It’s a simple question of birth and development. While sophisticated and somewhat ‘grown-up’ financial markets such as the US or UK have been offering passive management services for quite some time, Germany is one of those European markets still in its infancy. A closer look at the possible reasons for this development, or lack thereof, offers several explanations. We also analyse the current situation and make predictions on the future of the passive management market in Germany. There is clearly a trend to be seen, constantly confirmed to us by our clients, our prospects and top consultancy firms.
Perhaps it all goes back to German investors’ traditionally conservative (risk averse) investment views – with little or no equity exposure, whether they be private individuals or institutions. Of total German pension fund assets only 11% are invested in equities, according to a 1998 Watson Wyatt study. It wasn’t until a few years ago that the German investor realised what a positive impact a solid equity exposure in Germany, Europe and/ or the US could have on his overall portfolio’s performance.
In the past few years Germans have witnessed historically low bond interest rates and low real estate or rental returns. Previously these were areas of primary investment focus. Simultaneously, equity returns have skyrocketed. This, combined with investors’ more sophisticated expectations for better performance standards has no doubt heavily influenced the Germans’ interest, and increased investment in equities. Additionally, recent asset/liability studies have also supported this trend of higher equity and lower fixed income exposures.
We have also noted three steps German investors seem to be taking to increase their equity exposure and hence also a move towards more international portfolio diversification. First, investors have already gone from a pure German equity (Dax) portfolio to a DJ Euro Stoxx one. Secondly, they are now beginning to add more exposure to the US and Japan. And lastly, they are showing signs that in future they are willing to spice up their portfolios with a flavour of emerging markets.
German investment laws limit the equity exposure an institutional fund can have to 30% of total assets. Insurance companies and pension funds make up a large part of the main German institutional client base. Because of these regulatory limitations, pension funds and the infamous ‘Spezialfonds’ tend to hold a big proportion of domestic debt. This conservative type of asset allocation has been influenced by both cultural considerations (risk-averse investing) and regulatory constraints. An amendment to the existing German investment law was passed in April 1998 to include and allow for the registration of index or index-related funds – and so ‘real’ index funds were born.
The slow development of the passive portfolio management market in Germany could also just be a matter of education. It doesn’t seem to have been a topic of the German business media until a few years ago; most often in the last 12–18 months. But as investors are educated more thoroughly, while seeing the results of years of rising equity markets around the world, they are developing a certain (and well-justified) appetite for passive management – or just outsourcing the management of their institutional monies, in general.
Historically, 99% of German institutional assets have been managed actively. The big German banks and financial institutions have had a strong hold on the German savings industry, accounting for some 75% of total market shares. Logically, with their foothold in the various financial fields, these banks also became the number one address for asset management as it became popular. However, German corporate clients soon learned, the hard way, that active management often adds only minimal value to the portfolio performance relative to a passively managed mandate – especially in the bull markets we have had in the past few years. Both 1997 and 1998 showed us that even in bull and/or bear markets, the actively managed portfolios underperformed.
It all seems to become a matter of the ‘right mix’, as clients are realising the benefits of passive for some situations (like blue chip portfolios) and active management for others (as with small cap or specialist mandates).
One reason passive management may be more widely accepted in Germany in the future could be the past bundling of costs. Charges, especially in actively managed mandates (which make up the majority of German portfolio management ac-counts), have not been very transparent. Over time, these costs have gnawed away at performance relative to the indices. German investors are ready for a change. The benefits of financial sophistication and education (through, for example, the business media) have left German CFOs and treasurers to think twice about the fees they are being charged by their asset manager, and whether or not a portfolio should only be managed on a traditionally active method.
Also, with average additional costs totalling up to 1.7% for blue-chip and 3% for small-cap funds (which in turn affects the overall performance), according to Vanguard experts, we can surely expect increased interest in the cost-efficient passive management approach.
In any case, as the markets progress, information on asset management practices worldwide is published in German financial journals and hence German investors (both individual and institutional) become better educated, more sophisticated and ready for the changes we are witnessing in markets outside Germany.
Whatever the reason for German corporates getting on the passive bandwagon a bit late, the average treasurer or corporate client is now waking up to passive!
Major consultants such as William M Mercer, Watson Wyatt and Feri Institutional Management confirm they are witnessing increased interest in passive in the German institutional market. All expect a considerable rise in the future. As for the prospects and existing clients that we at State Street have been speaking to, there is a clear need for passively managed portfolios with a transparent and cost-efficient fee structure.
It is the index management offerers, that will be the future winners of passive mandates. They can capture, with the experience and know-how they have, a large part of managed monies in Germany.
Today 1–3% of total German institutional assets are managed passively. It is predicted by SSGI and other industry specialists that this will increase over the next few years to 5 – 10%. This is quite a lot when total German assets under management in Spezialfonds in 1998 amounted to about DM722bn (E369bn) and have grown at an annual rate of 23% over the past 20 years; up by 31.3% in 1998 alone.
Our own experience shows that about 80% of our German Spezialfonds accounts are, in fact, passively managed, because that is what our clients need and are asking for.
It is not a question of active versus passive, but rather of finding the ‘right mix’ of the two. The future German institutional asset management market will be marked by increased equity exposure, no doubt. Transparent and fair cost structures, a variety of active and passive investment tools and strategies, and a ‘survival of the fittest’ bunch of asset managers (whether German or foreign) who have understood the clients’ needs and can offer the appropriate products – these will be the key factors to success in this developing market.
The German investor is just starting ‘to walk’ in asset management – and especially passive – but it will take some time before this infant can start running at the same speed as the ‘grown-up’ financial markets.
Thomas Uhlmann is head of sales and marketing at State Street Global Investment in Munich