Beneath the tranquil surface
German institutional investment patterns have shifted fundamentally in the last two years, a result of both declining equity markets and a series of strategic decisions by institutional plan sponsors. Spring 2002 interviews by Greenwich Associates with more than 200 of the largest sponsors of Spezialfonds and other external asset mandates across Germany reveal major reductions in allocations to equities and a reversal of a once-strong trend of adding new managers to institutional rolls.
The average amount of assets under management in a typical German fund is E3.4bn, a figure unchanged from our last major German pension study two years ago, but beneath that seemingly-tranquil surface, our research reveals massive movements between asset classes. Partly as a result of the declines in the stock markets, partly as result of consequent shifts in their investment policies, German institutions have executed an abrupt about-face in terms of what had been an increasing reliance on equities.
Specifically, as depicted in the table below, the proportion of European stocks in the average institutional portfolio fell from 22% to 16% between our last study (which recorded year-end 1999 data) and this study (recording data as of year-end 2001). Even more radically, the proportion of total equities went from 27% to 19% – a huge shift in such a relatively short time.
Not surprisingly, the chief beneficiaries of this move have been bonds and cash. European bond allocations jumped from 53% of total assets at the end of 1999 to 57% at the end of 2001, and international bonds from 2% to 3%, for a total increase from 55% to 60%. Over the same period, cash holdings soared in relative terms, from 4% to 9%.
Equally striking are the asset allocation shifts managers of these institutions expect to make by 2004. As can be seen in the graphic above, they expect a very substantial decrease in cash holdings, thereby reverting their recent ‘defensive’ allocations. Furthermore, they expect to continue big increases in their use of bonds. With regard to equities, they expect to raise their stakes in North American and other international equities while at the same time further reducing their European equity portfolios.
Twice as many institutions expect to reduce their allocations to active European equities by 2004 as expect it to rise. On the passive side, our 2002 research shows that as many expect a rise as expect a fall; but since the passive allocation is only 2% of total assets, and the active component 14%, the overall direction is clearly down.
Far more institutions expect their use of non-European equities in general, and North American equities in particular, to rise than expect it to fall. Since these allocations currently represent just 3% of total assets combined, such long-term increases reflect a decision by German sponsors to more closely align their allocations to prevailing market capitalisations.
The great majority of German institutions also expect much of their cash to be invested by 2004; those expecting their cash allocation to be lower outnumber those expecting the contrary by better than four to one.
By a margin of better than three to one, more institutional investors expect their allocations to real estate will rise rather than fall in the next two years. As with international allocations, though, this will make only a minor change in the overall portfolio mix, since real estate presently accounts for only 4%.
Much the same applies to German allocations to private equity and hedge funds. More than 20% of institutions expect these to increase, and virtually none expect the contrary – but present allocations are only 1% of total assets for the former, and less than that for the latter. What is behind these shifts in expectations, which must represent shifts in investment policies? We believe there are four principal factors:
The basic shift from equities to bonds is largely driven by the precipitous declines in stock values over the last two years, while total returns on bonds have remained substantial and, thanks to the low rate of inflation, substantive. It also reflects a response to the volatility of the equity markets – a flight to the relative security of fixed-income securities, particularly for those with limited time horizons.
It is noteworthy that German institutions’ interest in non-European securities is nevertheless rising. More than anything else, this reflects the fact that many of these institutions have been relatively late in diversifying into North American and Asian markets, which respectively represent only 2% and 1% of their assets at present. Until quite recently, our research regularly showed that they were generally reluctant to invest outside Germany, but in the past few years they have gone heavily into other European securities, and now they plan to catch up in other key economic areas.
The increased interest in real estate also represents, primarily, the desire to diversify, though there is also a feeling real estate offers more short-term stability than stocks.
One sector getting a great deal of interest from German institutions is private equity and hedge funds. The attraction of hedge funds is clear – investment strategies that take short as well as long positions have another weapon in their investment-return arsenal, one particularly potent in markets where so many stocks have declined.
Private equity investments likewise offer the chance for disproportionate returns, but present their own challenges as finding opportunities and analysing them sufficiently to make investment decisions takes a lot of time and effort.
One response to such challenges, both in private equity and hedge fund investment, is to rely on fund-of-fund structures – an approach being taken by a significant number of German institutions. Investment via the fund-of-fund vehicle reduces the reliance on the expertise of any single firm, and helps spread overall investment risk.
Although German sponsors no longer plan to expand their rosters of investment managers, they are still hiring vigorously – but firing still more vigorously, creating something of a churning pattern reflected in our research by the disparity between overall average-number-of-managers data and the hiring and switching activities revealed by specific types of funds.
Across all segments, German sponsors now use an average of 5.8 external managers—unchanged from 1999. But as can be seen in the graphic below, there have been sizable shifts in the average roster size of managers across specific types of funds over the two-year span measured in our data. Corporate pension fund managers have reduced the average number of managers they employ from 6.0 to 5.3, insurance companies have reduced their rolls from 6.3 to 5.6, and churches and foundations have cut back from 9.0 to 7.7. Offsetting that, public pension funds have increased their average number of managers from 5.7 to 6.2, while savings banks have increased theirs from 3.5 to 4.2.
There is a significant reduction in the overall number of external investment firms sponsors expect to use in the future. Whereas two years ago they were expecting to be using an average of 6.2 outside managers, the expectation now is for an average of 5.9, almost identical to the 5.8 firms they use now.
As many as 40% of German institutions have hired a new manager in 2002, but this hiring activity is increasingly dominated by switches rather than new hires – with as many as 69% of German institutions terminating a manager and hiring a new one in the same year.
As many as 33% of sponsors, up from just 17% two years ago, have fired a manager within the past 12 months. Savings banks and public and industry pension funds have been most decisive in this regard, with 40% of the former and 37% of the latter both terminating a manager, in both cases up from only 19% doing so two years ago.
The majority of the casualties in Germany have been balanced managers. As many as 19% of funds, up from only 6% two years ago, have recently terminated this type of manager.
By much the same token, hiring of managers in Germany these days is almost entirely on the specialist side. As many as 34% of sponsors have hired a specialty manager this year, up from 27% two years ago, and 38% expect to hire one in the near- or medium-term future. By contrast, only 10% of funds have hired a balanced manager last year, and only 12% are expecting to do so. While the disenchantment with balanced management may not be as deep in Germany as it is in the UK, there is clearly a shift away from the balanced concept of investment management which had been in vogue in both countries.
It has been a time of transition for the German pension community in other ways as well. Recent market movements are not only causing changes in German institutions’ asset allocations, but also in the way they organise the management of their investments. To some extent, these shifts also reflect change in perception of the value of outside managers. The key difference: a generalised reduction in the proportion of their assets managed externally, from 32% of the total to 28%; related to the decline in equity asset values, this results in an average decrease in externally managed portfolios of no less than 14%.
Where corporate pension funds had 52% of their assets externally managed in Spezialfonds or other discretionary mandates two years ago, our research shows that they now have 48%. Where public and industry funds had 54%, they now have 45%. At insurance companies, the decline is from 22% to 18%.
However, two counter trends are also worth noting. Corporate and public/industry pension funds are shifting a growing proportion of externally managed assets into mutual funds and other commingled or pooled vehicles, with as much as 8% of corporate pension funds now in this type of investment, and 4% of the assets of public and industry funds. Secondly, savings banks, churches, and foundations have increased their use of external asset management. At savings banks, usage of externally managed Spezialfonds and other discretionary mandates is up from 22% of total assets two years ago to 27% now. Among churches and foundations, such usage is up from 56% to 63%, and these institutions also have 2% of their totals in mutual funds and similar types of investment.
Such transitioning has had an effect on the competitive landscape of the market as well. As in previous Greenwich research, the market penetration of most ‘establishment’ firms, Deutsche Asset Management being an exception, is continuing to erode. The chief beneficiaries of this trend have been smaller firms, several of them foreign, which are perceived by many clients to be offering particularly high-quality service. It remains to be seen whether these firms will continue to gain share. Typically, the qualitative leaders in each of our prior studies have proven unable to sustain such qualitative superiority from one year to the next.
Three additional points about investment management organisation in Germany should be noted:
Sponsor use of Master Kapitalanlagegesellschaften KAGs is going to rise sharply. Our 2002 study shows that where 13% of German institutions use these vehicles now, an additional 14% expect to concentrate their existing KAGs in Master KAGs in the next 12 months. Large insurance companies are particularly active in this respect, and demand is also very strong at pension funds: 20% of public and industry funds, and 14% of corporate pension funds, are expecting to put a Master KAG in place shortly.
Our research also reveals a number of noteworthy changes in the criteria upon which sponsors base their selection of new investment managers, with the trend being to place much more emphasis on client service. Thus, whereas the capabilities of prospective managers’ investment professionals was a leading criterion in Germany for the past decade, it has now dropped to fifth place, behind such factors as managers’ understanding of client goals and objectives.
Fewer managers are making new business development presentations. Solicitations are down sharply, with sponsors receiving an average of only 5.5 this year, in contrast to 7.4 two years ago. This may be partly due to the recent poor performance of the markets, which leave many managers with little to boast about; partly due to sponsors’ shift from equities into fixed income, which more institutions manage internally; and partly due to the extensive reorganisations and some mergers of almost all the leading German KAGs, which have dampened the marketing efforts of these managers.
From several viewpoints, methods and strategies of German plan sponsors are strikingly different from those of pension funds in other European nations.
Where German institutions had just under 20% of their total assets in equities at the end of 2001, the average for other continental institutions was 30%, and for UK pension funds – despite a continuing decrease – close to 70%.
German institutions are not adding to their rosters of external managers, but still use more external managers than investors in other European markets. Institutions on the rest of the continent more generally expect to expand their use of external asset managers, and – like those in Germany – to focus on the specialty side. In the UK, too, use of specialty managers continues to rise, but very few sponsors are expecting to hire balanced managers.
Berndt Perl and Chris McNickle are consultants for Greenwich Associates who specialise advising fund managers in Europe