Released from many investment restrictions for the first time, Germany’s investment institutions have emerged blinking in the sunlight. The Investment Modernisation Act allows them to rearrange existing holdings and step into the hitherto virtually banned world of hedge funds.
But how much has really changed? For the time being most pension funds are staying firmly put, at least until they can really see how the land around them lies. And many vital details of the new act which came into force at the beginning of the year are still unclear, as institutions wait for the government to issue a promised circular.
“A lot is still up in the air,” says an officer at one large corporate pension fund. Until the circular is issued, no one knows exactly what investment institutions will have to do to comply, he says.
Whatever the details turn out to be, funds agree that the new law does make conditions easier for them in the investment arena.
“It will bring us a certain level of relief in the sphere of external investment funds,” says Hans-Wilhelm Korfmacher, managing director of the North Rhine Westfalia Accountants’ pension fund. “For instance, we can buy into mutual funds,
and we can use multi-manager structures.”
However, the aspect of the new law which has attracted most public attention – that it opens up the opportunity to invest in hedge funds – will have no effect at all on the accountants’ pension fund, he says. “That is not on the agenda for us,” he says. The fund, he says, has no plans to start investing in hedge funds, though he does not rule out the possibility that such investments will be considered at some point in the future.
“But it does ease things, with the abolition of some administrative regulations. There is a certain de-bureaucratisation, which we welcome,” says Korfmacher.
He sees no reduction in costs happening as a result of the liberalisation, though. “It will increase our flexibility in terms of our investment structure,” he says.
“The law mainly affects KAGs,” says Guenter Mayer, portfolio manager at the Baden-Wuerttemberg Pension Fund for Doctors, Dentists and Vets. “But it does give our funds greater possibilities for investment.”
The new law might open things up, but this will not prompt the fund to review its asset allocation, he says. “It means a far wider liberalisation; up to now we were limited in how derivatives could be used – limited in scope.” It was necessary to have cash equal to derivatives positions and there were restrictions on how calls could be written. “Now there is more flexibility.”
At the same time, though, the law brings with it tougher demands than before from the legislators. “Only those who fulfil the risk requirements can make use of the new liberty,” says Korfmacher. A deadline of 13 February 2007 has been set, and by this date, the new act must be fully implemented. Up until then, Sondervermögen which have not been adjusted to comply with new legislation remain subject to the old regulations.
Even though freer market conditions should in theory lead to greater competition and a lowering in prices, in many instances at least, institutions are doubtful that the new German act will lead to them paying less for asset management services. “It would be desirable, but we don’t know that it will happen,” says Nestlé Pension Fund Secretary Anita Horstmann.
Korfmacher says that paradoxically, the opposite will probably prove to be true.
“Up to now in Germany, it was the case that there was a compound calculation for fees… so management fees were lower.” The subsidiaries of the German banking organisations, by using their parent bank to carry out trades, were able to get best price execution – an advantage not shared by foreign asset managers. Typically this meant management fees of just 0.2% for domestic subsidiaries against 0.5% for those with parents domiciled outside Germany.
“If fees are unbundled, I think they will be more expensive,” says Korfmacher. Will this be the case for domestic managers too? “That all depends on whether the connection with the parent remains,” he says.
And on top of this possible increase in costs for the investing institutions, comes the expense of complying with the additional risk controls and reporting demands from the government. “With this new law, the demands are greater. This will be a burden in terms of costs,” he says.
Another pension fund official agrees that at least from the administrative side, things would be more expensive for institutions as a result of the law. “We may not have increased costs from the managers, but we will be paying more in controlling risk,” he says. “This whole supervision of risk levels and the fact there will be new structures… this is bound to lead to an increase in our costs.”
“We do see the act, on the whole, as a relaxation, but there are plenty of things that will need to be done to comply. All contracts will have to be altered and redrafted, and they must all comply with the stipulations,” he says.
Though the Investment Modernisation Act has created clear regulations for investment in hedge funds, there have been ways before now that German institutions could gain access to the hedge fund market. The Nestlé pension fund has included hedge funds in its asset mix since 2001, says Horstmann.
The route to this investment sector has been cleared even further with the new law, but this is not going to persuade the Nestle fund to up its exposure. “We won’t change it (the allocation), because we have seen that there are only a very few transparent hedge funds available,” says Horstmann.

Apart from investment supervision concerns, this is important in terms of costs. There are tax advantages for those investing in hedge funds, she says, but those are only available in cases where the funds are transparent.
In 2003 the allocation to hedge funds was raised a little, says Horstmann, but only because the total asset level increased. The percentage allocation for hedge funds, which are held via a structural trust, remained the same.
One aspect of the new law which the Nestlé fund has already made the most of is the Master fund solution. “Now there is opportunity to hold mutual funds within this master fund, bringing all of the Sondervermögen together,” she says. The fund set this structure up at the beginning of 2004 when the law first came into force.

Heribert Karch, joint pension fund manager of the Metallrente industry-wide pension scheme, sees more room for manoeuvre as a result of the new legislation. “With this modernisation of investment law we have gained a bit more flexibility, which is good,” he says, but adds that not all that much will change.
In the insurance sector, observers say the new freedom to move investments into hedge funds makes little difference in practical terms. Investment operations of the country’s insurers have traditionally conservative habits anyway, and the equity losses suffered in the first three years of the new millennium have only confirmed these.
“A lot has been written about institutions switching investments into hedge funds, but despite this, investment insurers have been very cautious,” says one asset manager with close links to the insurance sector.
“The fact is that in Germany on average hedge funds have made up around 1% of total assets for insurance companies, and now that has risen to 2%,” he says. “It is not spectacular… We are in a different country to Holland or the UK… here in Germany, insurers are scared of unknown investments,” he says.
The stockmarket losses racked up institutions in Germany, Italy and France were much steeper than those seen in the UK and US, he points out. Between March 2000 and March 2003, equity values fell by 75% as opposed to the 60% seen in the UK.
“There were big losses, and that was with asset classes which we thought we knew,” he says. However, in each country there are some investors who are always going to act more boldly than others, and this will be the case in Germany too, he says. There will be some institutions that do increase their investment in hedge funds to 5 or 10%, he predicts.
Robert Helm, managing director for institutional business at Meag Munich Ergo KAG, however, is positive that hedge funds will
have an important role to play in future.
“The leading asset managers in Germany will have to make the shift from relative return to absolute return,” he says. “They have to concentrate much more strongly on the liability demands of their customers. This means that on the sales side, they have to move away from
short-term advice to long-term client care.
“Within the field of absolute returns, hedge funds can open up extra profit potential. Because of this, Meag has a receptive attitude towards hedge funds,” he says.
Helm says the new law gives more freedom but also places additional demands. “The investment act and the decree on derivatives do give more freedom as far as capital investment is concerned. The asset manager and his sales operations have to adjust to that,” he says.
“Consultation will become more demanding, and as a result there will be a shift away from salesperson and towards client adviser,” he says, adding that this will not have any lasting impact on total fund sales.

A unit-linked issue for insurers
One of the challenges facing life insurers in Germany in the wake of the Investment Modernisation Act, is what to do about unit-linked insurance products. In many cases, their attractiveness has diminished as a result of the new law, because of changes in the way they are taxed.
“The question is now, what is better for the client with these changes in the law?” asks Christian Wegner of Bonn-based Deutscher Herold. “Up to now you haven’t had to pay any taxes on unit-linked, whereas if you invest directly in funds, you have to pay capital gains tax.”
So this change could be difficult from the life insurance providers. However, there is an interesting exception to this taxing of unit-linked policies, Wegner points out. “If the client takes an annuity, if he doesn’t take the capital, then he doesn’t have to pay capital gains tax,” he says. This gives rise to the possibility of annuity-linked products. “We will see more unit-linked annuities and less unit-linked endowment insurance,” he says.