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Factor investing in credits: research, implementation, clients
In cooperation with
WHITE PAPER May 2018
Casper Hammerich, CAIA Principal, Kirstein Jeroen van Zundert, PhD, CFA Quantitative Researcher, Robeco
Patrick Houweling, PhDHead Quantitative Credits, Robeco
For professional investors
Introduction It is hard to overstate the impact of the rise of systematic, or ‘factor’ investing over the last decade. Nearly every day a new ‘factor’ or ‘smart beta’ product is launched, and it’s a topic on the agenda of most asset management conferences nowadays. The main forces driving this change are the prospect of higher risk-adjusted returns, style diversification compared with fundamental strategies and lower fees. However, the adoption of factor investing is concentrated mainly in the equity space, with fixed income so far largely being ignored.
In this joint Kirstein and Robeco study, we examine the current status of fixed income factor investing in the Nordics – how it is perceived, to what extent and how it is implemented – and look at some investor concerns. The second part of the paper looks at the compelling evidence for factor investing in credits based on various research studies. It also examines some of the challenges related to its implementation and addresses some of the concerns, such as crowding and lower liquidity. Finally, we zoom in on how factor strategies can be customized to fulfill specific requirements, using client cases to illustrate this.
2 | Factor investing in credits: research, implementation, clients
Contents PART I – Kirstein Nordic survey on factor investing in credits 41.1 Executive summary 51.2 Research panel 61.3 The slow migration from equity into fixed income risk premiums 71.4 Benefit of credit risk premiums 131.5 Operational concerns 151.6 Topics for further discussion 17
PART I I – RobecoResearch on and implementation of factor investing in credits 18 2.1 Convincing evidence on factor investing in credit markets 202.2 Overcoming implementation challenges 24
PART I I I – RobecoCustomization and client cases 28 3.1 Defining the investment universe 293.2 Choosing the factor weights 303.3 Integrating sustainability targets 303.4 Incorporating Solvency capital requirements 32
PART I
Nordic survey on factor investing in credits
4 | Factor investing in credits: research, implementation, clients
1. Executive summary
The objective of this research paper is to examine Nordic investors’ experiences of factor
investing with the specific purpose of putting the institutional demand for fixed income
risk premiums into perspective. This paper highlights and discusses the perceived benefits
and obstacles of swapping risk premiums for traditional fixed income strategies or adding
them to existing solutions. In essence, it seeks to uncover the degree to which a risk-based
approach to fixed income is perceived as a valuable addition to an institutional portfolio.
This research paper shows that interest in factor investing has developed notably during
the past couple of years, and today a large proportion of Nordic investors indicate that they
are looking to increase allocations to equity factor strategies – and gradually also to fixed
income – in the coming years. Looking specifically at credits, the concept of implementing
factor strategies is most popular among the fixed income savvy Danish and Finnish
investors and the largest entities in Sweden.
One frequently mentioned reason for implementing factor strategies relates to the growth
in scientism in the context of the performance of actively managed strategies. While this
has made many investors switch allocation from the traditional space to either alternatives
or pure index mandates, dissatisfaction with fundamental active managers has also
made investors rethink whether asset classes can be managed using a better approach.
This has opened the door to a wide range of different types of strategies, managers and
other market participants in the field of risk premium investing. Still, for many investors,
the preferred alternative to actively managed strategies has been to take a pure passive
approach, despite the clear limitations to maneuvering efficiently in the more illiquid
parts of the traditional space. When it comes to fixed income risk premiums, institutional
investors have so far seemed to find it challenging to find a specific place for these
strategies within their existing asset allocation.
In conclusion, the jury is still out on the true benefits of implementing credit risk premiums.
This means asset managers in the field of factor investing are still faced with the task of
educating investors on the existence, persistence, and relevance of factor premiums, not
least in credits. In general terms, however, Nordic investors seem to be open to considering
factor investing, as long as asset managers can prove the long-term value of allocating to
risk premiums.
PART I | Nordic survey on factor investing in credits
Factor investing in credits: research, implementation, clients | 5
2. Research panel
This study has been prepared by Kirstein A/S and is based on both interviews and
quantitative data from 31 institutional investors based in four Nordic countries (Denmark,
Sweden, Norway and Finland). The investors were selected to make up a representative
universe of the full Nordic market in terms of number, size and origins. One third of the
participating investors hold the position of CIO, and the rest of the peer group are fixed
income specialists who are either manager selectors or portfolio managers.
2.1 Breakdown of research panelThe combined assets of the investors taking part in this study amount to EUR 435 billion,
and this makes up about a third of the total Nordic institutional assets. The breakdown of
investors is shown in Figure 1.
PART I | Nordic survey on factor investing in credits
14 50% 17
79%
5 9%4
15%
7
7%
10
6%5
34%
Participating investors by country
Total AuM
EUR 435 bln31 31 EUR 435 bln
Participating investors by segment
Total AuM
Denmark Finland Norway Sweden
Non-pension
Insurancecompanies
Pensionfunds
Figure 1. Number, size and origins of the research panel
Source: Kirstein Research and Kirstein Intelligence 2015
To provide this research with opinions from the most seasoned investors, Danish investors
account for 45% of the participating investors and half of the surveyed assets. Swedish
investors account for one third of the asset base in this research, while participating
investors in Finland and Norway tend to be smaller in size and account for a small part
of the surveyed assets. The universe is intentionally tilted towards pension funds and a
number of the largest insurance companies. Overall, we consider the surveyed group to be
a representative peer group of Nordic investors, offering a sufficiently robust selection to
show how the Nordic market is moving in terms of fixed income factor investing.
6 | Factor investing in credits: research, implementation, clients
3. The slow migration from equity into fixed income risk premiums
The level of interest in factor investing has developed quite rapidly during the past
few years among those investors in the survey. Since the financial crisis, the increased
attention on managing portfolios with a specific focus on risk management has led to
much greater interest in factor-oriented strategies, especially in equity. This is shown in
Figure 2. The rationale for implementing factor strategies in institutional portfolios differs
quite significantly across the four Nordic countries, both in terms of credits, but also when
it comes to equity-related factor investing (only aggregated Nordic numbers are shown).
There is often a notable correlation between investors’ current experience with equity
related factors and their level of interest in fixed income risk premiums.
PART I | Nordic survey on factor investing in credits
2015 2018
1
2
3
4
5
Denmark Finland Sweden Norway Nordic (credit risk premiums)
Nordic (equity risk premiums)
Inte
rest
2.0x
2.7x2.3x 1.7x
2.4x
3.0x
Figure 2. Interest in fixed income (and equity) factor investing
Question: Please indicate your level of interest in factor investing in fixed income on a scale from 1-5, (1 = low interest, 5 = high interest).Source: Kirstein Research and Kirstein Intelligence 2015
To the rather fixed-income savvy Danish investors, many of whom are already quite
experienced in investing in single factor premiums in separate buckets/strategies, factor
investing in credit has been generally well received. Danish investors often say that
implementing a factor approach in fixed income portfolios seems to work well with the
established risk framework that encompasses the way risk management is structured into
the portfolio. The Danish investors were among the frontrunners on equity factor investing
and also express the greatest level of interest in fixed income factor investing.
Factor investing in credits: research, implementation, clients | 7
Finnish investors are often seen as the most seasoned fixed income investors in the Nordic
region, and therefore investing via factor premiums in credits should not be far from their
comfort zone. They also have a long history of managing rather complex fixed income
structures which makes them more likely to embrace the theoretical foundation of risk
premiums. They have a slightly lower level of interest in fixed income factor investing than
the Danish investors, which is mostly because of the larger proportion of smaller investors
participating in this study. This provides a clear indication that on the whole the larger
entities in Finland are more prepared to take a risk-based approach to credit than the
smaller investors. The Finnish level of interest, however, has increased quite significantly
between 2015 and 2018, in tandem with the trend in Denmark.
Swedish investors – and particularly the largest investors – indicate a rather high level of
interest in a risk premium approach. This is often restricted to a number of the AP Funds,
but in this case also more traditional investors are expressing an interest in gaining a
better understanding of the benefits of factor investing. Finally, Norwegian investors show
relatively limited interest in fixed income factor investing, mostly because they have a
relatively conventional approach to fixed income.
As seen in Figure 2, interest in credit risk premiums was quite low across the four Nordic
countries in 2015. Since then, a small group of dedicated asset managers have been
working on grooming investors perception of the benefits related to credit risk premiums.
This study demonstrates that they seem to have been successful and that interest has
started to materialize among a wider range of investors.
PART I | Nordic survey on factor investing in credits
‘Factor investing
has a longer track
record in equity,
but it is clear that
both the academic
world and the
asset management
industry are carrying
out a lot of research
on fixed income,
and this has
improved awareness
considerably.’
Danish Pension Fund
8 | Factor investing in credits: research, implementation, clients
3.1 A factor-heavy approachSince the early days of factor investing, year by year factors have become more numerous
and more exotic. Figure 3 shows a sample of factors from a risk premium search carried out
by the Danish investor Spektrum (subsidiary of Kirstein A/S) in September 2017.
PART I | Nordic survey on factor investing in credits
Observations
0
5
10
15
20
25
30
35
Value Momentum Carry Defensive (Low volatility)
Quality Small cap Liquidity Growth Eventdriven
ConvertibleArbitrage
Sentiment Macro Options
Figure 3. Factors available in the market
Source: Kirstein Research.
As Figure 3 illustrates, the most common factors offered in the market are value,
momentum and carry, followed by the defensive (low volatility) and quality factors.
Relating this to conversations with those investors who took part in the study, there seems
to be a rather high degree of overlap between the factors that the investment community
looks at and what is offered by the asset management community. Less seasoned investors
will often only look at a few factors, whereas those with more experience will look at a wide
variety – from conventional factors to alternative and even illiquid risk premiums.
This proliferation of factors might suggest that it is better to have more factors rather than
less. That said, there seems to be little consensus today among institutional investors as to
how many, and more importantly which factors will provide the best returns, diversification
benefits etc. in the years to come.
Factor investing in credits: research, implementation, clients | 9
3.2 A resource-heavy approachOne thing common to all the investors taking part in this study is the fact that entities with
an above average level of interest in factor investing in credits have the largest investment
teams, as shown in Figure 4.
PART I | Nordic survey on factor investing in credits
1
2
3
<10 >10
Size of �xed income team
Moderate interest
Low interest
1.8x
Figure 4. Interest in fixed income factor investing compared to size of investment team
Source: Kirstein Research.
Having a larger team obviously makes it easier to analyze a wider range of fixed income
approaches and strategies. It is therefore reasonable to conclude that the apparent
hesitance among smaller investors to embrace factor investing in credits is not really a
reluctance to do so. It is more a case of resources being stretched, causing new initiatives
to often be temporarily shelved. Looking to the future, it is evident that the most sweeping
changes are taking place among the largest investors, while the smaller participants
mainly follow the actions of these larger players and only adopt some elements of the new
strategies. Based on the growing appetite for fixed income risk premiums shown in Figure
2, implementation among the larger investors could make it easier for the smaller players
to follow suit.
3.3 A manager-dependent approachShould we seek external guidance or do it ourselves? This is often a dilemma for many
investors, and as Figure 5 shows, this is also very much the case when it comes to fixed
income risk premiums.
10 | Factor investing in credits: research, implementation, clients
Figure 5. Dependence on asset managers
Question: Please indicate your preferred type of set-up when working with risk premiums. You are welcome to indicate more than one option.Source: Kirstein Research.
PART I | Nordic survey on factor investing in credits
At one end of the spectrum, it may come as no surprise that the playing field grows
concurrently with investors’ years of experience. A large proportion of the most experienced
investors in the field of factor investing have been scaling up their internal resources to take
investments in-house and today the majority have an internal portfolio following one or
more factors to some extent. These portfolios are often benchmarked against a strategy
from an asset manager, hence the ongoing dependence on asset managers illustrated in
Figure 5. From conversations with those investors taking part in the study, it seems that
investment banks have served a key role in terms of implementing factor portfolios, and
although many investors acknowledge that working with investment banks rarely adds
services over and above implementing, the speed and effectiveness of banking algorithms
is difficult to neglect. Also, the move from long-only risk premiums to long-short risk
premiums has put a number of hedge fund managers back on the map.
At the other end of the spectrum, Figure 5 also suggests that being an early-stage investor
in the field of risk premiums calls for additional help and guidance; services over and
above ‘just’ implementation. When asked, investors indicated a clear preference for asset
managers in new asset classes, and particularly in the field of fixed income risk premiums.
3.4 A multiple-credit approachThe level of interest in fixed income risk premiums has increased significantly since 2015
and one of the main issues for investors is to decide how to implement this approach in
their existing portfolio. This is shown in Figure 6.
5
0
2
4
6
8
10
12
In-house team Asset managers Hedge funds Investment banks Asset managers
10
8
7
6
Experienced investors Early-stage investors
10
8
7
6
Factor investing in credits: research, implementation, clients | 11
Figure 6. Finding the right fit for factor investing
Question: If you were to add a factor-based strategy to (part of) your credit portfolio, please indicate the most likely place. Please use a scale from 1-5 (1 = low importance, 5 = high importance).Source: Kirstein Research.
PART I | Nordic survey on factor investing in credits
2015 2018 2015 2018 2015 2018 1
2
3
4
5
Impo
rtan
ce
Investment grade High yield Cross credit
Three years ago, when we did a similar in-house study on the evolution of factor investing,
those questioned mainly considered investment grade and cross credit (typically investment
grade-like risk) as feasible areas for implementing credit risk premium strategies. However,
sentiment has gradually moved from the more liquid asset classes to also considering
factor investing in high yield bonds, for example, to an almost similar degree to high grade
bonds. One potential explanation for the increase in high yield may be attributed to Nordic
investors’ growing scientism when it comes to the ability of active credit asset managers to
beat (or even match) benchmark returns after costs, especially on a risk-adjusted basis. As a
result, many investors have been looking for new ways to manage high yield, in particular,
causing a preference for pure passive solutions, but also for dedicated factor strategies. Fees
and illiquidity, however, often make it difficult for passive strategies to completely match
their benchmarks. Overall, it would be fair to conclude that the investors in this study are
increasingly looking at the non-investment grade markets.
12 | Factor investing in credits: research, implementation, clients
4. Benefit of credit risk premiums
Investors today are faced with a number of external factors (such as fee pressure, market
consolidation, changing regulatory landscapes etc.) that impact decisions regarding
institutional investments. As Figure 7 indicates, providing risk-adjusted returns is the main
perceived benefit from investing in credit, so the additional benefits and low correlation still
seem to be considered as less obvious advantages.
PART I | Nordic survey on factor investing in credits
1
2
3
4
5
Improves risk- adjusted returns
Low correlation to the existing portfolio
Low-cost alternative Easier way to implement ESG
Solvency-optimal solution
Obj
ectiv
e
Early-stage investors Experienced investors
1.3x
1.2x
Figure 7. Benefits of factor investing
Question: Please indicate what would be your main objectives in selecting a factor-based strategy in fixed income.Please use a scale from 1-5 (1 = low importance, 5 = high importance).Source: Kirstein Research.
Seeking greater risk-adjusted returns is obviously an important (if not the most important)
parameter when seeking new investments for both-early stage and more experienced
investors alike, and the search for improved risk-adjusted returns often pushes investors in
the direction of asset classes with a lower correlation to their existing portfolios. Managers
with a more quantitative approach often offer solutions at a discount to fundamental
managers. Therefore, it is rather surprising that fixed income risk premium investing is not
yet perceived as a low-cost alternative to traditional strategies. Typically, the largest and
most seasoned fixed income investors have been considering the private credit markets
when looking to substitute investment grade credit with something else. Private debt
appears to be most popular, especially for the largest investors in Denmark and Finland.
Norwegian investors are more reluctant to acknowledge the benefits of factor investing,
which goes hand-in-hand with their lower level of interest in the field.
Factor investing in credits: research, implementation, clients | 13
From a sell side point of view, investors today are bombarded with solutions that have been
structured to serve one specific purpose: to help investors optimize current portfolios in a
Solvency II landscape. Again, a bit surprisingly, solely focusing on credit risk premiums is
not perceived as a solution to solvency-related matters. Only a couple of the Danish and
Finnish Solvency II-regulated investors that took part in this study indicate that Solvency II
is one of the reasons for implementing a risk-based approach to fixed income.
When it comes to sustainable investments, interest has grown significantly during the last
decade. The investment community has made it a clear priority to improve the carbon
footprint of investments, and the pressure from regulators and the public has led to
significant improvements in the sustainable investment framework. The Nordics, along with
the Netherlands, of course are some of the leaders in this movement. While sustainable
investments mostly started out as an equity, and partly real asset, phenomenon,
institutional investors have now realized that they should be incorporated throughout the
portfolio. This is of course easier said than done. The road to sustainable investments is
clearer in equity, where it’s relatively easy to develop approaches such as screening and/
or engagement. Interestingly, the more experienced investors in the field of fixed income
risk premiums have found it difficult to implement ESG. The investors who took part in this
study often mentioned that applying equity screening lists to corporate bonds or excluding
certain government bonds from their investment universe is not an optimal approach.
PART I | Nordic survey on factor investing in credits
14 | Factor investing in credits: research, implementation, clients
5. Operational concerns
As the previous sections have shown, investors express a solid level of interest in factor
investing in fixed income, although some experience a degree of hesitancy when it comes
to pulling the trigger. As shown in Figure 8, it is quite clear that concerns differ between the
early-stage and the experienced investors. That said, no single concern stands out from the
rest, suggesting that investors find it difficult to pin point what specifically keeps them from
allocating to the approach.
1
2
3
4
5
Crowding in conventionalrisk premiums
Sourcing of capable managers
Ease ofimplementation
Crowding in conventionalrisk premiums
Sourcing ofcapable managers
Lack of liquidity
Conc
ern
Early-stage investors Experienced investors
Figure 8. Concerns regarding fixed income factor investing
Question: If you were to add a factor-based strategy to (part of) your credit portfolio, please indicate the most likely place for it. Please use a scale from 1-5 (1 = low importance, 5 = high importance).Source: Kirstein Research.
Crowding is considered the greatest concern among those investors approached. If
everybody is chasing value, small cap, momentum and low volatility, what is left for me?
This is quite a common issue in factor investing and one which is also cited by equity
investors. Concerns regarding crowding are mostly found among early-stage investors,
but are also mentioned as the greatest concern for experienced investors. Issues with the
perceived crowding in conventional risk premiums seem strongest among the very large-
scale Finnish investors and among Danish pension funds.
Sourcing of capable managers is also seen as a concern to many. Whereas the early stage
investors indicate concern about where to start looking, the more experienced investors
mention a need for managers that offer more complex structures and advice in addition
to the product itself. Implementation is key in factor investing, and while the more
PART I | Nordic survey on factor investing in credits
Factor investing in credits: research, implementation, clients | 15
experienced have already tackled this issue, early-stage investors are still considering their
options. Finally, the more experienced an investor gets in the field of risk premiums, the
more emphasis they are likely to put on liquidity.
PART I | Nordic survey on factor investing in credits
16 | Factor investing in credits: research, implementation, clients
6. Topics for further discussion
Overall, there still seems to be evidence that Nordic investors have embraced equity factor
investing and that many have also started to appreciate the benefits the approach can offer
in fixed income. Having said that, execution and implementation of credit risk premium
strategies are still rare, and in the sections below we highlight a couple of the topics that
still seem to concern investors.
6.1 Live performanceAsset managers still seem to need to convince Nordic investors of the advantages of
implementing a credit risk premium approach either in the form of an overlay or as a
substitute for traditional portfolios. It is clear that investors still need proof of performance
through live strategies and to see that this performance can be maintained in both bull
and bear markets. Whereas many Nordic investors seem to be very quick to pull the
trigger when it comes to alternative investments, hesitation is quite common when it
comes to fixed income, particularly when discussions relate to newly developed fixed
income approaches. That said, hesitation does not necessarily mean reluctance. To give an
example, in 2015, very few investors saw the potential for private debt, and very few were
investing in CLOs, direct lending and other types of structured credit. Today, just three years
later, Nordic investors are buying as much private debt as they can. The most interesting
question today in terms of factor investing is whether Nordic investors will implement these
solutions and if they do, how quickly this will occur. While the interest in fixed income factor
investing has increased since 2015, the approach has yet to reach acceptance among a
broader audience.
6.2 Added benefitsThe investors who took part in this study often allude to how the current market
environment to a large extent dictates which approaches are accessible for new
investments. Search for yield, ESG requirements, Solvency II, fees, etc. are all variables that
investors need to take into account when choosing new investments. According to this
research paper, the added benefits (beyond risk-adjusted returns and correlation) from
investing in credit factors seem unclear to investors, and while risk premium strategies
could provide valuable added benefits to portfolios, these advantages still need to be
highlighted by the investment community.
PART I | Nordic survey on factor investing in credits
Factor investing in credits: research, implementation, clients | 17
PART I I
Research on and implementation of factor investing in credits
18 | Factor investing in credits: research, implementation, clients
PART I I | Research on and implementation of factor investing in credits
In recent years, many asset owners have tilted their equity portfolios to well-known factors,
such as low risk, quality, value, momentum, and size. The main force behind this strong
trend is the desire to move away from inefficient market value-weighted indices and to
benefit from the higher risk-adjusted returns offered by factors. Factor portfolios also offer
additional benefits when compared to fundamentally managed active portfolios such
as lower fees and style diversification. Investors are increasingly looking beyond their
equity portfolios and seeking to reap the benefits of factors in other asset classes too.
The application to corporate bonds is now at the forefront of the dissemination of factor
investing beyond equities.
In this article, we address three types of questions related to applying factors to corporate
bonds. First, foundational questions such as: does factor investing work for credits, what is
the added value beyond traditional fundamental management and beyond factor investing
in equity markets, and can factor premiums be crowded out? Second, we identify credit-
specific implementation challenges, such as dealing with the lower liquidity and higher
transaction costs of corporate bonds, choosing between different bonds issued by the same
entity, and the difficulty of taking short positions. Finally, we discuss the customization
of factor strategies to meet specific requirements. This includes defining the investment
universe, choosing factor weights, and incorporating sustainability targets or solvency
capital requirements.
‘Factors work in credits and offer diversification benefits’
Factor investing in credits: research, implementation, clients | 19
PART I I | Research on and implementation of factor investing in credits
1. Convincing evidence on factor investing in credit markets
Factors give access to higher risk-adjusted returnsIn our academic paper ‘Factor investing in the corporate bond market’1 we show how
factors can be defined for corporate bonds, and how a systematic allocation to factors
delivers higher risk adjusted-returns than passively investing in the market value-weighted
index. We also describe how these factor premiums have their origins in human behavior
and how this plays an important role in why they exist. This behavior could either be an
irrational bias, such as overreaction, overconfidence or herding, or a rational response to
regulation or incentives. This implies that factor portfolios that seek to benefit from these
behavioral patterns should work in any asset class.
In Figure 9 we summarize the findings of the academic study by plotting the risk and return
of each factor portfolio over the period 1994-2017 for investment grade and high yield
credits. We find that each factor delivers a higher risk-adjusted return than the market,
by improving the return and/or reducing the volatility. We also observe in our study that
each factor has a distinct risk-return profile and that the mutual correlations between
the factors are relatively low. Therefore, a multi-factor portfolio mitigates the risk of
underperformance, leading to a lower tracking error and higher information ratio than the
individual factors.
The results of our study provide a strong motivation for investors to tilt their credit portfolios
to factors to obtain better investment results than passively investing in the market value-
weighted index. Depending on their investment objective, specific investors may make
different choices in designing their factor portfolio, e.g. optimizing return, Sharpe ratio, or
information ratio.
1. See Houweling & Van Zundert, 2017, “Factor investing in the corporate bond market”, Financial Analysts Journal, Vol. 73, No. 2, pp. 100-115, www.cfapubs.org/doi/abs/10.2469/faj.v73.n2.1. The article won a 2017 Graham and Dodd Scroll Award of Excellence.
20 | Factor investing in credits: research, implementation, clients
PART I I | Research on and implementation of factor investing in credits
Figure 9: Risk-return plot per factor portfolio for US investment grade (left) and high yield (right)
Source: Robeco, Bloomberg Barclays. Methodology as in Houweling & van Zundert (2017). Extended sample period: 1994-2017.
Market
Size
Low Risk
Value
Momentum
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
0% 2% 4% 6% 8% 10% 12% 14%
Market
Size
Low Risk
Value
Momentum
0.0%
0.5%
1.0%
1.5%
2.0%
0% 1% 2% 3% 4% 5% 6% 7%
Credit return volatility
Cred
it re
turn
Factors in credits add value beyond factors in equitiesIf asset owners already allocate (part of) their equity portfolio to factors, should factor
premiums also be harvested in other markets, or is the equity market alone sufficient? This
is an important question so, in our study, we also analyze factor investing in a multi-asset
context. We use a hypothetical multi-asset portfolio, allocating 25% each to government
bonds, equities, investment grade, and high yield. Figure 10 illustrates our key finding
– that replacing a passive credit portfolio with a multi-factor credit portfolio adds about
1% return per annum, without increasing the risk, even if the equity portfolio is already
allocated to factors. This is the result of the only modestly positive correlations between
equity factors and credit factors, which means that simultaneous allocation to factors in
both markets enhances the diversification benefits.
This finding implies that investors should pursue factor investing in multiple markets. This
is confirmed by many of the conversations we have had with asset owners all over the
world: after successfully applying factor investing in their equity portfolios, they are now
broadening its application to other asset classes.
Factor investing in credits: research, implementation, clients | 21
PART I I | Research on and implementation of factor investing in credits
Figure 10: Risk-return plot of US multi-asset portfolios
2. See Houweling, 2017, “Global Multi-Factor Credits as a style diversifier”, Robeco white paper.
Source: Robeco, Bloomberg Barclays. Methodology as in Houweling & van Zundert (2017). Extended sample period: 1994-2017.
Diversification benefits of a factor strategy If an asset owner already invests in one or more fundamentally managed active credit
strategies, it is logical to ask what a systematic multi-factor strategy brings to the
table. After all, both approaches are active investment strategies that deviate from the
benchmark. There are, however, several key differences between these two investment
styles: the systematic and transparent investment process of a factor-based strategy
(compared to the human decision-making process in a fundamental strategy), the
balanced exposure to all factors (compared to a focus on a single factor, if any), and the
beta-neutral portfolio construction (compared to an active beta policy or structural high-
beta bias).
In a 2017 white paper, we show that these differences lead to a low correlation between
the outperformance of a multi-factor credit portfolio versus its benchmark and that of
fundamentally managed credit portfolios against their respective benchmarks2. In that
paper we analyze 25 global credit funds and compare their investment results to our
Robeco QI Global Multi-Factor Credits (GMFC) fund. The main result is shown in Figure 11,
demonstrating a negative correlation between GMFC and the average fund in the peer
group. The data also shows that GMFC has one of the highest Sharpe ratios, one of the
lowest volatilities, one of the lowest fees, and one of the highest sustainability scores.
Therefore, the multi-factor strategy offers diversification benefits when combined with its
fundamentally managed peers and also improves a multi-manager credit portfolio in a
number of other ways.
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
6.0% 6.5% 7.0% 7.5% 8.0%
Passive credits & Multi-factor equities
Multi-factor credits & Multi-factor equities
Passive credits & Passive equities
Volatility
Retu
rn
22 | Factor investing in credits: research, implementation, clients
PART I I | Research on and implementation of factor investing in credits
Figure 11: Average of outperformance correlations of a fund with each other fund in the peer group
Source: Morningstar Direct, Bloomberg Barclays, Robeco. Period: July 2015-June 2017. GMFC = Robeco QI Global Multi-Factor Credits. B to Z are 25 anonymized global credit funds. Outperformance
is calculated vs. Bloomberg Barclays Global Aggregate Corporatess.
Factor premiums unlikely to be crowded outBy definition, all empirical research uses historical data to prove the existence of factor
premiums. One could hypothesize that, if many investors around the world were to
organize their credit portfolios around factors, the alphas would be crowded out. There are
two reasons why we think this is unlikely to happen. First, given that credit factor investing
is still only just starting to be adopted by investors, the amount of money managed using
factors is an almost negligible percentage of the total market capitalization of the credit
market. This is also evident in the correlations in Figure 11: there is currently no other global
credit fund with an investment strategy resembling a multi-factor strategy. Secondly, and
most importantly, we attribute the existence of factors to human behavior; and this is
unlikely to change. For instance, low-risk bonds are unattractive in a benchmarked strategy,
as they do not outperform the market. Given the vast amount of money being managed
against a benchmark, the perceived attractiveness of low-risk bonds is not likely to change
any time soon. Likewise, the value effect exists because investors overreact to news, and
overreaction is a deeply engrained human trait.
Robeco QI Global Multi-Factor Credits FH EUR -27% Fund B 3% Fund C 13% Fund D 20% Fund E 21% Fund F 25% Fund G 25% Fund H 26% Fund I 29% Fund J 30% Fund K 34% Fund L 36% Fund M 36% Fund N 37% Fund O 37% Fund P 38% Fund Q 40% Fund R 41% Fund S 42% Fund T 43% Fund U 44% Fund V 46% Fund W 46% Fund X 47% Fund Y 47% Fund Z 48%
-30% -20% -10% 0% 5% 10% 20% 30% 40% 50%
Factor investing in credits: research, implementation, clients | 23
PART I I | Research on and implementation of factor investing in credits
3. See Whirdy, Houweling, Muskens & Van Zundert, 2016, “Implementing factor strategies in the corporate bond market”, Robeco white paper.4. See Blitz, Huij, Lansdorp & Van Vliet, 2014, “Factor investing: Long-only versus long-short”, ssrn.com/abstract=2417221
2. Overcoming implementation challenges
Dealing with bond-specific characteristicsBoth stocks and bonds depend on the financial well-being of the issuing company.
Therefore, stock returns and bond returns tend to be positively correlated, and variables
that can predict stock returns also have predictive power for bond returns. Nonetheless,
stocks and bonds are different instruments with their own unique characteristics. Also,
a company typically issues only one or two types of stock (common and preferred), but
far more bonds, sometimes dozens. And these bonds have different characteristics, such
as their maturity date, size, currency, and subordination. These characteristics require
careful treatment, especially in defining the factors and designing the investment process.
For example, to benefit from the low-risk factor, investors need to be able to distinguish
between low- and high-risk bonds from the same issuer. Another example is the value
factor, where they have to determine the relative attractiveness of each and every bond.
Not all bonds need to have the same valuation: some might be cheap, others expensive.
As a final example, the portfolio should be sufficiently diversified across issuers, and not, in
what would be an extreme case, only buy bonds issued by one company.
Incorporating illiquidity and transaction costs in the processIn addition to their characteristics, bonds differ substantially in terms of their liquidity.
Whereas some bonds trade every day, others trade only infrequently. In the same
context, transaction costs vary strongly from one bond to another too. Both research and
implementation of factor portfolios need to take these variations in availability and cost
into account. We design our factor strategies such that they provide an optimal balance
between factor exposures and alpha potential on the one hand, and turnover and
transaction costs on the other hand. In our white paper ‘Implementing factor strategies in
the corporate bond market’3, we describe how liquidity management can be structurally
embedded in the investment process and how this leads to cost-efficient implementation
for factor portfolios.
Long-only vs. long-short implementationRoughly speaking there are two main schools of thought on the optimal implementation
for factor portfolios: some argue in favor of long-only portfolios, while others prefer a
long-short implementation. In the article ‘Factor investing: Long-only versus long-short’4
our Robeco equity research colleagues argue that although a long-short approach may
be theoretically optimal, it is more sensitive to practical implementation costs, such as
transaction costs and borrowing costs. These considerations are even more important
for corporate bonds, as in the case of bonds the costs are larger relative to their alpha
potential.
24 | Factor investing in credits: research, implementation, clients
PART I I | Research on and implementation of factor investing in credits
An additional argument in favor of a long-only implementation is that, in contrast to
the equity market where it is usually quite easy to short stocks, only a small part of the
corporate bond universe can actually be shorted. Therefore, the diversification potential
of the short portfolio is much poorer than of the long portfolio. The issue of limited
breadth also applies to an implementation using credit default swaps (CDS) instead of
actual corporate bonds, as liquid CDS are only available for a few hundred companies, as
compared to the thousands of companies that issue bonds.
Therefore, we feel that the case for a long-only implementation of factor portfolios is
stronger than the argument for long-short implementation. A long-only portfolio can still
benefit from the factor strategy’s ability to predict which bonds will underperform. By not
investing in bonds that have bad factor scores, the portfolio effectively underweights them
versus the benchmark and so when they perform poorly, this results in an outperformance
of the portfolio versus the benchmark.
Risks beyond the scope of the factor modelWhen presenting our factor credit strategies, we are frequently asked whether a multi-
factor model can capture all risks of investing in a corporate bond. The fair answer to this
is: it cannot. A model is a best-efforts representation of the many risks associated with
the bond and its issuer. With the increased availability of data and computational power,
models have become richer over time, increasing their ability to better evaluate risks.
Nonetheless, there are still risks that we cannot represent as a numerical value. This may
be because of their complexity, or a lack of relevant (historical) data to verify models.
Examples include measuring the quality of a company’s management, the impact of
new legislation on a company’s business, or the risk of the country in which the company
operates. Other challenges for a purely quantitative approach are events that will
materially change the company, but are not yet reflected in current data. For example, a
company announcing a merger or an acquisition, or splitting-off a part of its business.
Because of these non-quantifiable risks and material events, we incorporate human checks
in the investment process of our factor strategies. Before we make an investment in a bond
that is top-ranked in the multi-factor ranking model, one of our more than 20 fundamental
credit analysts performs a final check to identify risks and events beyond the scope of the
model. If they flag such a risk, we do not invest in that bond, and move on to the next
investment opportunity. This happens in 5 to 10% of the cases. We may also decide to sell
an existing portfolio holding if a new risk is flagged. This happens a few times each year
for every portfolio. With these fundamental checks we aim to avoid losers that could be
selected using a purely quantitative investment process.
‘Design and implemen-tation need to be credit market-specific’
Factor investing in credits: research, implementation, clients | 25
PART I I | Research on and implementation of factor investing in credits
Proven in practiceRobeco has been doing research on factor investing in credit markets since the end of
the 1990s. Since 2005 we have managed an internal multi-factor high yield mandate.
Since 2012, we have been offering factor strategies to external clients too. We find that
the live track records of the various strategies are nicely in line with the backtest results
found in research, in terms of information ratio and Sharpe ratio improvements versus the
benchmark. Today, Robeco manages approximately EUR 5 billion in credit factor investing
strategies, including the flagship strategies Conservative Credits, Multi-Factor Credits, and
Multi-Factor High Yield. Below we discuss various customizations that we have developed
for specific clients.
26 | Factor investing in credits: research, implementation, clients
PART I I | Research on and implementation of factor investing in credits
Factor investing in credits: research, implementation, clients | 27
PART I I I
Customization and client cases
28 | Factor investing in credits: research, implementation, clients
1. Defining the investment universe
For any investment strategy it is important that its universe contains a large number of
investment opportunities. This is called the ‘breadth’ of the strategy, and according to the
fundamental law of active management5, it determines its success, together with its skill.
Our flagship strategies therefore use a large investment universe.
In the tailor-made solutions that we have developed for specific clients, we often use a
customized investment universe. As long as there is sufficient breadth, we are confident
that a factor strategy can reach its goals within such a universe. It is important, however,
that the client is aware that a strategy will inevitably generate better results in a larger
universe than it will in a small one.
We give some examples of customizations below:
– Ratings: typically the universe is either investment grade (with some tolerance for
downgrades to BBs) or high yield. A German pension fund wanted a pure-investment
grade universe and a UK insurer a high yield universe excluding CCCs. A Dutch pension
fund and an Asian sovereign wealth fund preferred a combined investment grade + high
yield universe, which actually increased the breadth.
– Currencies: typically the universe is global, including all currency denominations.
Several European clients wanted a euro-only universe. A US dollar-only application is
also possible.
– Maturities: typically the universe includes all maturities (except for the longest-dated
bonds as motivated by the low-risk factor). For a German pension fund we implemented
a factor strategy on a 1-10y universe. The maximum time to maturity for the bonds in
our Conservative Credits strategies (targeting the low-risk factor) is six years.
– Sectors: typically all sectors are included in the investment universe. A German pension
fund did not want any financials in its portfolio. For a Dutch health insurer we excluded
tobacco names from the investment universe. We also exclude weapon manufacturers
for several clients.
It should be noted that irrespective of the definition of the investment universe, we can
separately hedge FX, duration, and credit beta exposures to the desired targets using
derivatives.
PART I I I | Customization and client cases
5. See Grinold, 1989, “The fundamental law of active management”, The Journal of Portfolio Management, Vol. 15, No. 3, pp. 30-37.
‘Universe, factor mix, and ESG-profile can be tailored to each client’
Factor investing in credits: research, implementation, clients | 29
PART I I I | Customization and client cases
2. Choosing the factor weights
In our multi-factor strategies we provide balanced exposure to all factors, meaning that
each factor is equally represented in the portfolio. This results in the best diversification
between the factors. The beta of such a balanced strategy is around 1, making it easy to
benchmark the portfolio to a standard index.
In dialogue with the client, we can also design strategies that are tilted to one or more
specific factors. In such factor-tilted strategies we still incorporate the other factors to avoid
undesired negative factor exposures. The most popular choice so far has been for solutions
tilting to the low-risk factor. Such a strategy, which we call Conservative Credits, invests in
shorter-dated bonds from safer issuers. Given the shorter duration of the portfolio, it is a
natural fit for investors with shorter-dated liabilities, such as insurance companies. For an
Australian pension fund we developed a strategy that is tilted to the value and momentum
factors, optimizing return, instead of the Sharpe or information ratios.
3. Integrating sustainability targets
Clients increasingly aim to improve the sustainability profile of their investment portfolios.
At Robeco we have a long track-record in integrating sustainability into the investment
process of our strategies. We incorporate sustainability in our factor credit strategies in four
specific ways6:
– We require the ESG score of the portfolio to be better than the ESG score of the
benchmark, as measured by the RobecoSAM SmartESG score. This restriction is used
in constructing the portfolio, alongside other risk and allocation restrictions, while the
primary goal is to optimize factor exposures.
– As described above, our fundamental analysts conduct a check on risks beyond the
scope of the model. This includes ESG-related risks, such as poor governance or large
claims resulting from litigation.
– We exclude companies that are on the Robeco Exclusion List7. This relates to companies
that exhibit controversial behavior (i.e. violations of the UN Global Compact Principles),
companies that manufacture controversial weapons, and companies that are involved
in the production of tobacco products. We can also exclude more sectors or names from
the investment universe to fulfill specific client requests.
– We engage with companies to improve their corporate behavior on environmental,
social and/or corporate governance-related issues8. The goal of our engagement with
companies is to improve their long-term performance and ultimately the quality of the
investments we make for our clients.
6. See Muskens, Houweling, Whirdy, Van Zundert, 2016, “Integrating sustainability into factor credit strategies”, Robeco white paper.7. The Robeco Exclusion Policy can be downloaded from our website: https://www.robeco.com/docm/docu-exclusion-policy-and-list.pdf8. The Robeco Engagement Policy can be downloaded from our website:https://www.robeco.com/docm/docu-robeco-engagement-policy.pdf
30 | Factor investing in credits: research, implementation, clients
PART I I I | Customization and client cases
We are also able to design strategies that score better on specific sustainability targets.
Combining RobecoSAM’s historical company-level sustainability data with our historical
bond and equity databases, we can efficiently backtest such customized solutions.
We give several examples of customizations below.
– Instead of the requirement that the portfolio has a better ESG score than the
benchmark, a Dutch pension fund was interested in more ambitious targets, e.g. 10, 20
or 30% better than the benchmark. Figure 12 shows the impact of increasing ESG targets
on the Sharpe ratio and the outperformance of a factor strategy.
– A Dutch insurance company wanted to reduce the CO2 emission of their investment
portfolio. We tested various reduction levels to show the impact on the historical risk
and return of their low-risk strategy. Likewise, RobecoSAM has data on the energy
consumption, water use, and waste generation of individual companies, which we can
use to design strategies that have less environmental impact on these specific aspects
versus the benchmark.
– As mentioned above, we can exclude undesired sectors from the investment universe.
For several insurance clients we exclude tobacco names. We could also exclude more
sectors, such as alcohol, weapons, gambling, and sex.
– A more recent development is to apply positive screening to the investment universe,
selecting companies that contribute positively to the UN’s Sustainable Development
Goals (SDGs). RobecoSAM has developed a framework that allows us to assess the
extent to which a company contributes to one or more of the 17 SDGs.
Figure 12: Impact on Sharpe ratio and outperformance of requiring the portfolio’s ESG score to be x% better than the benchmark for a sample investment strategy
Source: Robeco, RobecoSAM, Bloomberg Barclays, FactSet. Sample period: 2003-2017. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
Outperformance
0.0
0.1
0.2
0.3
0.4
0.5
Equal to BM 10%Improvement
20%Improvement
30%Improvement
Equal to BM 10%Improvement
20%Improvement
30%Improvement
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
Sharpe ratio
Factor investing in credits: research, implementation, clients | 31
PART I I I | Customization and client cases
Because factor strategies are highly systematic, they lend themselves very well to the
incorporation of other quantitative objectives. Above we mentioned various examples
regarding sustainability, here we highlight another, namely integrating Solvency II capital
requirements. In our white paper ‘Solvency II integration in factor credit strategies’ we
describe our research on this topic much more extensively9.
For European insurers, and selected pension funds that are subject to Solvency II regulation,
the risk-adjusted return on their investment portfolio is no longer the primary performance
measure. Instead, they have shifted their attention to the return on capital, defined as the
portfolio return divided by the amount of required solvency capital. Our research shows
that under the Solvency II framework the credit risk solvency capital requirement (SCR)
is highly correlated with return volatility. Therefore, factor portfolios – providing a higher
return on volatility (i.e. Sharpe ratio) – also provide a higher return on SCR than a passive
market value-weighted credit portfolio. Moreover, since the SCR and volatility are not
perfectly correlated, there is room for improvement. In our white paper, we show that by
explicitly incorporating SCR into the investment process we can further improve the return
on capital. Depending on their risk appetite and the trade-off between return and return
on capital, clients can construct the optimal portfolio. In one case, designed for a Danish
pension fund, Figure 13 shows the improvement in return on capital of SCR-integrated
multi-factor credit and high yield strategies versus the standard strategies.
0.00
0.05
0.10
0.15
0.20
0.25
0.30
Market Multi-factor credits Market Multi-factor high yieldInvestment grade High yield
Market Without SCR integration With SCR integration
Figure 13: Return on capital for global multi-factor credits and global multi-factor high yield strategies, with and without SCR integration
Source: Robeco, Bloomberg Barclays. Sample period 1994-2017. The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
9. See Muskens & Houweling, 2018, “Solvency II integration in factor credit strategies”, Robeco white paper.
4. Incorporating Solvency capital requirements
32 | Factor investing in credits: research, implementation, clients
Conclusion The evidence to support implementing a factor-based approach to corporate bonds is clear. Its low correlation with traditional fundamental investment styles also supports this. Implementation challenges exist – some of which are specific to credit markets, such as liquidity and bond issue selection. These make a credit-specific implementation a necessity. Factor strategies can be customized in many ways, for example in terms of factor weights, investment universe, ESG parameters and solvency targets.
Investors in the Nordics are aware of the improved risk-adjusted return benefits and the low correlation advantages factor credit strategies offer. Preferences for an individual factor approach or multi-credit solution vary from one country to another and implementation and sourcing managers remain concerns. But it is clear that here too interest in factor investing in credits is picking up, with Nordic investors considering increased allocations to this investment style, also as an extension of their experience in equity factor investing.
Important Information Robeco Institutional Asset Management B.V. has a license as manager of Undertakings for Collective Investment in Transferable Securities (UCITS) and Alternative Investment Funds (AIFs) (“Fund(s)”) from The Netherlands Authority for the Financial Markets in Amsterdam. This document is solely intended for professional investors, defined as investors qualifying as professional clients, have requested to be treated as professional clients or are authorized to receive such information under any applicable laws. Robeco Institutional Asset Management B.V and/or its related, affiliated and subsidiary companies, (“Robeco”), will not be liable for any damages arising out of the use of this document. Users of this information who provide investment services in the European Union have their own responsibility to assess whether they are allowed to receive the information in accordance with MiFID II regulations. 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34 | Factor investing in credits: research, implementation, clients
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Additional Information for investors with residence or seat in SpainThe Spanish branch Robeco Institutional Asset Management B.V., Sucursal en España, having its registered office at Paseo de la Castellana 42, 28046 Madrid, is registered with the Spanish Authority for the Financial Markets (CNMV) in Spain under registry number 24.
Additional Information for investors with residence or seat in SwitzerlandThis document is exclusively distributed in Switzerland to qualified investors as defined in the Swiss Collective Investment Schemes Act (CISA) by Robeco Switzerland AG which is authorized by the Swiss Financial Market Supervisory Authority FINMA as Swiss representative of foreign collective investment schemes, and UBS Switzerland AG, Bahnhofstrasse 45, 8001 Zurich, postal address: Europastrasse 2, P.O. Box, CH-8152 Opfikon, as Swiss paying agent. The prospectus, the Key Investor Information Documents (KIIDs), the articles of association, the annual and semi-annual reports of the Fund(s), as well as the list of the purchases and sales which the Fund(s) has undertaken during the financial year, may be obtained, on simple request and free of charge, at the office of the Swiss representative Robeco Switzerland AG, Josefstrasse 218, CH-8005 Zurich. The prospectuses are also available via the website www.robeco.ch.
Additional Information for investors with residence or seat in the United Arab EmiratesSome Funds referred to in this marketing material have been registered with the UAE Securities and Commodities Authority (the Authority). Details of all Registered Funds can be found on the Authority’s website. The Authority assumes no liability for the accuracy of the information set out in this material/document, nor for the failure of any persons engaged in the investment Fund in performing their duties and responsibilities.
Additional Information for investors with residence or seat in the United KingdomRobeco is subject to limited regulation in the UK by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.
Additional Information for investors with residence or seat in UruguayThe sale of the Fund qualifies as a private placement pursuant to section 2 of Uruguayan law 18,627. The Fund must not be offered or sold to the public in Uruguay, except in circumstances which do not constitute a public offering or distribution under Uruguayan laws and regulations. The Fund is not and will not be registered with the Financial Services Superintendency of the Central Bank of Uruguay. The Fund corresponds to investment funds that are not investment funds regulated by Uruguayan law 16,774 dated September 27, 1996, as amended.
Additional Information concerning RobecoSAM Collective Investment SchemesThe RobecoSAM collective investment schemes (“RobecoSAM Funds”) in scope are sub funds under the Undertakings for Collective Investment in Transferable Securities (UCITS) of MULTIPARTNER SICAV, managed by GAM (Luxembourg) S.A., (“Multipartner”). Multipartner SICAV is incorporated as a Société d’Investissement à Capital Variable which is governed by Luxembourg law. The custodian is State Street Bank Luxembourg S.C.A., 49, Avenue J. F. Kennedy, L-1855 Luxembourg. The prospectus, the Key Investor Information Documents (KIIDs), the articles of association, the annual and semi-annual reports of the RobecoSAM Funds, as well as the list of the purchases and sales which the RobecoSAM Fund(s) has undertaken during the financial year, may be obtained, on simple request and free of charge, via the website www.robecosam.com or www.funds.gam.com.
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ContactRobeco
P.O. Box 973
3000 AZ Rotterdam
The Netherlands
Kirstein
Casper Hammerich [email protected]
Robeco
Bas Eestermans [email protected]
Stefan Laszlo [email protected]