A change for the better

Investment by German institutions today is a far cry from where it was at the turn of the century when equities were being pushed up towards their 30% limits and conservative institutional Germany was beginning to get bullish about what the stock market could do for its pensions.
Their timing, perhaps, could not have been worse. After years of being told that they should rack up their share quotas and surf the buoyant returns, many German investors did just that in 1999/2000 – timing the market crash almost perfectly – with some hit by significant losses.
As Bettina Nürk, institutional director at DekaBank in Frankfurt points out, the fall-out has been dramatic: “I would say that on average pension funds and insurance companies would have something like 10% in equities today, certainly no more than that.
However, as Claus Sendelbach, director at DekaBank, points out: “That would be their total equity position, but half of that is likely to be hedged, so the open equity position would be more like 5-6%.
“Two years ago we talked about 30% equity figures and the discussion was about opening up our 30% frontier!”
However, Rainer Schröder, managing director and head of sales at Invesco in Frankfurt, argues that not all pension funds may have been so loose with their risk budgeting: “There is no doubt that there has been a reduction in equities, but the degree to which this has happened differs from one institution to the next.
“Those who were more careful with their risk budgets before the market dropped very often did not reduce. Others had to reduce to a very high degree or limit their exposure with hedging strategies to make sure that the fund does not go below a defined threshold.”
The irony is, of course, that those that held on to equities, notably domestic shares, will have been well rewarded by the performance figures of the year to date.
For insurance companies, however, these equity limits are deemed to have dropped even lower, particularly after the collapse of German insurer Mannheimer and the intervention of German regulator Bafin to suggest equity investment limitations.
Fortunately, Germany is virtually unaffected by the issue of pension underfunding that has gripped the Anglo-Saxon world (there are after all very few pure pension funds). But as Christian Wrede, CEO at Frankfurt-based AXA Investment Managers (AXA IM), notes, there has been an ‘awakening’ in Germany that there could be serious problems if pension plans do not meet their investment targets.
These targets, that now look like relics from a golden age, often stand at around 6% to 7% per annum, although some insurance companies have been through the publicity mill of having to revise these down to between 4% and 5%. Pension plans are under pressure to deliver the same kinds of returns and, with equities under pressure, need to source higher yields to do so.
Sabine Vlieghe, director institutional advisory at AXA IM, believes some of this is coming through a switch in the equity product mix with institutions ratcheting up their European small cap exposure or swapping passive strategies for ‘enhanced’ approaches - particularly amongst the larger funds.
Indeed, Wolfgang Hötzendorfer, managing director at State Street Global Advisors in Munich, says that something like 15% of their index business today in Germany is run via enhanced mandates.
As elsewhere in Europe though, much of the excess allocation has gone towards bonds, as Wrede notes: “The switch to bonds will remain appealing to investors in Germany in need of a steady stream of income and who have a liability matching need.”
How far German institutions go in pursuit of this income stream appears to be a function of size and experience though.
European and overseas corporate bond exposure has certainly been an increased focus for institutions across the board.
But as State Street’s Hötzendorfer, points out, further shifts down the risk spectrum will not be the choice of all: “In our experience large industrial companies would be looking, for example, at non investment grade and high yield exposure, whereas standard pension funds will stick to investment grade.”
Schröder at Invesco agrees: “The need for yield has led to more pronounced moves into fixed income and in a few cases sub investment grade or emerging market mandates amongst the bigger funds”.
Conversely, however, a number of investment managers also point out that traditionally conservative German investors have also returned in numbers to secure fixed income investments such as Namenspapier, Pfandbriefe and Shuldschein.
Peter Schwicht, managing director at JPMorgan Fleming Asset Management in Frankfurt, comments: “It’s a question of risk aversion. The danger of underperformance is almost zero because most of this is trading at 100, although, of course the economic risk remains.”
Achim Küssner, managing director at Merrill Lynch Investment Managers (MLIM) in Frankfurt, adds that capital guarantee products – be they equity or bond – are also generating significant interest.
“The area of capital guarantee products is not always easy to define as it can mean total return funds for equity or cash and involve the use of derivatives, etc.
“The bottom line though is that clients want to pay for protection. “We can also now offer this in a bond form with a CPPi product and institutions are increasingly asking for this, even if it is more expensive. Clients have gained experience in the last three years and some are seeking security first before they talk about how much equity or bond exposure they want.” The other asset class where German institutional interest has had something of renaissance in the last year or so has been property.
Vlieghe at AXA IM likens growth in the real estate arena to the rise of a “phoenix from the ashes”.
“Property is being recognised again by investors disillusioned with the performance of equity. Many would now have some direct and indirect exposure and consider it as a real separate asset class.”

This comes despite some of the leanest times in the German real estate market – a factor acknowledged by Sendelbach at Deka Bank – one of Germany’s largest real estate houses.
“I have the impression that a lot of the reallocation by German investors was directed towards real estate. We certainly have a lot of insurance companies and pension funds that are asking us for exposure and we are receiving a lot of consultant questionnaires for this asset class.
“However, for the most part we are not selling access in the German market because the cash position we are holding in our funds due to current market conditions is too high for most pension plans.
“It is interesting though because the institutional real estate scene in Germany almost died during the bull market. There were discussions amongst many firms about whether to close their shops for real estate because no-one was interested.”
Schwicht at JP Morgan sees an opportunity within this re-evaluation of bricks and mortar to persuade German institutions that they might look further afield for exposure.
“To date appetite for non-European real estate has been very low, although we think there is future potential, for example in the US Reits market and I think we have to continue educating investors in this area.”
Another area where asset managers are eyeing up future potential is in hedge funds. A change to German law from January 2004 will ease the possibility for institutional and retail investors to gain exposure to hedge strategies, as Schröder at Invesco explains: “The main problem with hedge fund investment until now was that the most attractive vehicle for German institutional investment – the Spezialfond – was not allowed to be set up as a hedge fund.
“The main difference for institutions is that this will change under the new law. There’s no change in the maximum amount that pension plans can invest in hedge funds, but it will be much easier to do than before.”
While German investors are not expected to stream into the asset class from January 1, the issue is near the top of the product agenda for most asset managers in the market.
Hötzendorfer at State Street comments: “We are having discussions in a number of client meetings about hedge funds and it will certainly be one of the hot topics at conferences next year. You might start seeing hedge funds included as a satellite exposure because even small pension funds are looking at it as an asset class.
“I certainly expect new managers to come into this market looking for hedge fund business.”
Vlieghe at AXA IM says the area of hedge funds and alternative assets has appealed to top end German institutions in need of greater flexibility over the last few years and agrees that this looks to broaden in the coming years.
“Hedge funds have been on offer in the German market but because they come under the foreign investment law they were heavily penalised from a fiscal perspective.
“A number of managers are jumping on that bandwagon now and setting up hedge fund companies because the term absolute return has become a bit like a mantra in Germany today.”
Martin Theisinger, managing director at Schroders in Frankfurt urges a degree of caution, however.
“I think we need to see the full legal and fiscal detail before launching any hedge fund product in Germany. But if these two issues are cleared up satisfactorily then I do see a rush of investors into the asset class.
“Many smarter institutions have done this already through offshore vehicles so they know the risks and advantages.” Theisinger says he certainly expects to see more volume going towards alternative assets, noting that German consultant Feri Trust had recommended that some 15% of assets be placed in alternatives including real estate.
Private equity, Wrede at Axa IM notes, is still around in German institutional portfolios, but unlikely to represent more than 1-2% of assets.
“The lack of income stream is hampering any moves at present to private equity and maybe even 1-2% would be on the optimistic side for any pension fund.”

The potential shift to alternatives would suggest that Germany is experiencing the same core/satellite undercurrent as many other European institutional markets. The potential shift to alternatives would suggest that Germany is experiencing the same core/satellite undercurrent as many other European institutional markets. However Küssner at MLIM says it is difficult to describe the change as a pure move to core/satellite.
“There has certainly been a growth in specialisation and increased business wins for foreign managers facilitated by the master KAG structure and the change in the German KAG advisory law.
“Investors were disappointed with the performance of some of the domestic managers, the old Hausbank type arrangements, and also had the burden of duplication in reporting lines from different managers. This happened at the same time as they were seeking more diversification.”
Josef Kaesmeier, managing director at Munich-based Merck Finck Invest, however, believes that the specialist move is not so clear cut and could actually reveal something of a schism in the way the German institutional market is shaping up.
“Larger German institutions are no doubt specialising and focusing on investment through a master KAG with a single custodian etc.
“However, we find a lot of smaller clients who do not have billions to invest, those with say e500m in assets, and who are still thinking about hiring three or four balanced managers and don’t have a problem with three or four different KAGs and custodians.
“This contrasts with two or three years ago when everyone seemed to be going down the specialist route and looking at growth versus value strategies. After that our typical ‘mittelstand’ client was coming back to us and saying that actually a balanced portfolio served them best, perhaps with fewer equities and more diversification within the portfolio. They don’t want to deal with separate managers who might cause problems with performance in different years.”
Wolfgang Lotze, director at Siemens Financial Services in Munich also scents opportunity in an opening market.
“There is definitely a high level of frustration with current asset managers. A recent survey asked companies whether they would select the same asset managers again and 70% said no.
“I think we have an advantage in that we have the experience of working with Siemens’ various global pension plans, while in Germany we also have the experience of talking to some of the smaller/ mid size plans in the country that the foreign asset managers don’t tend to approach. Our core strengths are in European equities, bonds and tactical asset allocation, but on top of that we can offer services along the value chain such as legal and tax issues.
“Another area where you have to look closely in Germany is at cost/income ratios for asset managers. You have to ask how many asset managers are actually making money here, which if you are a plan sponsor is something you might want think twice about to ensure your manager is going to remain in the market.”
Nonetheless, while the trend to specialisation and the influx of foreign managers into Frankfurt and Munich has undoubtedly hurt the large German banks, they still control the market by a long shot.
Andreas Krebs, head of consultant relations and vice president at Cominvest in Frankfurt acknowledges the challenge, but believes that the large German houses are now better placed to defend their home turf.
“The German players have refocused and are reshaping their profiles because we all had to face the fact that in the last two years it was easier for foreign competitors to come into the market.
“With the advent of specialisation and the opening up of markets it’s become obvious to institutions that there are experts in certain asset classes such as emerging market debt that you can now hire from anywhere in the world!
“We did our homework though, honed our product ranges and became more professional I believe. The foreign houses will have times of reshaping their businesses also and it is probable that investors will then come back to the familiarity of the German houses. At the same time we are also trying to make our own in-roads into other markets as well.”
Krebs also notes that the drive to professionalism in Germany has been fuelled by the increased prominence of investment consultants in the market.
“We’ve seen the big breakthrough for investment consultants in the last year, which is a good sign. In the first six months of 2003 Germany was a consultant driven market place, which means that levels of competition and transparency are much closer to the Anglo-Saxon model.”
Theisinger at Schroders adds that the rise of the consultants is also having a marked effect on the way fees are being structured in
Germany – a traditionally grey area.
“Consultants are telling clients that if they want certain asset classes and levels of service they will have to pay for it.
“In specialist mandates our experience is quite promising because people are prepared to pay higher fees – not the 70 basis points (bps) that a UK, Dutch or US investor might pay, but maybe 50 bps which is feasible and better than three years ago.”
Schröder at Invesco adds: “As result of consultant influence it has become easier to convince clients where any hidden pricing components are in Germany. They have offered price transparency studies and told investors to look where their asset managers make their money, and why, for example, the fee for an active equity fund cannot be 10 basis points unless you win something from the transactions.”
The increasing prominence of advisers in Germany has also undoubtedly kicked the door open for the mainstreaming of ALM studies and a broadening of the universe of managers as far as differentiating between styles, etc.
At the same time it is becoming a highly competitive market in its own right.
Four to five big German players including Feri Trust, RMC, Seil and Alpha Portfolio Advisors currently control the market and have seen business boom in recent times, as Hötzendorfer at State Street attests: “Around 50% of our business is now coming through the consultancy channel. They are doing ALM work and recommending portfolio construction and asset managers.”
Another phenomenon – the one-man-band consultancy – has also started to spring up in Germany, predominantly as a result of the shake out of senior people from the investment management industry.
However, the major international consultants have had trouble penetrating the market to date and have yo-yo’d in and out of Germany over the years.
That may be about to change though. The recent defection of an advisory team from Towers Perrin to Mercer signalled a significant beefing up of presence in the German market for the latter.
This comes at a time when there has been talk in the market that some of the local advisors may be overreaching themselves by trying to juggle ALM work, asset allocation advice and manager selection with a raft of other investment and funds services.
Many are waiting to see what the reaction to Mercer’s move will be amongst the other major international consulting names.
Schwicht at JPMorgan flags up another interesting development in the advisory market – the increasing presence of the ‘e-consultants’.
“I think managers are going to have to look into this a lot more because it changes the dynamic in that the process becomes purely quantitative for asset managers. At the same time though it is adding more credence to the idea of a global investment village and increasing the possibilities for houses to manage outside their home market. We need to take this very seriously.”
The burgeoning advisory market suggests that the prospects for the German investment management market remain as important as ever, despite the acceptance by most that the much trailed Riester pension reforms have been more of a damp squib than the great multi billion euro asset shower expected.
As one manager jokes: “Riester was a typical German product – a perfect idea but much too complicated!”
While most managers applaud the endeavour by the German government to broach the question of greater individual savings – moving towards DC arrangements and away from the overburdened pay-as-you-go system, many feel that Riester might go through several variations, or even some kind of compulsion before it can really be judged a success. A significant number believe that Germany is in need of some kind of 401k type pension savings arrangement before it can truly relieve itself of some of the heavy baggage of state pension provision.
“Five or 10 years down the road we will probably say Riester was a valuable move,” says JP Morgan’s Schwicht.
Before then though, German institutions will have to feel their way through a hopeful recovery and decide just exactly what long-term pension investment means for them. The signs are though that the market is developing apace in terms of new infrastructure, products and professionalism and the next year or so will be crucial in determining the direction this will eventually take.
(See Spezialfonds Special Report with this issue.)

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