German Asset Management: One step at a time
Nina Roehrbein outlines institutional investors’ asset allocation intentions and behaviour
The low interest rate environment has forced traditionally conservative German pension fund investors to take action in order to meet their return targets.
“Half of these institutions have missed their target return,” says Thomas Fleck, managing director for institutional business at Union Investment. “In addition to these risk and return issues, there are regulatory challenges which make life increasingly difficult for institutional investors and ‘plain vanilla’ does not work. This means investors have to become more open-minded.”
Michael Fuss, co-head asset management Germany at Deutsche Asset & Wealth Management (DeAWM), believes a major shift in asset allocation took place in 2010 and 2011 when, driven by the euro crisis, German pension funds began to diversify in fixed income.
“Last year those asset classes – investment grade bonds, emerging-market debt and high yield – performed well due to the liquidity situation and rally,” he says. “The year 2013 is proving to be much more difficult – it is a year of diversification and differentiation. In 2012, investors were able to play the macro theme relatively easily. Today this requires more detailed knowledge of regions, asset classes and decision making on various equity strategies, total return approaches and benchmark approaches.”
Nigel Cresswell, head of investment consulting at Towers Watson in Frankfurt, says: “The realisation that government bonds in particular are not risk free has led institutions to re-think their fixed income allocation. They have been moving down the credit spectrum with a better understanding of the risks and rewards than they had in the past. They spread those risks more effectively and access different segments of the market with different levels of quality.”
This means German institutions have been gradually reducing their exposure to sovereign and corporate bonds. According to market participants, pension funds have increased their investments in high-yield, emerging-market and absolute-return strategies, as well as loans, corporate bonds and covered bonds.
“Pension funds typically have a core holding of euro-government and euro-corporate bonds, to which they try to add a more diverse, global pool of fixed-income instruments, potentially reducing the currency risk by hedging,” notes Creswell. “Investors have increasingly moved to emerging markets but it is taking them more time to get comfortable with high-yield or leveraged loans, as a sub-investment grade investment.”
Hard currency mandates were the natural entry points for sovereign investments in emerging markets. This has now shifted to include local currency and corporate exposure as well.
“The final step of this evolution has been emerging-market corporates,” says Cresswell. “A lot of those investing in emerging-market debt [EMD] will have some exposure to emerging-market corporates but only because within their EMD hard currency exposure the manager is going slightly off benchmark. Investors with a dedicated emerging-market corporate mandate have been few and far between due to a nascent market and the limited number of high quality managers.”
Pension funds still take a global approach, with few mandates concentrating on regions, such as Asia.
“Since the market correction this summer with bond yields rising, EMD, which was still hugely popular in the first few months of the year has been put on hold,” says Bilal, head of distribution at Pioneer Investments in Germany. “This has been replaced with demand for other yield strategies. Flexible fixed income strategies such as Euro Aggregate where you invest into the entire spectrum from rates to credits with mid to low duration are also sought after. But while we have seen plenty of renewed or changed fixed income strategies we have not witnessed any significant redemptions out of fixed income into other asset classes, such as equities.”
An average German Versorgungswerk, a first-pillar pension fund for professionals, is now typically invested in 50% Schuldscheine and other variants of privately placed debt, 15% investment-grade corporate bonds, 10% emerging-market bonds, high yield loans and high yield bonds, 10% global equities, 10% real estate and 5% in hedge funds, private equity and commodities, according to Carlos Boehles, head of institutional sales in Germany for Schroders.
“But risk-taking Versorgungswerke often have equity exposures of 25-30%,” he says. “We have seen a slight increase in the willingness to take risk, as there is more room to manoeuvre in the risk budget following the sound performance of 2011 and 2012.
Michael Schütze, head of corporates for Germany at Allianz Global Investors and managing director at Allianz Corporate Pension Advisors, adds: “Those with a sufficiently high funding level can afford to take more risk and thus answer to a low yield environment.
Regulated pension funds such as Pensionskassen take less obvious additional risks, meaning while non-regulated entities move into equity or spread products such as corporate bonds, high yield or emerging markets, regulated ones allocate to alternatives where they try to capture, for example, liquidity premiums, which from a regulatory standpoint of view are not as stress-tested as a higher equity allocation.”
Others feel the rally in equities has already gone too far and do not trust those high valuations anymore especially in US equities, which is why they shy away from investing now. “Those with a relatively strong equity exposure already believe that after a long cycle of growth outperforming value, value should start to outperform again,” says Bilal.
If they are intent on a higher equity allocation, they need to check how they will be able to cope with the resulting higher volatility.
“They can make use of equity funds with volatility caps or investments in long/short UCITS funds, which feature sharply reduced draw down risks,” says Boehles.
Mercer has seen a shift in allocation rather than additional inflows, particularly in the active space. “Investors are allocating away from Europe and the US to emerging markets and Asia as a region,” says Herwig Kinzler, head of Mercer’s investment consulting business in Central Europe. “Many German institutions were traditionally invested in global equities where it has been extremely difficult to earn alpha over the last few years, which has led to separate mandates, such as European, US, emerging markets and small and mid-caps.”
Instead of allocating to equities, German institutions have moved into real assets, particularly real estate and infrastructure but also timber and private equity, while other alternative asset classes continue to play a minor role.
“Real estate has been part of the asset allocation backbone for a long time,” says Cresswell. “Despite issues around the open-ended funds the underlying asset class is still popular in Germany. Last year we witnessed a shift towards REITs, away from direct investments.”
German investors favour German real estate where, according to Bilal, very low leverage ratios still exist.
“Most of the private and commercial real estate purchasing has been done on equity or cash rather than debt so, which is why a stronger rise in interest rates should not affect the German housing market,” he says. “In addition, the German housing market on average still looks fairly priced compared to other European real estate markets and the UK.”
But Fleck admits that it is difficult to find high quality properties in the market now.
“Our investments include retail shopping malls and hotels but those types of property, with high quality standards, are generally limited,” he says. “However, investors can achieve an average return of 4% and above.”
Kinzler has seen some allocations to real estate double, from 7% to 15%. However, as the core property markets are already expensive, such as Berlin, Hamburg and Munich, as well as in London and Paris. German investors have started to access opportunistic, slightly riskier and higher yielding parts of the market too.
The demand for infrastructure meanwhile has outstripped supply.
“There are simply not enough available projects and assets to invest in,” says Bilal.
“Pension funds struggle, for example, to find infrastructure projects such as renewable energy projects of a scale that justifies cost and resources investors need to spend on these.”
“Demand for infrastructure – both on the equity and debt side – is higher than what the market or asset managers can deliver at the moment despite the financing gap created by the banks as they largely withdrew from this activity,” agrees Schütze. “Investors remain sceptical and spend a lot of time on due diligence, meaning they are relatively slow in adapting to new asset classes.”
Because of the challenges in implementing infrastructure within the regulations, overall the asset class plays a minor role, according to Cresswell.
And as investors diversify through the credit spectrum or into alternatives, governance requirements are increased. “Most investors probably do not have the appropriate governance in place to deal with this at the moment,” says Cresswell. “Some may have to think about outsourcing some of those governance requirements. Small pension funds often neither have the governance nor the size of allocation to be able to invest in an asset class such as private equity. The same applies to hedge funds, although we have seen institutions use UCITS type vehicles as a proxy for hedge fund allocations.”
But Cresswell warns that investors need to tread carefully here because while UCITS regulations provide some liquidity and leverage constraints, this also prevents some strategies from being implemented. They are still hedge funds and pension funds need the same level of governance and due diligence for these investments. According to Cresswell, it is also doubtful whether investors using the UCITS route will find the best-in-class managers.
Despite the long-term, fundamental market trend towards passive in traditional core assets, passive investments recorded outflows for the first half of 2013. Bilal says: “Most investors know they cannot buy into beta at this point in time after volatility has returned to the market,” he says. “There is a potential threat of further depreciations on the EMD and in equity, which drives investors into active, fundamentally researched asset management rather than passive.”