During 2005, the volume of assets held in instiutional investment funds (Spezialfonds investing in securities) rose by 13%, from €552bn to €624bn. The satisfactory rise in the volume managed has continued, so that for the time being 2001 and 2002 are still the only two years in the history of the Spezialfonds in which there has ever been a downturn in the volume. Further growth is likely in the current year; at any event by May 2006 the volume had risen by another €12bn.

The volume growth is due both to the favourable situation on the equity markets, and to the net receipts from Spezialfonds investors. Accordingly, over the course of 2005 Spezialfonds brought in a total of €35.3bn, and another €19bn in the first five months of 2006.


Sharp fall in number of funds

Although assets are flowing in and new Spezialfonds are certainly being set up, and although the volume of managed assets has risen overall, the actual number of Spezialfonds has continued to fall. The peak number of 5,591 Spezialfonds was reached in August 2001. The number is currently decreasing by an average of almost one Spezialfonds every day, so that by the end of May 2006 there were only 4,533 Spezialfonds.

As a result of the simultaneous increase in managed volume and reduction in the number of Spezialfonds, there has been a sharp rise in the average size of the individual Spezialfonds. At the end of 2005, this amounted to precisely €134m, compared to €112m the year before, and just €90m in 2002. This trend shows that many investment fund management companies (KAGs) are systematically working towards reducing their managed mandates. With too small Spezialfonds it is not so easy to present a reasonable distribution of risk, just as it is almost impossible to impose specific strategies on small portfolios. Of course, raising the average fund volume can also improve the profitability of a KAG.


Few changes in competition

There was no change in the number of Spezialfonds KAGs in 2005, which remains at 52. The only changes to report were one new fund being established, one withdrawing from Spezialfonds business and two changing their names. The newly established fund was the Deka Fundmaster, which is to concentrate on master funds business in the Sparkassen group's fund product arm. According to the latest statistics from the BVI Bundesverband Investment und Asset Management (BVI), this company already had 16 investment funds under management by March 2006, with a volume of €2bn.The setting up of master funds is a business model that is also being taken up by a number of other KAGs. One of the advantages for the investor lies in the division of responsibilities. The master KAG format means that the requisite structures are available for setting up an investment fund, in particular the framework organisational, technical, legal and regulatory conditions. The actual management of the portfolio, making decisions on the global asset allocation, the selection of individual securities and the use of derivatives, is left to one or more external consultants or managers, which as a rule are chosen by the investor. The Frankfurter Service KAG, which took over from BHW Invest at the beginning of the year, is also concentrating on this concept. In addition, it offers to supply individual modules, such as only the bookkeeping, or only the risk control.

The downside of such products, combined with the steadily growing range of organisational or legal requirements being placed on KAGs, are decisions that are causing institutions such as ABN Amro to surrender their KAG licence. Their Spezialfonds have been transferred to other KAGs, with portfolio management being retained by the group. In Germany, however, there are no longer any portfolio management entities, as this role has been concentrated on just a few global locations. And finally, West-AM has changed its name to WestLB Mellon Asset Management.

Private banks and insurers increase their market share

The biggest change in market share has been realised by the private bank KAGs, whose share rose from 17.7% to 20.1%. The insurance companies' KAGs also managed to increase their market share, from 11.9% to 12.6%. Apart from the KAGs of the commercial and regional banks, whose share has remained unchanged, at one-third, the other provider groups have lost market share correspondingly.

There are considerable differences in the composition of investors among the different KAG groups. In the case of the insurance companies' KAGs, 90.5% of the managed resources derive from insurance companies, which in most cases would be group companies. The year before, this figure had been very slightly lower, at 89.1%. Among other companies, the proportion of resources that derive from group or combine level is not so easy to determine. Of the Spezialfonds of KAGs from the savings bank (Sparkassen) camp, 55% of them are held by investors from the credit institutions (Depot-A) sector. At the end of 2004, this figure was slightly higher, at 55.9%.

The biggest change in investor composition took place in the private bank KAG sector, where the proportion of investors from the institutional pension funds sector fell from 33% to 19%. In absolute terms, this means that the total of €23.4bn is €8.5bn less than the total reported the year before.

Also worthy of mention is the increased importance of insurance business for the foreign bank KAGs. The value of funds entrusted to them has risen from €7.6bn to €9.2bn, so that 36% (end 2004: 27%) of the resources managed by this KAG group now derives from insurance business.


Tenfold increase in receipts

Overall receipts in 2005 amounted to €26.1bn, more than 10 times the total of €2.1bn recorded the year before. There can be no question of the receipts being evenly spread among the various investor groups over the past three years (cf Table 1). Up to 2002, the situation for the Spezialfonds was such that the highest receipts were expected from the insurance companies, followed more or less closely by the credit institutions and, at a respectable distance, by the other private sector companies. Other investors (social insurance institutions, churches, associations, trade unions, etc), including the non-resident investors, played only a subordinate role.

But then one investor group after the other began to record net falls, no doubt in the wake of the turmoil on the capital markets. As a result, in 2002 the "other companies" fell by over €200m, in 2003 the credit institutions by €1.3bn, and in 2004 the insurance companies by €9.4bn. Compared to the total managed volume of over €500bn, this may not seem excessive. But an individual KAG would be seriously affected by such falls, especially if its business planning had been based on the previous year's rates of increase.

In 2005, with the exception of the "other investors" (foundations, associations, churches and others), which fell by €1.1bn, all investor groups recorded positive receipts. The insurance companies invested the largest amount, totalling €8.3bn, even though it was less than the fall had been in 2004. At the end of 2005, the total volume attributable to the insurers was thus €222bn. The institutions providing old-age pensions, which have also been recorded separately by the Bundesbank since 2004, built up their holdings of Spezialfonds units by €5.7bn, to €67.5bn. The credit institutions put in €5bn, and now hold Spezialfonds with a total value of €145bn. The non-resident investors are traditionally less significant, depositing a mere €200m to take the assets at their disposal to over €2.5bn, exactly the same as six years ago.

With the insurance companies being by far the largest group of investors in Spezialfonds, it is very interesting for the fund companies to know how the importance of Spezialfonds is growing within the insurers' capital investments. This can be seen from the balance sheet statistics issued at the end of each quarter by the German Financial Supervisory Authority (BaFin). The total value of capital investments by the insurers increased during 2005 from €1.09trn to €1.16trn. Of this total, at the year end €407bn were invested in securities and a further €258bn of that in investment units.


Significance for balance sheets

These figures are book values, which means that market-related changes in value have only a limited effect on the balance sheet values. In particular, following the strict principle of "lower of cost or market", increases in value are not taken into account until such time as they are realised by disposal of the securities. Even where a security is sold at a profit within the investment fund, this does not automatically have the effect of raising the profit in the investor's balance sheet. Only when the investor sells the investment unit, or if the KAG decides to distribute disposal gains realised within the investment fund, can this gain be shown as revenue in the investors' balance sheets. Whereas losses are in principle reflected immediately in the balance sheet by means of a "write-down to fair value" (that is, a reduction of the book value to the fair value), here too the possibility exists of avoiding it by, for example, justifying it as only a temporary impairment in value.

The book value of the investment units held by the insurers fell for the first time in 2004, albeit only slightly, from €236bn to €232bn. The rise over the course of 2005 to €258bn represents an increase of over 11%, compared to an increase of only 5.8% in the total value of capital investments. As a result, the proportion of investment units in the total capital investments rose by 1.1 percentage points to 22.3%.

This corresponds to the value for the year 2000; the highest level recorded, however, was 22.9% in 2001.


Proportion of Publikumsfonds is rising

Based solely on the insurance companies' securities portfolio, rather than on the capital investments as a whole, the proportion of investment funds has once again fallen slightly, by 0.4 percentage points to 63.5%. In this case, the peak value of 67.7% was attained in 2002. If we consider that insurers are in a position not only to purchase German federal government bonds (Bunds) and mortgage bonds (Pfandbriefe) directly, but also that an incredible number of certificates are designed specifically for investment of insurance company assets, then a share of just below two-thirds of the insurance companies' securities portfolio represents a resounding success for the investment branch.

The part played here by Publikumsfonds is one that just cannot be ignored. Even though the fund management companies only reported €3.4bn in Publikumsfonds units in the hands of insurance investors to the survey, the actual value could well be between €30bn and €40bn. For the reasons indicated above, insurance investors are likely to be even more hungry for Publikumsfonds in the future.


Banks stocking up

As the second largest group of investors, the banks built up their Wertpapier-Spezialfonds from €133bn to €145bn during 2005 (according to the Bundesbank's capital market statistics). The Bundesbank's banking statistics show an increase from €135bn to €149bn. The difference between the two sets of statistics arises because the capital market statistics reflect the market value of Spezialfonds units, whereas the banking statistics show the book value of the Spezialfonds units and also of the Publikumsfonds units held by the banks. For the survey, the KAGs allocated Publikumsfonds units valued at €6.7bn to the credit institutions investor group. However, the true value could be double that, which would therefore be some one-tenth of the total value of Spezialfonds units.

A series of special regulations apply to investments by credit institutions in investment funds, because they have to back investment funds - along with all other risks - with share capital. These regulations relate to the credit institutions' solvency, liquidity and cluster risks. The common rationale behind these regulations is that each credit institution must be in a position, even in the event of precisely defined losses (failure of debtors of the bank or price losses on the investment markets) to repay the monies their depositors have placed with them (savers, etc). Previously, it was relatively simple to define the instances of loss that have had to be covered by the banks' share capital.

For example, it is assumed that 8% of the equities and corporate bonds could suddenly become valueless, whereas repayment of government bonds and Pfandbriefe would always be secure. In future, there will be a more flexible rule, whereby the amount to be covered by 8% of the share capital can be set higher or lower than the respective market value, even with equities and corporate bonds.

Concrete recognition should be oriented to a risk assessment made on each security, whether based on the rating by a recognised rating agency, or on an internal risk assessment by the credit institution concerned.


New methods of risk assessment

In Germany, investment in investment funds is subject to the established rule whereby the credit institution either treats its investment units as equities or as corporate bonds, fully weighted (ie, to be covered by 8% of the share capital), or dealt with in accordance with the alternative method proposed by the BaFin and weighted at the "average solvency ratio" provided by the KAG. The latter is calculated by the KAG in such a way that the share capital ultimately required by the credit institution is just as high as it would be if the credit institution were to invest directly in investment fund assets (Bunds, equities, etc).

In this case, the solvency ratio can be calculated both according to the actual fund composition and according to the fund composition that represents the maximum possible solvency ratio under the investment fund's contract terms.

The transparency solutions that have been available previously will also be permitted in future. Under the draft of the new solvency regulation, however, allowance should be made for a new standard method, whereby the credit institution is to make the investment units subject to individual risk assessment - as is the case with other securities. This does, of course, mean a certain additional cost, because a rating will have to be obtained for each Spezialfonds, or some other form of risk assessment set up.


Greater importance in future as a result of lower equity requirements?

On the other hand, this will finally make it possible to take into account the risk-reducing portfolio effects that are typical of an investment fund, whereby the equity requirements of the credit institutions investing in the fund fall relative to a comparable direct investment. In this case, the investment in a fund could gain a tangible, albeit justified advantage over the direct investment. This could then lead to a sharp rise in the investment fund share of the credit institution's total securities portfolio. At the end of 2005, this share amounted to 10.3%, and by the end of May this year had once again risen slightly to 10.4%, corresponding to investment units valued at €158bn.

The development to date of fund investments by credit institutions is shown in Figure 4. The highest absolute value, €165bn, was recorded in 1998, which actually corresponded to a share in the credit institutions' total securities portfolio of only 9.8%. The highest relative value, however, 12.1%, was recorded in 2001, although after the sharp fall in prices this represented a share worth only €146bn.


Price loss lower for funds than for direct investments

Although it is conceivable in theory that this shift could be due to the credit institutions reducing their direct securities portfolio rather more than they have done with their investment units, by selling them off. There is, however, much more to suggest that the price losses by the funds were lower than those by the direct investments, as many Spezialfonds KAGs were at the time already offering concepts to maintain the capital of the Spezialfonds managed by them.

Nine of the 21 KAGs which responded to the supplementary questions indicated that they had a particular competence in following such capital maintenance strategies, for example constant proportion portfolio insurance (CPPI) models.

The impetus and the decision to develop, or continue to develop, as the case may be, could as a rule have been provided by the balance sheet constraints of investors who could have found themselves struggling to survive if their upper loss limits had been exceeded. From our own experience, we can report that such loss-limiting strategies have indeed saved the commercial lives of a few investors. One advantage of the Spezialfonds in this case is that KAGs use such strategies in a more disciplined way than many a direct investor who has suffered further losses in the hope that the markets would pick up.

The fondness that Spezialfonds and their investors have for certain investment categories has changed repeatedly over time. Up to the end of the 1990s, domestic securities, and domestic bonds in particular, dominated the asset allocation. Up to 1997, their share of total volume was over 50%; since then it has fallen continuously. The maximum absolute value was recorded over the two years 2000 and 2001, at over €160bn, or roughly 30% of the considerably increased fund volume.


Foreign bonds make up lion's share of Spezialfonds assets

At this time foreign bonds were flying high (peaking in October 2000 at €176bn, or 33%), and foreign bonds presently make up the lion's share of Wertpapier-Spezialfonds assets. In this case, the highest level yet reached was €222bn, just below 39%, in September 2005.

Since then, the interest rate hikes on the markets, and the resulting falls in the value of bonds have also appeared to be mirrored in the Spezialfonds assets. At the turn of the year, the total value of foreign bonds in Spezialfonds was just €217bn (although over this period, receipts exceeded payouts by more than €2bn). In parallel with the slight fall in total volume, by €6bn to €564bn, in the first five months of this year, the value of foreign bonds has also fallen (by €2bn to €215bn at the end of May 2006).

The proportion of equities in Spezialfonds recovered during 2005, from 25.9% to 28.7%. The highest value recorded to date was in August 2000, at 46.8%. The proportion of equities then fell to 21.2% in March 2003, and has since fluctuated around 25%. In February and March 2006 it reached its highest level since July 2002, at 31.1%.

Naturally, much of this trend is due to the rising equity markets, but irrespective of that there are signs of growing confidence among investors in the equity markets, which is evidenced by the active build up in the proportion of equities. Another possible contributory factor is that there is a growing familiarity in dealing with derivatives, and higher proportions of equities can be built up without raising the level of unsecured risks to the same extent.

A comparison of the domestic and foreign equities in the Spezialfonds portfolios shows that foreign equities overtook domestic ones precisely as the euro was introduced on 1 January 1999, at least with regard to their importance in the Spezialfonds portfolio. In December 1998, both types were still essentially equal, with €72bn in both domestic and foreign equities (each making up 19% of total assets). After that, the importance of foreign equities continued to rise, and that of domestic equities to fall.


Euro Stoxx is the new benchmark

Since May 2006, Spezialfonds have invested more than four times as much in foreign than in domestic equities (€132bn, or 23%, compared to €32bn, or 6%). Most of the foreign equities are of companies who are domiciled in Europe; the Euro Stoxx has long superceded the Dax as the most important benchmark for the proportion of equities in Spezialfonds. Efforts are being made to realise additional portfolio effects by diversification into other countries, especially into US and Japanese equities.

We do not, therefore, expect to see a reversal of the above trend or a rise in the proportion of domestic equities.

Another point worth mentioning is the new peak value of target funds (units of other investment funds acquired by Spezialfonds for investment purposes). This proportion reached a value of 2.5% of the total Spezialfonds volume for the first time in April 2006. Just 12 months before, incidentally, the proportion of target funds in the total assets had topped the 1% mark. This makes target funds an ideal investment vehicle, especially for smaller Spezialfonds and for covering smaller market segments. Also, the previous maximum limit of 5% no longer applies, with the changeover from the contract terms of the individual Spezialfonds to the new investment legislation. It seems that considerably more use will be made of this new possibility in future. Target funds included in the funds of funds have already been incorporated into the above quotas.


Hedge funds have barely any part to play

The Bundesbank's statistics show that at the end of 2005 there were a total of 16 money market Spezialfonds with a volume of €2.1bn, plus 59 fund-of-funds Spezialfonds with a volume of €2.2bn. Together, these two fund types made up a share of well under 1% of the total Spezialfonds volume. Even less significant were the hedge funds of any class. At the end of 2005 there were four hedge fund Spezialfonds, with a total volume of €171m. May 2006 saw the first report of a fund-of-funds hedge fund Spezialfonds, with a volume of €60m.

Hedge funds play a fairly insignificant role, not only as a Spezialfonds sub-group, but also as a class of assets. Only three companies reported to the survey that they had acquired hedge fund units for the Spezialfonds managed by them.

The new Investment Act only permits the acquisition of hedge fund units for the type of fund known as the "gemischtes Sondervermögen" (it is generally Wertpapier-Spezialfonds that are converted into this type of fund), to which is applied an upper limit of 10% of Spezialfonds assets.

It may be that this upper limit has been set too narrowly to make it possible to mix hedge fund units into Spezialfonds in any commercially viable volume. But there is little chance of this limit being changed in the short term, as private investors still regard hedge funds as a highly risky vehicle, and the above limit on target hedge funds is designed to protect the normal private investor from such risks.

But it also protects institutional investors such as insurers, which are allowed to hold no more than 5% of their tied assets in hedge fund instruments.


Institutional business outside the Spezialfonds

Apart from Spezialfonds, increasing numbers of investors are investing in Publikumsfonds, or are leaving the management of their securities portfolios entirely in the hands of a KAG, or issuing consultancy mandates to that effect.

For this reason, the survey on which this study is based extended its coverage to the situation as described. It was not possible to record all fund volumes, and in particular there are many KAGs which do not know their investors well enough to know exactly which Publikumsfonds are owned by which institutional investor.

If, for example, a credit institution draws on investment units, these may take the form of both own investments (known as "Depot A") and resales to end clients (known as "Depot B"). At any event, €22.8bn has been allocated to Publikumsfonds units, €72bn to free asset management, and €9.2bn to consultancy mandates.

Publikumsfonds units are therefore enjoying roughly the same level of popularity among credit institutions as among other business enterprises, each of which holds over €6 billion, or just under 30%, of the Publikumsfonds volume represented. Insurance companies, however, hold just 15%, or €3.4bn, only slightly more than non-resident investors, whose share is 14% or €3.2bn. With regard to the non-resident investors, it should be noted that their investments in Publikumsfonds far exceed those in Spezialfonds (€2.3bn).

In the free asset management sector, insurers are once again the largest customer group, with 41%, or €29bn.

Non-resident investors have entrusted more than €13bn (18% of managed volume) to fund management companies, more than they have invested in Spezialfonds and Publikumsfonds together. The third largest customer group are the credit institutions, with €11bn, then the other business enterprises with €8bn. The distribution of the consultancy mandate customers, who reserve the final decision for themselves, is quite different.

Here the dominant group are the other business enterprises, with €3bn, or 28% of the total consultancy volume. The credit institutions and the institutionalised pension providers are virtually level-pegging. With these groups, the investment volume is €2.3bn and €2.5bn, or 21% and 23%, respectively.

The slight fall in Spezialfonds volume in 2001 and 2002 is clearly a thing of the past. Even if a rapid return to the rates of growth in the boom years is unlikely, the Wertpapier-Spezialfonds once again recorded satisfactory growth in the 2005 review year.

Fund companies are also offering new services, such as free portfolio management or the taking over of individual areas of fund management.

And if the Spezialfonds is not a suitable vehicle in individual cases, the Publikumsfonds is available as a substitute. The investment branch therefore has a suitable product to offer all institutional investors.

Till Entzian is a lawyer based in Frankfurt and consults on Spezialfonds, enzian@kagg.de