a worry. That was a growth driver in the past, but it’s not necessarily one that China will continue with in the future, except in the form of overseas investment once it cuts back on domestic investments.”

“About two-thirds of Chinese innovation can be attributed to imitation, and that isn’t surprising. As developing countries catch up they improve what’s already out there, but for China to become prosperous, it needs to innovate. That’s the big motivation for China’s rebalancing, and for pushing its economy into having a bigger set of drivers.” “Allowing private enterprises to flourish and compete against some of the best companies in the world is one of the ways you can show that your domestic economy is improving in leaps and bounds. This is hard to do, but China is really pushing for it. As Chinese firms go global they want to show they are in a position to be big multinational companies that can produce things that consumers want.” Yueh says that the sheer scale of China works in its favor. She joked that while the US smartphone market was saturated, “there are another billion people in China who can get addicted to smartphones and tablets. The country’s rise could be transformative. And that’s why China is so exciting.”

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THE ART OF FACE CHANGING

A mask can be used to hide your face. And it was an appropriate object for entertainment purposes during the Robeco World Investment Forum (RWIF), since the theme was ‘Hidden opportunities in a Slow Growth World’. Anna Chau did an impressive Face-Changing performance during the RWIF Gala dinner. Chau is the first female master of the Chinese Art of Face Changing in Hong Kong. She can change as many as 25 masks in a flash within arm’s length of her audience. She also can magically change into as many as five different costumes on stage. Face Changing was originally part of the Sichuan Opera, which is one of the oldest local operas originating from Sichuan province in China. The changing of masks reflects a character’s different moods. Bian Lian, Mandarin for ‘Face Changing’, is a Chinese National Treasure that is protected by the government as a Level 2 state secret. It is an art that can be learned through apprenticeship and only a very select group of people are chosen to practice it.

This document is solely intended for professional investors

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