German asset managers widen ‘domestic’ territory
The introduction of the euro in January 1999 gave fresh impetus to moves that had been taking place since the Maastricht Treaty of 1991. While it may not have been apparent to market players at the time, the message from some quarters of the asset management industry was that the new currency would lead to changes in the perception of risk and in the definition of domestic assets. If the prices of some assets were no longer to be subject to fluctuations against the Deutschmark, then clearly some foreign currency risk was eliminated. This also meant that it would be necessary to redefine the traditional borders within asset management.
Rather than the traditional view of compartmentalising into domestic and rest of the world, asset managers introduced more European or Eurozone, as well as sector-based, investment products. Domestic was no longer German, but Euro-zone or, sometimes, European.
In 1992, a new insurance law was passed in Germany that redefined securities investments (for those pension funds, life insurers and other investors regulated by the insurance authorities) in the European Economic Area as domestic.
Traditionally Germany has had lower inflation and higher real returns on debt instruments than the UK or US, which accounts partly for the general bias towards fixed-income investments. Allied to the low inflation was a relatively strong currency (over the long term) that usually ate up much of the returns of any foreign (non-DM) denominated assets. These factors conspired to make foreign investments comprise a tiny percentage of total assets.
New European and Euro-zone benchmarks were introduced by various publishers to account for the new opportunities. In some cases these were seized on by managers as something different to try to outperform, perhaps rendering them less comparable with other managers. There is a much-heard adage in Germany that benchmarks are something for managers to hide behind.
However, our experience as performance measurers teaches us that a customised benchmark is the specific mix of assets which, passively managed, on past investment experience, will deliver the required investment return in an appropriate manner. A benchmark converts the requirement into a measure that aids understanding, control and improvement where necessary. We would say a benchmark is absolutely necessary, so that a manager has nowhere to hide. It provides the means whereby the benefits of active management may be assessed, particularly relative to the risks taken.
What are benchmarks used for in Germany? From our observations of and conversations with investors and portfolio managers in Germany, we conclude that the attitude towards benchmarks by all concerned differs substantially from that prevailing in the Anglo-Saxon and Dutch markets. There, benchmarks tend to result from some study of liabilities, together with assumptions made about asset returns. This leads to a strategic benchmark, which is then broken down into individual components for individual asset managers. The manager’s brief is generally clear.
This objective use of benchmarks in Germany, while gaining acceptance, is still coloured by an investor’s attitude, best summed up as: ‘be in equities when they’re going up, but make sure you’re out of them when they’re falling’ (ie, a balanced brief with loose guidelines). This unwillingness to define investment goals more narrowly has led to a hotchpotch of portfolios, differing from each other mainly according to the individual portfolio manager, thus introducing an additional risk dimension. Clearly, our experience tells us that managers cannot time markets successfully. Even when they get one side of the transaction right (eg, building up cash before a market falls), they then fail to get back in as markets rise. It is not all doom and gloom, however. Some institutional investors have worked out what they want from their managers and what is realistic to expect. In the portfolios we measure at WM, we see a greater use of benchmarks to assess managers’ skills critically.
There is still some distance to travel on this road, because in many cases, where a Euro-zone benchmark has been adopted for the equity portion of a portfolio, the bulk of the equities remains invested in Germany. From a benchmark perspective this adds risk, but many of our clients are not explicitly concerned about this, as they remain intuitively more at ease with a high proportion invested in domestic (old definition) assets.
We sometimes ask whether they would be as complacent if, given a Euro-zone benchmark, 75% of their equity allocation were invested in French equities, as these are just as ‘domestic’. Clients who follow the markets on a day-to-day basis always know what the DAX did, but not necessarily what happened to the Euro Stoxx 50. This is probably true in most countries, where the domestic indices are the main focus of attention.
Another consequence of this is for our universes, which are used by some investors in Germany less as a benchmark than as a rough-and-ready comparison of their portfolios with the rest of the market. In accordance with clients’ investments we have expanded the asset classes available for analysis within our German universe.
However, if – despite the use of a euro benchmark – the bulk of the equity portion of balanced portfolios remains invested in German equities, then it is clearly not right to carve out that portion (or even the rest, which is invested in the other Euro-zone countries) and label it a euro equity universe, because, although it might be representative of what is happening in some of the marketplace, it would provide a distorted picture of the risks and returns available relative to the benchmark.
While differences persist between European countries in the area of accounting conventions and publication of earnings, investors still need to be convinced that asset managers really can analyse a Portuguese, a Finnish and an Austrian pharmaceutical company on a par with each other. What it does, however, is provide a quantifiable measure of the impact of the explicit decision to skew the investments heavily towards a particular category, and it provides a framework for discussing why investment remains as it is, and is not rebalanced closer to the benchmark.
As performance measurement specialists, this is an especially interesting challenge to us, because the goalposts are set differently between countries (and within countries, too). Investors have different goals and perceptions of risk. We can provide all sorts of statistical evidence of the risks a manager has taken to achieve a specific target, but need to assess the relevance of any accompanying commentary.
While we have seen an increased use of clearly defined benchmarks in Germany, it has not yet reached the levels seen in other countries and its application is generally less strict than elsewhere. Attitudes towards risk vary widely from investor to investor, but a customised benchmark (which may be a peer group) encompasses a risk expectation.
David J. Mark is managing director at The World Markets Company in Frankfurt