German investors' gradual awakening
German pension funds are still trailing behind many of their European counterparts in terms of investing in alternatives.
“Pension funds still have a very limited exposure to private equity, with an allocation of less than 1% of total pension fund assets,” says Christian Edelmann, senior project manager, Mercer Oliver Wyman in Zurich. “And, as at end-2004, pension fund allocation to hedge funds was about 1% to 2%, which is only about half of what Swiss pension funds invest in hedge funds. By contrast, three-quarters of the demand for German private equity comes from insurers, while half the German hedge fund demand comes from high net worth individuals.”
FERI Institutional Advisers recently carried out a survey of
over 200 German institutions including significant numbers of pension funds, which showed that investment in alternatives has been pretty low, although interest is increasing significantly, according to Dirk Soehnholz, FERI’s managing partner.
“Private equity has been picking up, but only visibly since last year,” he says. “The private equity industry is trying to educate German pension funds, but it hasn’t been easy to get pension funds to listen to them. Several institutions invested in private equity, but at the wrong time.
The first pension funds went in at the end of the 1990s, buying venture including German venture, and that lost them quite a lot of money. So they are not happy with their private equity exposure. But more and more are thinking about it.”
He says there is also the problem that investors like to dip a toe in the water before committing themselves: “It’s common in Germany to do test investments, but you need seven or eight years before you see the results.”
But Matthias Schellenberg, head of alternative investment sales for the German and Austrian markets at Pioneer Investments, says: “There is a growing realisation that portfolio optimisation by using two asset classes only – public equities and fixed interest – will not do the job, especially in a low interest rate environment.”
As in other countries where pension funds are slow to invest in non-traditional asset classes, the perceived riskiness and complexity of alternatives, together with the lack of experience of pension fund investors, act as a brake on investment. And private equity investing also carries the drawback of unpredictable cash flows. But another key factor is regulation. Pension funds can only invest a maximum of 5% of their portfolio in private equity or hedge funds, although the relatively new pension fund structure has more flexibility than insurance companies in terms of constructing portfolios.
Schellenberg says: “Hedge fund investors are looking for uncorrelated pay-off profiles, which is why they naturally like to go in the direction of these funds. The main obstacles in Germany have been more the regulatory body’s risk control and reporting requirements which need to be applied, and the associated costs for personnel and IT.”
He says restrictions and requirements apply both to investors and to hedge funds themselves. “Some pension funds are simply too small to deal with these issues in an efficient way, with a maximum investment of only 5% of their assets,” says Schellenberg.But he says there is also a timing issue: “Equity markets have been performing extremely well, and fixed interest has also been keeping up, whereas hedge funds have experienced two difficult years.”
Interest in niche areas like commodities is even less evident.
“Direct investment in commodities is not allowed for pension funds,” says Valery Engelke, director of institutional business, Henderson Global Investors. “Many funds are looking at it but can only go via pooled funds, or use derivatives in a commodity basket such as the GSCI Goldman Sachs Commodity Index.”
But there are pension funds which use alternatives, and they generally do so via funds of funds, according to Klaus Bollmann, managing director of Union Alternative Assets.
“They do this to achieve diversification – in addition, they often lack inhouse resources for manager and strategy selection,” he says. “By the same token, these investments tend to be diversified globally, and in the case of private equity, also broadly diversified across stages of development.”
German pension funds can also invest in hedge funds through structured products issued by a bank in the form of a bank loan.
Although diversification is an underlying objective, alternative portfolios show a regional bias, according to Soehnholz.
“When pension funds do invest, they invest more in Europe than outside, because of the currency risk,” he says. “It is true that half of this European exposure is to the UK, and therefore to sterling, but it’s dollar exposure they don’t like. They go more for the larger funds or fund of funds, ie the brand names.”
Engelke says that a popular vehicle giving institutions access to private equity is public-private partnerships (PPP).
“PPP is a big thing in Germany, and there is a high level of demand from investors,” he says.
In fact, last year Macquarie raised over e100m from German and Austrian investors in a fund offering access to its Macquarie Infrastrukturfonds Nr 1, a wholesale vehicle which targets investments in infrastructure and related assets located in European OECD countries.
However, investors no longer expect unrealistic returns from alternatives, according to Edelmann.
“For hedge funds, 7%– 10% is considered sufficient, but at a relatively low level of volatility,” he says. “Return expectations for private equity are still somewhat higher.”
“Investors are looking for absolute returns with lower volatility than they get in, say, the stock markets,” says Bollmann.
“A spread of at least 300bps above the risk-free rate tends to be the expectation in the case of hedge fund investments. With private equity, investors are looking for a decent pick-up above the public equity markets in the long run, with lower volatility. However, equally important is that investors are increasingly looking also for a low correlation with stocks, bonds, and so on in order to achieve a positive portfolio diversification effect in the long run.”
As for the future, Bollmann also says that there is good potential for investment activity, since allocations are still low, on average.
“This is especially the case if stock markets do not experience a rally in the coming years, as they have in the past three,” he adds.
Schellenberg says: “The pressure to diversify and bring returns is constantly mounting. I think that 2006 could bring change, as people realise the need for diversification and the risks in long-only strategies for public equities at these levels, and if interest rates continue on a rising path.
He adds: “As hedge funds prove their strength in terms of risk diversification, i.e. to preserve capital even in falling markets, that could give a push to further establish them in Germany.”
“The major drive here is the changing perceptions of the regulators,” says Soehnholz. “In other countries, the regulators appreciate diversification more. But the financial regulator BaFin gives the impression that a 100% bond-only portfolio is best.”
However, Soehnholz considers that there are individuals at BaFin who are open to the idea of alternative investment classes. Already it is believed that the new German investment act, expected later this year, will relax some barriers to investing.
“Furthermore, the losses that investors are seeing in their bond portfolios show that a 100% bond-only fund is not the right approach,” he says.
But he warns that there is another market factor which could delay a more general acceptance of alternatives.
“German consultants are not strong in alternatives, therefore they are not promoting them, so it will take longer for pension funds to invest,” he says.