From hedging too to asset class
Before 2004 German legislation did not allow much leeway for active currency management. Currency management with derivates was allowed for hedging purposes but protection was the name of the game. Currency itself was seen more as a risk factor than as a single asset class that offered the opportunity to obtain additional alpha.
But this changed with the implementation of the Investment Modernisation Act. It introduced a so-called 200% rule, which meant that derivatives could be used up to 200% of market risk potential. And it was also important for currency management. For some time now, Germany has seen a trend towards specialised management and specialised mandates.
A new organisational form developed, the MasterKAG, a vehicle for portfolio management that enables efficient risk management. Specialised mandates are consolidated into a Spezialfond which is managed by external investment managers. The act made it possible to arrange or outsource asset management under the umbrella of a MasterKAG and, seen from this perspective, the act allows full-blown currency management overlay. The act also supports a move to alpha generation.
There are five different ways of funding occupational pension schemes. The Occupational Pension Act of 1974 established four that differ in terms of their treatment under labour legislation and in the investment opportunities they provide. The first is through a direct promise (Direktzusage), the second was a Pensionskasse, the third direct insurance (Direktversicherung) and fourth through support funds (Unterstützungskasse).
In 2002 the government introduced a fifth option, the Pensionsfond, with the aim of creating a funding vehicle that would provide more freedom of investment and new investment opportunities. It also wished to provide a means to introduce and finance a new form of pension plan, the Beitragszusage mit Mindestleistung - a defined contribution plan with a guaranteed interest of 0%.
By the end of 2004, German pension assets under management totalled €381bn, divided between the four vehicles (see diagram). Since the Pensionsfond has not been around for very long, its proportion of the total pension assets is still relatively low. At the end of 2004 it totalled €600m but this has since grown to over €1bn.
The most popular form was the direct promise, a form of internal funding via book reserves, which accounted for 58% of the total pension assets. Because they are internally funded, on the face of it book reserves would not appear to play a role in asset management.
However, during the 1990s, employers started to build external funding for their book reserves by creating so-called Spezialfonds, which are more or less segregated accounts.
And when more recently financial and rating analysts have begun to consider liabilities financed in this way as being unfunded, employers began to consider placing their liabilities in an organisational form to achieve a netting of assets and liabilities in the context of international accounting rules and the Contractual Trust Arrangements (CTA) was born.
A CTA is a legal entity separate from the employer or company and is essentially a trust arrangement that satisfies international accounting rules in respect of netting assets and liabilities.
A CTA is typically not supervised by the financial services authority (BaFin). The employer or the trustees are generally free to choose their investment strategy. But if they organise their funds in a support fund they must still comply with investment legislation.
Insurance companies, Pensionkassen and Pensionsfonds have to comply with the investment guidelines set out in the supervisory law (VAG).
While assets generally should be invested in the same currency as the liabilities the VAG allows pension schemes a 30% quota limit, that is up to 30% of the investment can be in the form of incongruent assets. But incongruent assets can be hedged. CTAs and support funds on the other hand, do not face any restrictions on congruence and the use of derivates because the VAG does not apply to this group of investors.
In general, CTAs are bound by self-imposed investment guidelines and the investment law. They gain the most from the new investment legislation.
Germany is still a fledgling player in terms of currency management. No exposure to foreign currencies and no currency risk often imply no currency management at all but exposure to currency risk and aiming for a strategic hedge ratio can imply passive currency management.
A more advanced approach would be to install an active currency management that reflects the existing exposure with dynamic hedging for additional alpha.
Currencies should be understood as another form of asset class, with a low correlation to traditional asset classes such as equities and bonds.
In this context it is not necessary to presume an exposure in one of the existing long-only underlyings.
And currency management is profiting from the visible trend towards installing CTAs, MasterKAGs and overlay structures. The "search for alpha" may also lead to additional interest in currencies as asset classes in their own right.
Bernd Haferstock is head of investment consulting at Wiesbaden-based benefits and compensation consultancy Dr Dr Heissmann GmbH