Why Bayer is turning to indexed investments
From the perspective of many German investors, the debate between active and passive management seems as neverending as it is in most other countries.
The academic context, however, is well understood. This asserts that active management can only be expected to outperform markets when these are - at least for the medium term - less efficient. By contrast most mature markets can easily be considered as satisfactorily efficient with regard to their liquidity and transparency.
Despite this intellectual awareness, the greater amount of institutional money is still managed actively, while the passive approach has only recently been introduced for the management of private money and only on a very limited scale.
In support of active management, it is argued that when markets are trending downwards, one can simply divert into more liquid assets, whereas one has to maintain a passive investment allocation. It would seem to be common sense therefore that in the reverse situation of an upward trend, it is fairly difficult for active managers to outperform markets and therefore passive managers.
The Bayer-Pensionskasse investment strategy, decided at the start of the 1990s, incorporated both passive and active management on the assumption that one might outperform the other, depending on market conditions.
The fund has assets of approximately DM9.5bn ($5.4bn), of which 25% is allocated to equity with half invested domestically and half internationally. It was initially decided that approximately one third of the equity exposure would be passively managed by external managers. The domestic exposure would be managed through full replication of the German DAX and international exposure through the award of international index tracking mandates.
Remarkably at this time, when the German asset management industry was confronted with the relatively limited challenge of replicating the DAX, some did not have the intellectual capital to do so. At least one company failed in its first attempt and was forced to restructure its portfolio, thus incurring additional transaction costs.
The competence of international managers was better established and was luckily already available to German investors, so that they could benefit from computer optimised index tracking portfolios with impressively low tracking errors and even more impressive low turnover volumes.
Since then, most German asset managers have learned the lesson of past mistakes. Indexed portfolios are now broadly available with some German service providers offering what can be described as a state of the art service.
German insurance brokers also provide replicating and tracking services as an add-on service and Bayer-Pensionskasse even considered taking the management responsibilities for passive portfolios in-house to avoid external management fees.
However a comparison of costs between in-house management and external passive management (management and custody fees) showed that this was unnecessary. The very specific German 'Spezialfonds fee culture' allowed us to negotiate impressively low external management fees so the benefits of bringing the management in-house would have been negligible.
In addition, this comparison did not involve an attempt to quantify the additional administrative and accounting consequences for in-house management while accounting for investments in a Spezialfond involves one single unit price.
Amongst German active portfolio managers, the picture is not much different than that of other countries. Only a few of the open-ended mutual fund managers outperform the index, reinforcing the claims of passive management to be a sound and plausible alternative.
The German magazine Das Wertpapier regularly publishes performance figures for listed German open-ended funds. In summary, for the period April 1996-March 1997, only seven out of 90 German equity managers have beaten the index. This means that 92% did not satisfactorily fulfil their job requirements.
The results of Bayer-Pensionskasse's investments, based on performance measurement results dating back to 1990 are very much in line with the performance of publicly quoted funds. Only one out of six active managers, acting on behalf of Bayer-Pensionskasse succeeded in significantly outperforming the DAX. In all other cases Bayer-Pensionskasse would have been better off by passively investing in German equities.
As a result, Bayer-Pensionskasse is now seeking to bolster its proportion of indexed investments which have actually declined in recent years by making new investments based on a quantitative active approach.
It is also possible to create synergy between different investment concepts. The investor can, for instance, benefit from active country allocations or investment grade decisions in combination with passively managed investment basket portfolios within the individual countries. Bayer-Pensionskasse has actually modified the directive of one external mandate, having made the disappointing discovery that all positive country allocation performance contributions had been lost by poor stock selection decisions.
The fund also intends to use index funds as part of a tactical asset allocation approach. Since efficient forward market instruments do not exist for many emerging or developing countries, the trading of index fund units provides the best means for properly re-adjusting the country weightings.
Fixed-income markets present even more difficulties for active management. The German bond market is much less diverse than than those of other countries making it extremely difficult for active managers to beat the market.
Figures for the 1980s reveal a decade of consistent underperformance by the fund's active bond managers at that time. As a result in the 1990s Bayer-Pensionskasse decided to move the bulk of its formerly externally managed money into one core portfolio to be passively managed in-house, augmented by a few external active managers who were selected to deliver a set of well diversified and distinctive active approaches.
Five years of this job-sharing" between in-house passive management and external active contributions for German bonds has brought promising results, comfirming it as an efficient and cost-effective approach.
As result of both informal and formal exchanges of views amongst members of the German institutional investment community, Bayer-Pensionskasse believes that its approach is being emulated by several major pension funds and insurance companies.
Jürgen Bader is chief investment officer with Bayer-Pensionskasse in Germany"