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Transcript of 494860 Factor Investi
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Sponsored eBook April 2015 An Institutional Investor Sponsored eBook
From Concept to Implementation
By Chris Wright
FACTOR INVESTING
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2 Institutional Investor eBook Sponsored by Robeco April 2015
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INSIDE
Factor Investing
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Factor investing is an approach that has its roots in academic research from as far back as the 1970s, but only now is being used in its most effective form. It uses ideas such as value, momentum and low-volatility, but combines them into a model that gives
much stronger risk-return outcomes than many other investment methods. In this guide, Robeco, one of the leaders and pioneers in factor investing, explains how it works and how it is best implemented.
Chapter 1: What is Factor Investing? ............................................................4
Chapter 2: The Robeco Philosophy ...............................................................8
Chapter 3: From Concept to Implementation .......................................... 12
Summary ....................................................................................................... 16
Contact Information .................................................................................... 16
About Robeco ............................................................................................... 17
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CHAPTER 1
What is Factor Investing?
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Factor investing is attracting increasing attention as an effective and evidence-based investment model. But what exactly does it mean?
Its good to start with terminology, says Joop Huij, Head of Factor Investing Research at Robeco in Rotterdam. The tricky
thing with factor investing is that multiple terminologies are used that refer to the same thing. The terms smart beta or risk-based investing are sometimes used to describe a similar philosophy.
So what do we mean by factor investing? To understand it, we first have to know what a factor is, and the established investment ideas that factors challenge. For years, many investors have been keen disciples of whats known as the efficient market hypothesis, which states that it is impossible to systematically outperform the market because the efficiency of stock markets causes them to reflect all the relevant information around them at any given time. To put it another way: stocks always trade at their fair value, and theres no such thing as a stock being undervalued or overvalued.
But since the 1970s, a growing body of empirical academic research has challenged this idea. There is a stream of literature that shows returns from different parts of the market cannot be attributed to differences in market risk, says Huij, and the consequence of that is that sometimes, it is possible to earn return higher than the market. Some of the most important examples of this are the value segment, the momentum segment, and the low-volatility segment of the market. These are factors, and there is an overwhelming amount of academic evidence showing that they earn returns higher than you would expect them based on the market risk involved.
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But identifying what a factor is is only the start. Factor investing involves taking these factors and using them intelligently and collectively in an investment strategy. And, given the wealth of academic literature that is available to demonstrate that factors exist, attempts to incorporate them intelligently in an investment process are surprisingly recent developments.
One could argue that the idea as an investment discipline stems from an influential report published by the government of Norway in 2009, through Norges Bank Investment Management, after its
vast sovereign wealth fund, now called Government Pension Fund Global, suffered badly in the global financial crisis in 2008. The government wanted to understand: why is this? Is the way that we manage our wealth the most efficient way to do it?
Norways approach was not just to ask established asset managers, but academics: Professors Ang, Goetzmann and Schaefer of Columbia University, Yale University and the London Business School respectively. Their conclusions were extremely comprehensive its one of the few reports I know with a summary of the summary, says Huij and so groundbreaking that factor investing is now sometimes known as the Norway model, even though Norway didnt immediately adopt any of the findings.
The reports most significant conclusion was that as much as two thirds of outperformance could be attributed to the market segments we now call
CHAPTER 1
Joop Huij, Head of Factor Investing Research
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factors. The academics therefore made an influential recommendation, which Huij summarizes as: why not directly allocate to these segments in a strategic allocation, instead of hiring an asset manager and hoping they will provide access to the right market segment? And here we come to the definition of factor investing: not just being aware of how factors impact performance, but taking responsibility for allocating towards them from the outset. l
4
revenues and is one of the largest investors
in the world. The study was carried out by three
highly acclaimed academics associated with
Columbia University, Yale University, and the
London Business School.2 The aim of the study
was to assess the investment performance of
the fund and to recommend ways for improving
performance.
Although the study is very comprehensive
and covers more than 180 pages, the main
recommendation can be summarized in
a few words: the researchers advise the fund
to construct its investment portfolio in such
a way that it is strategically allocated towards
the most attractive segments of the market.
In the case of equity investors, this could be, for
instance, the low-volatility segment, the value
segment or the momentum segment. This
approach is shown schematically in Figure 1.
In order to understand Figure 1, it is crucial
to know the meaning of the colors used in
the pie chart: the darker (lighter) the color,
the higher (lower) is the expected return in any
specific market segment. The way investment
portfolios traditionally are constructed is by
allocating towards equities, corporate bonds
and government bonds (represented by
Diagram 1). The expectation is that in the long
term, equities will deliver higher returns than
bonds. The equities asset class is then generally
subdivided into different regions (e.g., United
States, Europe and Japan; Diagram 2).
Next, as shown in Diagram 3, a number of
managers are selected for each region. While
some of these managers deliver above-average
returns, others, in contrast, are responsible for
below-average results. Investors often spend a
lot of resources in identifying the best managers.
However, many studies show that the majority
of investors are not consistently successful in
this area, and if they do find added value, this
can often be attributed largely to the fact that
consciously or unconsciously the manager
capitalizes on classical factor premiums.
In Diagrams 4 and 5 we show how factor
investing for equities can be implemented
within an investment portfolio. First, the asset
classes should not be split up into regions,
but into segments. These are precisely those
segments where academic research has
shown that significant return differentials
can be expected, such as the low-vol versus
high-vol segment; the value versus glamour
segment (i.e., stocks with a high price-to book
ratio versus those with a low ratio), and the
high-momentum versus the low-momentum
segment (i.e., equities with high return over
the last 12 months versus those of which
returns were low). Finally, the portfolio should
be concentrated in those market segments in
which the expected returns are most attractive:
the low-volatility segment, the value segment
and the high-momentum segment. If you
now compare Diagram 3 with 5, you see that
the expected return from the factor-investing
portfolio in Diagram 5 is higher than that of
the traditional portfolio in Diagram 3.
Risk-adjusted expected return low
high
Legend
Government bonds
Credits
Equities
Government bonds
Credits
Equities U.S.
Equities Europe
Equities Japan
Government bonds
Credits Equities
Eq. Hi.Val. Eq. Lo.Val. Eq. Hi.Mom.
Eq. Lo.Mom. Eq. Hi.Vol. Eq. Lo.Vol.
Government bonds
Credits Equities
Equities High Value
Equities High
Momentum
Equities Low Volatility
Government bonds
Credits
Equities U.S.
Equities Europe
Equities Japan
1. Traditional strategic asset allocation 2. Traditional break-down in regions 3. Search for skilled managers (alpha)
4. Factor premiums drive alpha 5. Strategically allocate to factor premiums
Figure 1: Strategic allocation based on factor investing
Several large professional investors have
now implemented such an approach. It is
interesting to note that European pension funds
(particularly Dutch and Scandinavian funds)
appear to be leading the field in this area.
This is probably linked to the size and
professional setup of European pension funds.
However, we also see that the U.S. institutional
market is recently catching up.
2 See the work of Ang, Goetzmann and Schaefer in 2009.
Strategic allocation based on factor investing
Source: Robeco.
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CHAPTER 2
The Robeco Philosophy
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Robeco does not claim to have invented factor investing, but it does have a distinctive philosophy about what to do with the idea. The three professors came up with it, but only as a theoretical framework, says Huij. The question is how to bridge the gap between this theory and
the reality of setting up investment vehicles.Robecos philosophy starts with recognizing the statistical evidence supporting
the effectiveness of factor investing. There is a lot of evidence suggesting that this approach is more effective than, for example, just active or passive management, he says.
But it is not enough to be aware that this statistical preference exists. It is even more important to know why it exists, and to incorporate these insights into the investment process. If you really understand what you are doing, this can help you to get more efficient exposure to factors, and to set up a better investment product.
To understand this in practice, lets look closely at one factor: value. Its not exactly a revelation to learn that value investing the idea that cheap
stocks, such as those on a lower than average price earnings ratio, will eventually be rewarded with above-market returns - is popular. The subject is part of the CFA curriculum, and has been studied by academics as noted as Nobel laureate Eugene Fama. There are thousands of studies that show the value effect exists, but if we look at studies of why this is a factor, there are very few, says Huij. If we look at the work of Professor Fama, he shows overwhelming evidence for the existence of the value effect, but only one paragraph about the potential explanation for what he observes.
Robeco believes this leads to some unfortunate practices. As a result of the
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lack of research on why the value effect exists, many people think that risk is the only determinant in deciding a return. They think that they must therefore buy stocks that are cheap, without necessarily observing that some stocks are cheap for a reason, and thinking about what that reason might mean for future performance. If a generic value strategy would be formed at this moment, it would be strongly overweighted financials in southern European countries and real estate, just because these are really risky and their price has gone down a lot, says Huij. People think its all part of the plan: that they must take risk to get a value premium.
Robeco, by contrast, wants to do more than just identify what a factor is. Its Quantitative Research team has studied data for many years, testing for causality rather than correlation, and could not find any proof that taking distress risk automatically leads to compensation in value premium. We could find no causal relationship between taking extra risk and earning the value premium, he says. And that is what we think investors should consider when implementing a value strategy: its not necessary to take a lot of risk to earn that value premium.
The Robeco approach, then, is to develop technology to take out the unrewarded risks and retain the premium. I like to refer to it, says Huij, as efficiently harvesting factor premiums.
Robeco has taken similarly rigorous approaches to other key factors, such as momentum and low-volatility. In momentum which holds that stocks that have been performing well will continue to do so even when fundamentals dont necessarily suggest they should Robeco found that half of the risk intrinsic to a momentum strategy does not contribute to its return, and can
CHAPTER 2
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be stripped out, halving the strategys volatility while retraining returns. In the low-volatility field, which argues that low-risk stocks have higher risk-adjusted returns, Robeco research found that the strategy works particularly well in the most liquid stocks, among other findings.
As the next chapter discusses, the other key element of the Robeco philosophy is good implementation, a process that is different for every client. Robeco offers fully-fledged solutions to investors, including implementation; or sometimes, for sovereign funds, an advisory role on a strategy which the fund itself can then choose to implement. The key, though, is understanding the clients needs and existing portfolio. l
8 Efficient Factor Investing Strategies
Across the board, the improvements in the Sharpe ratios come from both an increase in
return and a decrease in risk. The risk reductions are largely due to avoiding unrewarded
risks, as described earlier. The risk budget that is released by avoiding the unrewarded risks
also enables the efficient approaches to seek higher exposures to the factor premiums (i.e.,
through higher concentration and active share) resulting in higher returns. For instance,
whereas the MSCI Value Weighted index has an active share of only about 25%, the
corresponding figure for the Robeco Value strategy is around 90%.
The returns are also higher because of differences in exposures to other factors. For
example, the MSCI World Value Weighted and the MSCI World Minimum Volatility indexes
both exhibit a negative exposure to the momentum premium, whereas the efficient factor
premium strategies are designed to avoid negative exposures to other factor premiums.
Based on the above results, we can conclude that the added value of our research insights
is sizable.
Confirmed by live track-recordsOur live track-records confirm the added value of Robeco factor strategies. As table 3
shows, our factor funds have not only handsomely outperformed the regular capitalization-
weighted index, but also their corresponding factor indices. We note that these results
would be even better on a risk-adjusted basis, in particular for our low- volatility
(Conservative Equities) strategies, which have lived up to their promise of delivering a much
lower volatility than the capitalization-weighted index.
Table 3. Live performance Robeco factor strategies versus MSCI factor indices
Value all-
country
Momentum all-
country
Low-vol
developed
Low-vol
emerging
Start month Jan 2014 Sep 2012 Oct 2006 Mar 2011
Versus regular index
Robeco 10.58% 18.96% 7.21% 10.30%
MSCI 6.86% 15.18% 4.30% 1.29%
Excess return 3.72% 3.78% 2.91% 9.01%
Versus factor index
Robeco 10.58% 18.96% 7.21% 10.30%
MSCI 6.66% 13.55% 4.63% 7.68%
Excess return 3.92% 5.40% 2.57% 2.62%
Source: Robeco, MSCI. Returns are gross of fees and annualized for periods longer than 12 months. Base currency: EUR. Data through 30 June 2014. Strategies are: Robeco Quantitative Value, Robeco Momentum and Robeco Conservative Equities. Indices are MSCI Value-Weighted, MSCI Momentum and MSCI Minimum Volatility (net return). The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
8 Efficient Factor Investing Strategies
Across the board, the improvements in the Sharpe ratios come from both an increase in
return and a decrease in risk. The risk reductions are largely due to avoiding unrewarded
risks, as described earlier. The risk budget that is released by avoiding the unrewarded risks
also enables the efficient approaches to seek higher exposures to the factor premiums (i.e.,
through higher concentration and active share) resulting in higher returns. For instance,
whereas the MSCI Value Weighted index has an active share of only about 25%, the
corresponding figure for the Robeco Value strategy is around 90%.
The returns are also higher because of differences in exposures to other factors. For
example, the MSCI World Value Weighted and the MSCI World Minimum Volatility indexes
both exhibit a negative exposure to the momentum premium, whereas the efficient factor
premium strategies are designed to avoid negative exposures to other factor premiums.
Based on the above results, we can conclude that the added value of our research insights
is sizable.
Confirmed by live track-recordsOur live track-records confirm the added value of Robeco factor strategies. As table 3
shows, our factor funds have not only handsomely outperformed the regular capitalization-
weighted index, but also their corresponding factor indices. We note that these results
would be even better on a risk-adjusted basis, in particular for our low- volatility
(Conservative Equities) strategies, which have lived up to their promise of delivering a much
lower volatility than the capitalization-weighted index.
Table 3. Live performance Robeco factor strategies versus MSCI factor indices
Value all-
country
Momentum all-
country
Low-vol
developed
Low-vol
emerging
Start month Jan 2014 Sep 2012 Oct 2006 Mar 2011
Versus regular index
Robeco 10.58% 18.96% 7.21% 10.30%
MSCI 6.86% 15.18% 4.30% 1.29%
Excess return 3.72% 3.78% 2.91% 9.01%
Versus factor index
Robeco 10.58% 18.96% 7.21% 10.30%
MSCI 6.66% 13.55% 4.63% 7.68%
Excess return 3.92% 5.40% 2.57% 2.62%
Source: Robeco, MSCI. Returns are gross of fees and annualized for periods longer than 12 months. Base currency: EUR. Data through 30 June 2014. Strategies are: Robeco Quantitative Value, Robeco Momentum and Robeco Conservative Equities. Indices are MSCI Value-Weighted, MSCI Momentum and MSCI Minimum Volatility (net return). The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
Live performance Robeco factor strategies versus MSCI factor indices
Source: Robeco, MSCI. Returns are gross of fees and annualized for periods longer than 12 months. Base currency: EUR. Data through 30 June 2014. Strategies are: Robeco Quantitative Value, Robeco Momentum and Robeco Conservative Equities. Indices are MSCI Value-Weighted, MSCI Momentum and MSCI Minimum Volatility (net return).The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
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CHAPTER 3
Concept to Implementation
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Concept to Implementation
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Once a client has accepted that factor investing would be useful, how does it go about implementing it?We dont believe there is one optimal solution or allocation for all investors, says Huij. We think two things should be taken into account when constructing a factoring solution.
The first is the preferences of the individual investor. For example, we see big differences between the preferences of pension funds and sovereign wealth funds, Huij says. Pension funds are worried about coverage ratios, liabilities, and have a relatively shorter time horizon; sovereign wealth funds have different risks to worry about, such as inflation. First you have to identify which factors are relevant, and then come up with the optimal weights.
The second is knowing whats already there. Something thats often ignored is the exposure an investor already has in his or her portfolio, says Huij. If a sovereign wealth fund already has exposure to value, why add value investing in the solution you create for an investor?
Robeco gets around this danger of overlap with the software it has developed. Through it, it can work with clients, monitor exposures throughout the portfolio, and make recommendations accordingly. We can build around the exposures they already have in place. This is the way factor investing portfolios should be built: referencing the exposures that are already there.
Robeco has tested a wide range of different combinations of factors. An equally-weighted model, for example, would put one third each into value, momentum and low-volatility strategies. A maximum return model, for an investor more concerned about outright returns than matching
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liabilities, for example, would ignore low-volatility and instead split the allocation between value and momentum. A pension fund, which has to worry about coverage ratios, might favour a minimum volatility model. A risk-weighted model could be 30% apiece in value and momentum, and
40% in low volatility. Robeco has tested all of these models and found each of them delivers both outright outperformance and just as important considerably improved returns relative to volatility. The conclusion is that factor investing should be beneficial in any interpretation, but that there is no single optimal factor-investing portfolio that will fit every investor.
Factoring is, chiefly, an institutional story because of this need for customization, but some of the ideas within it can be applied to retail. Robeco, for example, has created a product solution which brings together some of the flavors that appear most frequently in factor investing. That is offered to retail and wholesale investors, says Huij. But the main target audience will remain large institutions.
As it has worked with institutions, Robeco has learned that there is a lot to be gained from the approach. As we have performed many factor scans with large institutions, it is quite intriguing, says Huij. There
CHAPTER 3
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are typically very big differences between what is optimal and what they actually have. It comes down to implementing the solution, and allowing them to change their exposures to what the optimal should be for that client. That suggests a great deal of opportunity for institutional investors to benefit from this exciting and rigorous investment approach. l
9 Efficient Factor Investing Strategies
Finally, we consider various approaches to constructing factor-premium portfolios. Table
4 below shows the performance of different combinations of the value, momentum and
low- volatility factors. We consider an equally-weighted (1/N) portfolio, a maximum-return
portfolio, a minimum-volatility portfolio and a risk-weighted portfolio. For the maximum-
return portfolio we take a fifty-fifty combination of value and momentum, assuming that
these factors have the highest future expected return. The minimum-volatility portfolio is
fully invested in the low-volatility factor. The risk-weighted portfolio weighs the individual
factor strategies by the inverse of their long-term volatility, thereby establishing equal
risk contributions. In unreported tests, we constructed several other portfolios, including
portfolios optimized in-sample for maximum Sharpe ratio or maximum information ratio.
Table 4. Portfolio performance of different combinations of efficient factor strategies
Equally
weighted
Maximum
return
Minimum
volatility
Risk
weighted
Absolute
Return 12.9% 13.2% 12.2% 12.8%
Volatility 13.5% 14.8% 11.6% 13.3%
Return/volatility 0.95 0.89 1.05 0.96
Relative
Outperformance 5.3% 5.6% 4.5% 5.2%
Tracking error 4.9% 4.7% 7.1% 5.1%
Information ratio 1.06 1.19 0.64 1.02
Factor allocation
Value+ 33.3% 50% - 30.1%
Momentum+ 33.3% 50% - 30.0%
Low-volatility+ 33.3% - 100% 39.9%
Source: Robeco, MSCI. Average returns are calculated geometrically. Sample period: 1988:05-2013:12. Base currency: USD. Based on simulations.
Basically, for all of the portfolios that we considered, we observe an improvement of the
return/volatility ratio from 0.5 for the market portfolio to roughly 0.9 to 1.1 for the various
factor-premium portfolios. While the performance improvement is significant in all cases,
we observe substantial differences in returns, volatilities, and tracking errors across the
alternative factor premium portfolios. For example, the minimum-volatility portfolio has
the lowest absolute volatility, but also the highest tracking error. The maximum-return
portfolio, on the other hand, has the highest absolute volatility, but also the lowest tracking
error. We conclude that factor investing is beneficial in the long run in all of the cases that
we examined. There is, however, no single optimal factor-investing portfolio.
Combining factors
Factor investing is beneficial in the long run
in all of the cases
9 Efficient Factor Investing Strategies
Finally, we consider various approaches to constructing factor-premium portfolios. Table
4 below shows the performance of different combinations of the value, momentum and
low- volatility factors. We consider an equally-weighted (1/N) portfolio, a maximum-return
portfolio, a minimum-volatility portfolio and a risk-weighted portfolio. For the maximum-
return portfolio we take a fifty-fifty combination of value and momentum, assuming that
these factors have the highest future expected return. The minimum-volatility portfolio is
fully invested in the low-volatility factor. The risk-weighted portfolio weighs the individual
factor strategies by the inverse of their long-term volatility, thereby establishing equal
risk contributions. In unreported tests, we constructed several other portfolios, including
portfolios optimized in-sample for maximum Sharpe ratio or maximum information ratio.
Table 4. Portfolio performance of different combinations of efficient factor strategies
Equally
weighted
Maximum
return
Minimum
volatility
Risk
weighted
Absolute
Return 12.9% 13.2% 12.2% 12.8%
Volatility 13.5% 14.8% 11.6% 13.3%
Return/volatility 0.95 0.89 1.05 0.96
Relative
Outperformance 5.3% 5.6% 4.5% 5.2%
Tracking error 4.9% 4.7% 7.1% 5.1%
Information ratio 1.06 1.19 0.64 1.02
Factor allocation
Value+ 33.3% 50% - 30.1%
Momentum+ 33.3% 50% - 30.0%
Low-volatility+ 33.3% - 100% 39.9%
Source: Robeco, MSCI. Average returns are calculated geometrically. Sample period: 1988:05-2013:12. Base currency: USD. Based on simulations.
Basically, for all of the portfolios that we considered, we observe an improvement of the
return/volatility ratio from 0.5 for the market portfolio to roughly 0.9 to 1.1 for the various
factor-premium portfolios. While the performance improvement is significant in all cases,
we observe substantial differences in returns, volatilities, and tracking errors across the
alternative factor premium portfolios. For example, the minimum-volatility portfolio has
the lowest absolute volatility, but also the highest tracking error. The maximum-return
portfolio, on the other hand, has the highest absolute volatility, but also the lowest tracking
error. We conclude that factor investing is beneficial in the long run in all of the cases that
we examined. There is, however, no single optimal factor-investing portfolio.
Combining factors
Factor investing is beneficial in the long run
in all of the cases
Performance of different combinations of efficient factor strategies
Source: Robeco, MSCI. Average returns are calculated geometrically. Sample period: 1988:05-2013:12. Base currency: USD. Based on simulations.The value of your investments may fluctuate. Results obtained in the past are no guarantee for the future.
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There is considerable evidence that factors work; now, this research is being accompanied by investment strategies that take advantage. Institutional investors can, through factor investing, avoid risks that dont reward them with returns. Instead, they can
gain market-beating premiums for the lowest possible amount of risk. As more and more investors realize the advantages of factor investing, we should expect to see them implement its lessons not just as an afterthought but a top-down matter of overall investment strategy.
Contact InformationIf you would like to know more about factor investing or the solutions that Robeco offers, please visit www.robeco.com/factorinvesting where you can also find information on your local contact persons.
Important informationThis statement is intended for professional investors. Robeco Institutional Asset Management B.V. has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam.
Neither information nor any opinion expressed in this document constitutes a solicitation, an offer or a recommendation to buy, sell or dispose of any investment, to engage in any other transaction or to provide any investment advice or service.
Summary
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About Robeco
Robeco is a global asset manager offering a wide range of investment products and solutions to institutions and individual investors. Robeco believes in quantitative research, sustainability and adding value for clients through constant
innovation.Headquartered in Rotterdam, the Netherlands, Robeco has offices in
13 countries across Europe, the US, Middle East and Asia Pacific with key investment centers located in Rotterdam, Zurich, Boston, New York and Hong Kong.
As at 31 December 2014 Robeco managed over EUR 245 billion.
Robeco and Team Brunel - pioneers with a passion for dataThere are many parallels between sailing around the world and
successful investing. Both combine technical know-how with careful risk management. And both require teamwork to win over the long term. That is why Robeco was delighted to become sponsor of Team Brunel, the Dutch entry in the Volvo Ocean Race 2014-15. This round-the-world race has eight boats competing. It will take nine months to complete this epic voyage, calling at nine stopover ports along the route. The sponsorship is a natural fit.
A pioneering spirit has long been embedded in Robecos DNA. We were the first to take sustainability investing seriously, among the
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About Robeco (continued)
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Video: Robeco and Team Brunel
18 Institutional Investor eBook Sponsored by Robeco April 2015
first to invest in emerging markets and one of the original users of quantitative investing models. There is a particular similarity between factor investing and this race. In order to win, a sailor has many options. For example, to follow a different route to the rest of the fleet.In factor investing, it can also benefit you to move away from the crowd, in this case the market. Doing things differently can pay off. l