factor investing in credits: research, …...contents part i – kirstein nordic survey on factor...

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


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.


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.


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.


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.


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.


‘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


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.


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.


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.


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.


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.


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


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.


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.


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.


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.


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.



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



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.



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 I

Research on and implementation of factor investing in credits


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’



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.



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.



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



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%



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.



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’



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.


PART I I I

Customization and client cases


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’



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



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



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


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. To the extent this information qualifies as a reasonable and appropriate minor non-monetary benefit under MiFID II, users that provide investment services in the European Union are responsible to comply with applicable recordkeeping and disclosure requirements. The content of this document is based upon sources of information believed to be reliable and comes without warranties of any kind. Without further explanation this document cannot be considered complete. Any opinions, estimates or forecasts may be changed at any time without prior warning. If in doubt, please seek independent advice. It is intended to provide the professional investor with general information on Robeco’s specific capabilities, but has not been prepared by Robeco as investment research and does not constitute an investment recommendation or advice to buy or sell certain securities or investment products and/or to adopt any investment strategy and/or legal, accounting or tax advice. All rights relating to the information in this document are and will remain the property of Robeco. This material may not be copied or used with the public. No part of this document may be reproduced, or published in any form or by any means without Robeco’s prior written permission. Investment involves risks. Before investing, please note the initial capital is not guaranteed. Investors should ensure that they fully understand the risk associated with any Robeco product or service offered in their country of domicile (“Funds”). Investors should also consider their own investment objective and risk tolerance level. Historical returns are provided for illustrative purposes only. The price of units may go down as well as up and the past performance is not indicative of future performance. 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Version Q1/18


ContactRobeco

P.O. Box 973

3000 AZ Rotterdam

The Netherlands

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Kirstein

Casper Hammerich [email protected]

Robeco

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Stefan Laszlo [email protected]