Equities return to favour
German institutional investors are continuing to adapt their investment behaviour in response to the sharp decline in equity markets since 2000 and increased geopolitical destabilisation since 9/11. In an expression of confidence that monetary policy will engineer a sustained economic recovery, investors are looking to increase their holdings in risky assets such as equities and hedge funds and so to move closer to their medium- to long-term target weightings for these asset classes.
In a survey of the investment processes of the top 500 German pension funds and insurance companies conducted by our firm, the participants with investments in excess of E200bn indicated that they would, in the medium to long term, be reducing bond holdings by 9% to finance a 5% increase in equities and to put an additional 4% into alternative investments, the majority into hedge funds.
The current weightings of over 60% in fixed interest, including corporate bonds, and just under 10% in equities reflect a mix of market movements and disposals of equities related to pro cyclical risk aversion. These disposals were required both by portfolio insurance and by regulatory measures designed to protect solvency.
The intention of investors to slightly reduce a current 6.5% weighting in corporate bonds recognises that credit spreads have come in as far as can be justified, partly in response to institutional demand; inflation has nowhere to go in the longer term but up, taking interest rates and credit spreads with it; and the equity risk premium has been re-established at an attractive level and hence is competitive to corporate bonds.
Four out of five German institutional investors determine a target asset allocation and of these a similar proportion use asset liability modelling techniques to identify the asset mix appropriate to the pension liabilities being funded. The overall volatility of the portfolio returns is restricted by the risk tolerance of the investor. There is an apparent tension between the long duration of the liabilities (10 to 20 years), the time horizon of the strategic asset allocation (12 months to 10 years) and the review period for the strategy (ont month to three years). This demonstrates the importance of a long-term investment strategy that can withstand the near-term reactions of finance directors, trustees and regulators who are concerned that the disruption caused by market movements does not become apparent during their watch.
The expected long-term rate of return on assets of German insurers and pension funds is in the range of
4% -6.5% and averages 5%. This conservative expectation is markedly lower than the 8% average for the 100 largest US corporates in the Milliman Pension Fund Survey 2003.
This is mainly explained by the high proportion of interest bearing assets that German institutional investors have in their target asset allocation at around 75% and by the correspondingly low proportion of 25% held in equities and alternative investments. The numbers are reversed in the US. An additional explanation is that in order to minimise currency risks, only 2% of bond investments and 10% of equity investments are held outside Euroland by German investors and on a like-for-like basis Euroland assets may be expected to offer a lower long-term rate of return than assets elsewhere in Europe or in the US, Japan or emerging markets.
A brief review of how institutional investors have behaved since 2000 reveals how asset classes have moved in and out of favour. In the first phase, the incurred losses in equities gave rise to a higher perceived risk associated with equities which led to further equity disposals. Bonds initially gained a safe-haven risk-free status, but investors realised that they offered insufficient income and that the stimulative monetary policy of central banks threatened capital losses. Going back into equities would involve loss of face and create agency problems, so higher returns were sought in corporate bonds, emerging market debt and high-yield debt. Hedge funds benefited from the investor perception that they offered consistent returns (eg, Libor + 600 bps), but negative associations with the product label have slowed investments. Investors are now recognising that the best protection against bond market losses is equity market gains. It is hard to find two other asset classes that in a market crisis are usually negatively correlated. Investors have come full circle to appreciate the benefits of asset class diversification and are now rebuilding their equity exposure.
German insurers are soon to be permitted by the financial regulator BaFin to invest up to 5% of their assets in hedge funds, subject to certain controlling capabilities. The investor survey, which also covers the various types of German pension plans including Contractual Trust Arrangements (CATs), indicates an intention by investors to increase their weighting in hedge funds from 0.4% to 2.7%, more than a fivefold increase.
While many investors are put off by their lack of experience in this asset class, by the low transparency and by the high fee structures, other investors are attracted by the apparent low correlation of hedge funds with other asset classes offering increased diversification and by the consistency of absolute returns against a money market benchmark. The impression of consistency of hedge fund returns may arise from the limited return history over a period of declining long-term interest rates which has provided a favourable environment for the use of leverage to gear returns and for strategies based on credit spreads, volatility and liquidity. The latter three factor risks are closely interlinked and are used in a number of strategies.
The survivorship bias to hedge fund returns is well recognised but the overstatement of returns and the understatement of volatility in calculating Sharpe ratios may be less widely appreciated. Risk is understated due to stale pricing, which leads to smoothing of the price series, while historical returns may enjoy an upward bias due to the infrequency of extreme events in the left-hand tail of a skewed return distribution.
The survey reveals that investors consider the most promising hedge fund strategies to be in classical arbitrage, namely the relative value, fixed income and convertible arbitrage and long/short hedge strategies. Investors who have gained more experience with hedge funds select a number of single-strategy funds appropriate to their needs, while less-experienced investors accept the higher costs of a hedge fund-of-fund certificate in exchange for a capital guarantee and a minimum return.
Active management remains the dominant investment approach of German institutional investors, despite the high level of costs involved both in respect of management fees and portfolio turnover. More cost efficient approaches, eg, core/satellite combined with passively-managed index components, are used by fewer than 25% of investors. By contrast, the identification of investors with absolute or total return products is increasing. In practice, the requirement for a positive return is often provided by portfolio insurance protection strategies, either built into the product or via the use of dynamic asset allocation in overlay management.
German insurance companies and pension funds manage over half of their assets internally, turning to external managers either for product expertise in hedge funds and private equity or where the active selection of single securities requires substantial global research resources, for example equities, corporate bonds or emerging markets. The Spezialfonds is the preferred vehicle after direct investments, with the use of mutual funds restricted to low volume mandates. Already 20% of survey participants have organised their investments in the form of a Master-KAG and a similar proportion are moving this way. They cite the main advantages of concentrating the administration of all their funds with one institution as: increased transparency from unified reporting and standardised valuation methodology and a reduced risk of capital writedowns given that in-fund diversification over different asset classes can be achieved by segmenting one master-fund into several sub-funds. The master-KAG enables investors to simplify the formulation of overall strategy, to implement overlay strategies and to facilitate the exchange of asset managers.
Particularly the latter benefit has far-reaching implications for German asset management. Historically, barriers to exit from an asset management relationship were high, including punitive tax charges on unrealised capital gains if a fund was closed. The master-KAG has clearly separated the fund administration capability from the investment performance track record of the external asset manager providing advice. In 2002/2003, the survey participants changed nearly three times as many managers as in 1998/1999 and that in spite of a slight recovery in investors‘ satisfaction with their asset managers from the 2001/2002 lowpoint.
The reasons given for this dissatisfaction include underperformance, lack of flexibility, internal reorganisation at the asset managers and high portfolio turnover, while the actual catalysts for changing managers were KAG closures, combination of existing mandates and the introduction of new Master-KAG solutions as well as poor performance and insufficient expertise for the overall mandate. The increased willingness of German institutional investors to change managers creates an opportunity for foreign asset managers with strong investment processes and sound performance track records to penetrate the market.
The survey reveals that institutional board directors and external consultants are primarily involved in deciding on strategy and in selecting managers, whereas the ongoing controlling function is still very much left to the internal department and even to the asset managers themselves. The consequence has been too much focus on compliance with investment guidelines and on the level of investment results, with insufficient focus on the underlying volatility of returns and on correctly attributing the sources of performance. Investment controlling will increase in importance to ensure that managers are delivering upon the mandate specification and where necessary to ensure that corrective action is taken.
Overall the HEISSMANN Investor Survey 2004 highlights the increased expertise of German institutional investors in using asset allocation to diversify risk and achieve higher investment returns. The characteristics of alternative investments are critically assessed and they are found to be a useful addition to the traditional asset class mix due to their historically low correlation.
German investors have clearly-formulated expectations of their product and service providers and are taking advantage of greater specialisation to unbundle services and to control costs. Improved reporting
has enabled investors to better formulate overall investment strategy and to implement overlay management solutions which protect asset returns.
Murray Burford is an investment consultant with Heissmann Consultants International, based in Weisbaden
The complete German text of the Heissmann Investor Survey 2004 can be requested free of charge from www.heissmann.de and an English-language executive summary can be downloaded as a pdf file