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1136E-0714

FACTOR INVESTING - TERMS AND DEFINITIONS

July 2014 | FACTOR INVESTING - TERMS AND DEFINITIONS ROBECO | 39

Contact details and information

Contact For further information on the factor-investing options available to you, please ask your contact person or get in touch via www.robeco.com/contact. Here you’ll find the contact details for the Robeco offices.

Information – What are Robeco's factor-investing strategies? Read more on this subject on www.robeco.com/factors – Find out more about our approach to quantitative investing on www.robeco.com/quantitative – Two research papers on factor investing by Professors Koedijk, Slager and Stork can be obtained from www.robeco.com/factorform

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linkedin.com/company/robeco @Robeco

Factor Investing Terms and Definitions Robeco

The terms and definitions are given in alphabetical order. Text Editing Coordination & production Design Printer

Marc van der Holst and Laurens Masereeuw Sef Laschek and Margret Smits Laurens Masereeuw Studio Robeco Drukkerij Damen

This publication has been compiled with the greatest possible care. However, we cannot vouch for the accuracy of all the information it contains and do not accept liability for any damage resulting from its application.

ISBN 9789080582576 Second edition

@2014 Robeco, Rotterdam. Nothing from this publication may be duplicated and/or published in whatever form without Robeco's prior written permission. Robeco reserves all intellectual property rights to this work. Important information Robeco Institutional Asset Management B.V. (Trade Register number 24123167) has obtained a license from the Netherlands Authority for the Financial Markets in Amsterdam.

July 2014 | FACTOR INVESTING TERMS AND DEFINITIONS ROBECO | 5

Rotterdam, June 2014 Dear Reader, It gives me great pleasure to present to you this compilation of terms and definitions. We note that while the group of professional investors showing an interest in factor investing has broadened significantly in recent years, the many different terms used in this field can be a source of confusion, and the lack of clear definitions tends to magnify existing ambiguities. Robeco attaches great importance to factor investing and performs extensive research work in this area. The company has developed a strategy of its own. Factors represent specific segments of the market that are more attractive than others in the long term. We use the term factor investing to describe a conscious strategic allocation to factors. Before starting to implement factor investing, it is essential to obtain a clear understanding of the terms employed. We hope that our list of terms and definitions will contribute to doing just that. Joop Huij Senior Researcher Robeco Joop Huij joined Robeco in October 2007 as Senior Researcher. He has a PhD in Finance and is part-time professor in Finance at the Rotterdam School of Management. He further has an MSc in Information Technology and Economics (honors) from the Erasmus University in Rotterdam.

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Introduction to factor investing Before presenting the different terms and definitions in this booklet, it makes sense to talk about the significance of factor investing and how it came into being.

Increasing interest in factor investing The popularity of factor investing has increased considerably over the last five years. More and more professional investors have started looking into the possibilities it offers and applying it in the portfolios they manage. Why is it attracting so much more interest now? Firstly, as a result of the major financial crisis of 2007 - 2009. Achieving diversification was more difficult than expected – equities, high yield bonds, hedge funds and private equity actually proved to be closely correlated in this period. So, since then, professional investors have given high priority to thinking in terms of criteria such as diversification. Now that investors have obtained greater insight into the underlying factors influencing risk and return, they are keen to construct a more robust portfolio better designed to cope with shocks. A second reason is that professional investors have become more critical about the role of active management. They are willing to pay for the portfolio manager's expertise and skills, on condition that good results are obtained. Factor investing is contributing to this discussion of the pros and cons of active management. In 2009, the Norwegian Government Pension Fund commissioned an in-depth evaluation* of its investment results. The conclusion reached by researchers Ang, Goetzmann and Schaefer was that the results achieved with active management could be explained by * A. Ang, W.N. Goetzmann, S.M. Schaefer. “Evaluation of Active Management of the Norwegian Government Pension Fund”, 2009.

July 2014 | FACTOR INVESTING TERMS AND DEFINITIONS ROBECO | 7

exposure to factors. Their recommendation was to allocate specifically to factors. Their research has resulted in a further increase in the interest in factor investing.

Academic research While the concept of factor investing is relatively new, most factors have a background of many decades of academic research. The principal subjects of study are outlined below. – The Low-Volatility Anomaly was discovered several years before the Value and Momentum effects, and just a few years after the Capital Asset Pricing Model (CAPM) was developed. The CAPM assumes a positive relationship between risk and return. Taking extra risk should therefore, on average, lead to higher returns. However, the first empirical tests showed that the link between risk and return is less strong than the theory would suggest. – Research performed by Haugen and Heins: ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’ (1972), shows that over the period 1929 - 1971, low-volatility equities realized extra riskadjusted returns. Later studies carried out by Haugen et al. reveal that the low-volatility anomaly is a global phenomenon: it is not exclusive to the United States, but also exists in Europe and the emerging markets. – Fama and French included the Value and Size factors in their model to explain equity returns, since they found that the traditional CAPM could not explain all the returns realized, and sought a better alternative. Instead of using the Market Risk factor, they incorporated the Value and Size factors. Eugene Fama and Kenneth French provided an alternative to the CAPM in their paper: ‘Common risk factors in the returns on stocks and bonds’ (1993).

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– In 1993, Jegadeesh and Titman published one of the first influential studies on the Momentum factor: ‘Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency’. They discovered that the US equities that performed best over 3 - 12 months also outperformed in the following year. The data they used covered the period 1965 - 1989. – Quality is one of the newest factors to be researched, and is as yet sparsely documented. Recent research by Assness and Frazzini: 'Quality Minus Junk' (2013), reveals that high-quality stocks provide better riskadjusted results. – The research paper published by Koedijk, Slager and Stork ‘Investing in Systematic Factor Premiums' (2013) shows that portfolios based on factors are generally comparable or better than portfolios based on market indices. This makes it possible to realize higher returns and to lower the risk level. These results apply not only to equities and bonds, but also to real estate and commodities. The research paper: 'Factor Investing in Practice: A Trustees' Guide to Implementation' (2014), distinguishes three methods of implementing factor investing. In addition to the factor optimization approach (page 18), these are the risk due diligence approach (page 32) and the use of factor tilts (page 20).

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Contents Definitions Active management 10 Anomaly 11 Behavioral finance 12 Capital Asset Pricing Model 13 Diversification over factors 14 Downside risk 15 Efficient (advanced) approach 16 Evidence-based investing 18 Factor optimization approach 19 Factor-tilt approach 21 Low volatility factor 22 Momentum factor 24 Monitoring factor exposure 25 Norwegian Government Pension Fund 26 Passive investing 27 Premium 28 Quality factor 29 Risk due diligence approach 30 Risk factor 31 Sharpe ratio 32 Size factor 33 Smart Beta or Alternative Beta 34 Traditional method vs factor allocation 35 Unrewarded risk 36 Value factor 37 Robeco's strategies Contact details and information

38 39

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A

ctive management

An investment strategy that does not invest according to a market-valueweighted index. This strategy often requires regular buying and selling transactions. The object of active management is to achieve an improved outperformance net of costs relative to the market. Factor investing and active investing are closely related. If you choose to use one or more factors, you are choosing to invest actively relative to a broad market-weighted index. Passive management means that investments are made in all market segments. In contrast to factors with a positive premium, there are also factors with a negative premium, such as high-volatility equities. The idea of factor investing is to actively avoid these segments.

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A

nomaly

This is a phenomenon that cannot be explained by standard theories. In the case of investing, these are often divergences from the CAPM*, which assumes that investors are rational and that there is a linear correlation between risk and return. The theory of 'behavioral finance' has since questioned the hypothesis of investor rationality. One well-known anomaly is the low-volatility (low-vol) anomaly. Based on the CAPM*-based theory, low-volatility equities can be expected to realize lower returns than high-volatility equities, since rational investors will only want to run more risk if they are rewarded for this in the form of extra returns. In practice, however, it can be seen that risk and return are less strongly correlated than is often thought. Figure 1. Historical performance characteristics of US equity portfolio, July 1963 - December 2010 10% Past winners

9% Value

Historical excess return

8% 7% 6%

Low vol

5% 4% 3%

Growth

Market

High vol

2% 1%

Past losers

0% 10%

15%

20%

25%

30%

Historical volatility Source Blitz (2012), Strategic Allocation to Premiums in the Equity Market, Journal of Index Investing The value of your investment may fluctuate. Results obtained in the past are no guarantee for the future. * CAPM = Capital Asset Pricing Model, see page 13.

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B

ehavioral finance

Behavioral finance studies the influence of psychology and sociology on the behavior of investors and how this can impact the financial markets.

This is important because it helps to explain why markets are inefficient and why factor premiums exist. Behavioral Finance assumes that investors are not fully rational in their actions, but rather constantly allow their decisions to be influenced by human emotions. These emotions elicit irrational decisions, also known as biases or prejudices. One example of this is the herding instinct: the shared tendency of investors to want to take the same decisions at the same time. This can be explained by the fact that investors do not want to run the risk of seeing returns on their portfolio fall short of returns realized by others. We are all familiar with the example of herding that occurred during the Internet bubble in the late 1990s. One of the main reasons that investors bought technology stocks at that time was because they saw others earning money with them. A second example is anchoring: the investors’ tendency to focus on irrelevant information when making their investment decisions. They prefer not to sell stocks at a price below their purchase price and so hold on to them for too long in the hope of recouping their losses. As a result of anchoring, stock prices tend to only gradually respond to news which is a possible explanation for the Momentum factor. Gaining an understanding of investor behavior through academic research plays an important role in establishing an explanation for factors and factor premiums and assessing the extent to which they will be sustainable in the long term.

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C

apital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is the product of a financial investment theory that reflects the relationship between risk and expected return. The model assumes a linear relationship.

The formula for calculating expected return is:

E(R) = Rf + ß * (E(Rm) – Rf) E(R) Rf ß E(Rm)

expected return risk-free return market risk expected market return

The CAPM is used to forecast returns that can be obtained with risk-bearing asset classes. The linear relationship means that taking extra risk will on average lead to higher returns. However, empirical tests performed in the early seventies* with this model showed that the relationship between risk and return is less strong than the theory indicates.

* The first study performed by Haugen and Heins: ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’ (1972), demonstrates that over the period 1929 - 1971, low-volatility equities realized extra risk-adjusted returns.

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D

iversification over factors

Exposing the portfolio to a variety of factors improves diversification. The aim of diversifying according to underlying factors is to make the portfolio more robust.

Diversification using the factor approach differs from the traditional method of distribution over asset classes such as equities, bonds and private equity, commodities, hedge funds and regions. The latter approach doesn’t provide insight into the underlying factors that determine the return-risk ratio of a portfolio. Factor investing means that we divide up a portfolio into factors with significant expected risk and/or return differentials. Accordingly, the assets in a factor-based portfolio are distributed over premiums such as low volatility, size, value and momentum.

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D

ownside risk

Downside risk in financial terms is the chance of an unexpected and undesirable event occurring that will impair the value of an investment.

As far as possible, investors will clearly wish to avoid any risk that is not offset by a reward in the form of extra return. It is important to note that volatility is not the same as downside risk. Volatility in the financial markets is the degree of fluctuation in the price of a stock or financial product such as a stock index or a currency. As price fluctuations can be either downward or upward movements, volatility also includes upside risk.

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E

fficient (advanced) approach

An investment approach that uses smart rules for stock selection and portfolio construction. The aim of this is to increase returns and to lower both risks and costs.

Robeco has developed an efficient approach of its own, which distinguishes between rewarded and unrewarded risk. Clearly, we will want to avoid the unrewarded risks. In addition, we select not only individual factors, but also include others in the assessment to prevent the positive effect of one factor being eradicated by the negative effect of another. Example: when following a pure momentum strategy, investors pick mainly stocks with a high valuation. As a result, the Value factor will have a negative effect on returns. However, by also taking this factor into account , investors can avoid paying too much for momentum stocks. A number of things stand in the way of actually harvesting factor premiums, and transaction costs form one of the biggest obstacles. An efficient approach is one that limits the number of transactions. Another aspect is to obtain effective distribution over sectors in order to prevent excessive dependency on any one specific sector.

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Ultimately, this approach will lead to much higher expected returns at a lower level of risk. The table below shows the results of this efficient approach using three factors relative to the market-weighted index. Table 1. Substantial improvements: Returns 5-6% per year; Sharpe ratio 0.3 - 0.5

MSCI World

Robeco

Robeco

Robeco

Value

Momentum

Low-volatility

Return over cash

2.1%

8.0%

7.9%

7.1%

Risk (volatility)

15.5%

14.7%

16.5%

10.6%

0.14

0.54

0.48

0.67

Sharpe ratio

Source Robeco Quantitative Strategies; Blitz, Huij, Lansdorp & van Vliet (2013): 'Efficient factor investing strategies'. The random test covers the period June 1988 through December 2011. Returns are net of transaction costs. For low volatility, Conservative Equity data have in fact been used as of September 2006.

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E

vidence-based investing

This is a form of investing that uses specific academic insights and evidence in constructing investment portfolios.

At the request of the Norwegian Government Pension Fund, Ang, Goetzmann and Schaefer carried out research into investment performance realized in 2009. Interest in factor investing increased further as a result of this study. Robeco believes in using an academic approach based on empirical evidence to identify and understand factor premiums. Robeco further conducts research into the reasons why factor premiums occur. This academic approach is also evident in the work the company performs jointly with the academic world and by the range of papers it publishes in academic journals. Two research papers produced for Robeco by Professors Koedijk, Slager and Stork are examples of this collaboration. The first research paper, ‘Investing in Systematic Factor Premiums' provides mainly academic evidence for the existence of factors. The second, titled ‘Factor Investing in Practice: A Trustees' Guide to Implementation' (2014), takes a more practical approach. In addition, Robeco organizes public debates on factor investing in cooperation with the academic world. Professors Gruber, Goetzmann and Ang, for instance, have been asked to speak during such debates.

* A. Ang, W.N. Goetzmann, S.M. Schaefer: 'Evaluation of Active Management of the Norwegian Government Pension Fund', 2009.

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F

actor-optimization approach

A method of implementation according to which a portfolio is fully allocated to factors.

Here, traditional investment strategies are replaced entirely with the factor approach*. Allocation takes place over the full range of asset classes. The research paper: 'Factor Investing in Practice: A Trustees' Guide to Implementation' (2014), distinguishes three methods of implementing factor investing. In addition to the factor optimization approach described here, these are the risk due diligence approach (page 32) and the use of factor tilts (page 20). The adjoining illustration shows a traditional portfolio with allocation to asset classes (equities and corporate or government bonds). In the case of a full factor approach, the portfolio is constructed with attractive factors.

* Robeco takes a balanced approach to equities that ensures diversification and exposure to the principal factor premiums, such as the so-called 1/n solution.

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6 5 4

Figure 2. Traditional portfolio versus the factor investing approach

Traditional Equities

Equitie Equitie Equitie Equitie

7

Credits 7

6

Government bonds

5 6 4 5

1

4

3

Aandelen markt

Factor approach

Bedrijfsobligaties markt Equities 7 Staatsobligaties markt Credits Government bonds

6 5

4 1 3

2

Aandelen markt Aandelen Low Vol (1) Source Aandelen Value (2) 2014 Robeco Investment Solutions Aandelen Momentum (3) Bedrijfsobligaties markt Bedrijfsobligaties Low Vol (4) Bedrijfsobligaties Value (5) Bedrijfsobligaties Momentum (6)

2

1

Aandelen 3 markt2 Aandelen Low Vol (1) Equities Aandelen Value (2) Equities LowMomentum Vol (1) Aandelen (3) Equities Value (2) Bedrijfsobligaties markt Equities Momentum (3) Bedrijfsobligaties Low Vol (4) Credits Bedrijfsobligaties Value (5) Credits Low Vol (4) Momentum (6) Bedrijfsobligaties Credits Value (5) Staatsobligaties markt Credits Momentum (6) Staatsobligaties Short term (7) Government bonds Government bonds Short term (7)

Credits Credits Credits Credits

Govern Govern

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F

actor-tilt approach

A method of implementation where part of a portfolio is invested specifically in factor strategies.

Specific factors that may be under-represented in the 'standard' asset allocation are added in this approach using dedicated factor strategies. Figure 3. Factor Tilts Add standalone factors

and/or Change benchmark (strategy) asset

Determine benchmark portfolio; construct with asset factors

Determine what style factors improve return/risk profile

Choose implementation method

Source Koedijk, Slager, Stork: 'Factor Investing in Practice: A Trustees' Guide to Implementation' (2014).

Different approaches to implementing factor investing can be distinguished, such as the risk due diligence approach (page 32) and factor optimization (page 18).

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L

ow volatility factor

Low volatility stocks realize comparatively high risk-adjusted returns. The same is true for corporate bonds.

The notion that greater risk pays off in the long run by generating higher returns has been proven incorrect by academic research*. Further studies show that the performance of low-risk stocks does not lag that of the market as a whole. The chart below demonstrates this on the basis of data from a study. Figure 4. Risk-return ratio 1931 - 2009 12% Low volatility 10%

Return

8% High volatility 6% 4% 2% 0% 0%

10%

20%

30%

40%

50%

Risk (volatility) Source Pim van Vliet: 'Low-volatility investing - a long-term perspective', January 2012.

Robeco's approach to investing in low-volatility equities is reflected in its 'Conservative Strategy'. Compared to an ordinary low-volatility strategy, this approach strives to achieve lower transaction costs, reduced risk and extra returns in a market upturn. * Haugen and Heins ‘On the Evidence Supporting the Existence of Risk Premiums in the Capital Market’ (1972)

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Robeco not only selects stocks on the basis of low volatility, but also looks at insolvency risk and Value- and Momentum-driven factors. For example, by taking the Value factor into account in the selection of low-volatility stocks, investors are prevented from paying too high a price. This is how this strategy differs from that used by low-vol investors who select stocks exclusively on the basis of historically low volatility.

Return

Figure 5. Improved risk-return ratio in Robeco's Low Volatility factor approach Robeco Conservative Equities

Conservative equities

Low risk factors

Low volatility

Risk Source Robeco, Quantitative Research, 2014.

Robeco uses the low-volatility anomaly not only for stocks, but also for bonds, and calls this approach 'Robeco Conservative Credits'. According to this methodology, investments are made consistently in the bonds of companies with a low level of expected risk. These bonds are characterized by a shorter time to maturity and a higher level of 'seniority' (the order of repayments in the event of default). The bonds are issued by companies with relatively low debt-to-equity ratios.

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M

omentum factor

Stocks tend to maintain recent price trends in the future, and the momentum strategy takes advantage of this phenomenon. When using a momentum strategy, it is important to be aware of the risk of trend reversals and of how that risk can be mitigated. The momentum premium is one of the largest factor premiums, but it is hard to capture because of two practical problems. First, a substantial drawdown can occur if there is a trend break like a market reversal, as the strategy will select equities with high market sensitivity in a bull market. Second, the group of stocks with the strongest trends changes all the time, causing high turnover in the portfolio. The transaction costs that this turnover generates eat into the momentum premium.

Return

Figure 6. Improved risk-return ratio with Robeco's Momentum factor approach

Robeco momentum

Momentum

Market

Risk Source Robeco, Quantitative Research, 2014.

Unlike ‘traditional’ momentum based on total returns, Robeco calculates ‘residual’ momentum, adjusted for market risk in particular. This avoids the unrewarded risks of a traditional momentum strategy. Furthermore, smart portfolio construction rules ensure only necessary trades are done and transaction costs are minimised.

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M

onitoring factor exposure

Robeco examines existing investment portfolios' exposure to factor premiums using its own customized scanning system. This is known as the 'Robeco Factor Exposure Monitor'.

The scan shows the relative underweights or overweights per factor (relative to the market portfolio). This can form a first step in the decision-making process for implementing factor investing. Figure 7. Relative factor exposures of portfolios 20% 15% 10% 5% 0% -5% -10% -15%

Top Value

Middle Momentum

Bottom

Low volatility

Source Robeco, Quantitative Research, 2014.

The chart shown above represents a portfolio that overweights the Value factor while underweighting the Momentum and Low-volatility factors.

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N

orwegian Gov. Pension Fund

Interest in factor investing has increased substantially as a result of research in 2009 into the investment results realized by the Norwegian government oil fund.

The fund invests the revenue from oil and gas extraction for future generations. In 2009, it commissioned a study* into the investment performance of active management. The disappointing investment results realized in 2008 formed the underlying rationale for this.  

The conclusion from this study by Ang, Goetzmann and Schaefer was that the results of active management could be explained by exposure to factors. Their recommendation was to allocate specifically to factors. Interest in factor investing increased further as a result of this study.

* A. Ang, W.N. Goetzmann, S.M. Schaefer: 'Evaluation of Active Management of the Norwegian Government Pension Fund', 2009.

P

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assive investing

Passive investing is following a market-weighted index without deviating from it to achieve extra returns (alpha). Investors thus obtain the index returns adjusted for costs.

In the case of active investing, trackers – also referred to as ETFs – are often selected. Investors use a tracker to follow a stock or bond index. A passive approach has advantages and disadvantages. Passive investors enjoy low management costs and low trading activity, but this is accompanied by a major disadvantage. Using the passive approach, investments are also made in those segments of the market that are characterized by an unattractive risk-return ratio. Take high-volatility equities, for instance. In an active approach, investors can avoid these segments and focus on the attractive parts of the market.

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P

remium

Reward or extra return for taking risk or exposure to factors.

Factor investing is a way of earning premiums by taking exposure to factors. Robeco wants not only to document certain statistical patterns, but also to find the underlying explanation for these factors. The theory of behavioral finance also provides explanations for factors. Premiums are often explained as representing compensation for risk, and are referred to as risk premiums. Research - some of which conducted by Robeco - has shown that premiums are not always the result of risk-taking (see explanation of unrewarded risks) and it is therefore better to use the term 'factor premiums'.

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Q

uality-factor

Forms part of an investment strategy that selects high-quality companies.

The criteria for this factor can be 'hard' (e.g., returns on shareholders' equity and free cashflows), but the application of this factor can also be based on 'softer' criteria such as quality of management, corporate governance and market position. As there is no precise fixed definition for Quality, academic circles are debating the use of this factor. Valuation can also play a role in the selection of Quality stocks. Therefore, ongoing debate is questioning whether this factor differs from the Value factor. Researchers Assness and Frazzini* define the Quality factor as investing in the stocks of safe, profitable, expanding and well-managed companies. Interest in the Quality factor increased in the aftermath of auditing scandals such as the Enron affair in 2001. Another reason for the increased interest in the Quality factor is the possibility of achieving greater diversification.

* Clifford S. Asness, Andrea Frazzini, and Lasse H. Pedersen: 'Quality Minus Junk', 2013

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R

isk due diligence approach

An approach* to implementing factor investing. An analysis is made to establish whether the current portfolio is suitably distributed over factors and does not incorporate excessive risk. This can be done using the 'Robeco Factor Exposure Monitor'. The advantage of this approach is that investors obtain greater insight into their exposure to specific factors in the portfolio. It also helps determine whether the portfolio contains desired or undesired concentrations of factors. It then becomes easier to assess the sensitivity of the portfolio in specific scenarios. The chart below shows a hypothetical portfolio of factor overweights and underweights. Per factor the portfolio has three subdivisions into levels of exposure: substantial (top), average (middle) and low (bottom). Figure 8. Relative factor exposures of portfolios 20% 15% 10% 5% 0% -5% -10% -15%

Top Value

Middle Momentum

Bottom

Low volatility

Source Robeco, Quantitative Research, 2014.

* Other approaches involve using factor tilts (page 20) and a system of portfolio optimization based exclusively on factors (page 18).

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R

isk factor

In factor investing, the term 'factor premium' can be replaced with 'risk factor' or 'risk premium', on the supposition that a factor premium represents compensation for higher risk.

However, the question remains as to whether the premiums actually represent compensation for higher risk or whether other aspects also play a role. If the first is true, the term risk factor is appropriate. This is in line with the belief in an efficient market, where returns and risk go hand in hand. However, Robeco prefers the term 'factor premium', as it is not always necessary to take more risk to earn such premiums. The most familiar example is the low-volatility factor (low vol). While investors actually take less risk using this factor, the returns they can expect match the market.

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S

harpe ratio

The Sharpe ratio describes the extent to which an investment compensates for extra risk. This ratio is also called the risk-return ratio.

Rp – Rf Sharpe ratio = ––––––

Rp R f p

p asset return risk-free rate standard deviation (of asset return)

The higher the ratio, the higher the risk compensation an investment offers. Investors will therefore have a preference for investments with a high Sharpe ratio or investments that raise the entire portfolio's Sharpe ratio through diversification. The Sharpe ratio calculates the risk-bearing return above the risk-free return, generally using the yield on AAA government bonds for risk-free return.

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S

ize factor

Stocks with a lower market value (mid and small caps) realize higher returns than those with a higher market value or capitalization (large caps).

In academic circles the discussion focuses on whether the better expected performance of companies with a lower market value is only compensation for the higher degree of risk. Another point of discussion concerns the transaction costs that accompany a strategy based on this factor. These costs are higher for equities with a lower market value due to the reduced liquidity. Robeco implicitely uses the Size factor by including mid and small cap stocks in its investable universe.

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S

mart beta or alternative beta

An index strategy that aims for a better risk-return ratio than the traditional market-capitalization weighted index. 'Smart beta' refers to the higher expected index performance, in terms of risk and return. The smart-beta strategy is an alternative index strategy for investing in a market-cap-weighted index, since the market-cap-weighted approach has a number of constraints for investors. For instance, most of the money flows into stocks with the highest valuation. This means that investments are made counter to the Value factor, which focuses on selecting stocks with a lower valuation. Just like factor investing, smart beta strives to create an improved risk-return ratio. An important aspect is that smart-beta strategies are not passively, but actively managed. Examples of smart-beta strategies are equally weighted equity strategies or low-volatility strategies. Although smart-beta factor approaches have proven capable of using factor premiums, there are a number of pitfalls. Taking unrewarded risk is an example, as are taking on higher transaction costs and the negative effects of other factors.

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T

raditional versus factor allocation

Traditionally a portfolio is constructed by distribution over asset classes (asset allocation), followed by allocation to subsegments such as regions or sectors. Factor investing applies strategic allocation according to factors. The example below illustrates this process of moving from traditional strategic asset allocation towards strategic distribution according to factor premiums for equities. Figure 9. Traditional strategic asset allocation

Government bonds Credits Equities

Traditional allocation across regions

Government bonds Credits Equities US Equities Europa Equities Japan

Strategic allocation to factor premiums

Government bonds Credits Equities remaining Equities High Value Equities High Momentum Equities Low Volatility

Source Robeco, Quantitative Research, 2014.

A factor portfolio divides the equities class into premiums such as low volatility, value and momentum, irrespective of regions and sectors.

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U

nrewarded risks

Higher risk that is not rewarded with higher returns.

Investors should strive to avoid unrewarded risk in their selection process, as this is not compensated for with any kind of payoff in the form of higher returns. An example of taking unrewarded risk is to buy cheap stocks of companies with a higher risk of default. It may appear that these are value stocks that enable the investor to benefit from a value premium, but our research shows* such stocks are very risky. Investors do not benefit from the value premium because they are not compensated for this higher level of risk with a higher return.

* W. de Groot and J. Huij: ‘Is the Value Premium Really a Compensation for Distress Risk?’, 2011.

July 2014 | FACTOR INVESTING TERMS AND DEFINITIONS ROBECO | 37

V

alue factor

Equities realize better returns if their current value is higher than their current price. A value strategy makes use of valuation ratios to select stocks that are attractively priced relative to their fundamentals. The price-to-book and price-earnings ratios are both frequently used. Stocks with low prices relative to their fundamentals are expected to appreciate in the future to properly reflect the real value of the company. However, the pitfall here is that an increased risk of insolvency can be the reason for a low valuation. A company that has an outdated business model, for instance, runs a greater risk of becoming insolvent, and its stock price will reflect this by having an apparently low valuation relative to its book value.

Return

Figure 10. Improved risk-return ratio with Robeco's Value factor approach

Robeco value

Value

Market

Risk Source Robeco, Quantitative Research, 2014.

Robeco’s approach to value investing is to make stock-selection adjustments that take a higher level of risk into account. This means that stocks that are indeed undervalued are selected, in contrast to companies whose low valuation merely reflects their higher level of risk.

38 | FACTOR INVESTING TERMS AND DEFINITIONS ROBECO | July 2014

Robeco's strategies Robeco applies factor investing via different strategies, such as the Developed and Emerging Quant strategies, and also uses it for the return portfolio of professional parties.

Robeco offers customized factor-investing solutions for (large) professional parties. These solutions may focus on individual strategies or on a combination of strategies, such as a 1/n solution. In addition, Robeco has four conservative strategies for low-volatility (low vol) investing in equities, and one for bonds. There is also a global equities strategy that applies the Momentum factor and one that uses the Value factor.

Conservative strategies Equities – Emerging – Global – European – US Bonds – Credits

Global strategies for other factors Equities – Momentum – Value

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Contact details and information

Contact For further information on the factor-investing options available to you, please ask your contact person or get in touch via www.robeco.com/contact. Here you’ll find the contact details for the Robeco offices.

Information – What are Robeco's factor-investing strategies? Read more on this subject on www.robeco.com/factors – Find out more about our approach to quantitative investing on www.robeco.com/quantitative – Two research papers on factor investing by Professors Koedijk, Slager and Stork can be obtained from www.robeco.com/factorform

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FACTOR INVESTING - TERMS AND DEFINITIONS