Germany introduced an innovative hedge fund regulation on 1 January last year. But German investors, including institutions, have yet to invest significantly in hedge funds, while international institutional investors are increasing their exposure to hedge funds and are even being attracted by German-regulated hedge funds. Are Germans missing the boat again?
There are good reasons why German and non-German institutional investors should invest in hedge funds. A look at the ways they can do so should focus on the role and types of transparency which the German law and institutions overall can and should require. Our firm has developed several customised structured products and also several offshore, as well as German, transparent hedge funds of funds. The lessons learned from these projects are relevant for non-German institutions as well.
Until June 2005 - when the official interpretation of the investment tax law was published - it was not clear what kind of tax transparency was required for German products. German private and institutional investors had invested several billion euros since 2000, mostly in structured products called ‘index certificates’. In reality, most were structured notes that promised to pay the investor the return of a hedge fund of funds. Most institutions bought them with capital guarantees. In addition to the single hedge funds and the funds of funds fees, these structuring costs deducted a further 100-300 bps from annual performance. Because of these extra fees, net returns have not been very convincing.
By mid-2005, the German insurance supervision authority declared that the insurance sector, so far a small investor in absolute terms but still the largest German investor, should not invest in structured hedge fund products that do not fulfil basic German regulatory requirements, including the ‘no-leverage at the fund of funds level’ rule. Therefore, most German insurance companies sold their previous holdings and are evaluating their next move.
Previously, most market participants assumed that position and transaction details of single hedge funds were required in order to achieve regulatory and tax transparency. This led to the conclusion that only managed accounts or in-house hedge funds of funds of one single funds provider could fulfil these requirements. Unfortunately, managed accounts-based products appear to have a disadvantage in terms of returns when compared with offshore funds.
Evidence for this hypothesis can be found when comparing managed accounts-based and offshore fund based hedge fund indices. The hedge fund index comparison is very relevant for institutions, since index investing is a natural first move in new investment segments. Also, most consultants, as well as the media, often use indices to prove the attractiveness or otherwise of hedge funds or hedge fund strategies, which can be very misleading.
Firstly, the majority of the prominent investable hedge fund indices produced a disappointing performance in the first half of 2005, whereas the average fund of fund has had a reasonable performance, given the low interest rate environment. Hedge fund performance overall is not directly related to stock and bond market movements, which is one of the most attractive features of this segment. But hedge funds, as absolute return vehicles, are linked to the levels of interest rates and their performance has to take the risk-free rate into consideration.
Secondly, the past performance of hedge fund strategies is usually a poor indicator of future performance.
Thirdly, hedge funds returns within the same stated strategy vary significantly, meaning that ‘tracking errors’ might be significant and therefore very attractive funds may be found in apparently unattractive market segments.
One German consultant recently publicly recommended that a large German institution should not invest in emerging markets hedge funds, since the emerging market hedge fund indices in the past showed non-attractive behaviour and looked more like expensive long-only investments. But emerging markets have become more liquid and provide more attractive derivatives contracts. Also, long-only investments appear to be quite risky in some markets.
Contrary to this consultant’s opinion, our firm is currently developing a new emerging markets long/short portfolio.
Non-investable hedge fund indices have been widely criticised for their numerous biases. They cannot be replicated and thus are not very helpful for benchmarking purposes. Since 2001, investable hedge fund indices are a more useful benchmarking tool as well as the basis for index-tracker products. However, good research on investable indices is still very limited. Investable indices differ in several respects, for example, the number of funds in the indices (highest with MSCI), the weightings of funds (asset-based for CSFB, whereas most others are equally based) and so on. The only significant difference, though, seems to be the basis of the indices. The managed accounts based indices of MSCI, S&P, HFR and FTSE seem to significantly underperform the offshore fund-based indices of CSFB and Feri (ARIX). (See graph and table 2: Hedge fund and index comparison.)
From this performance direct and indirect index tracker costs have to be deducted. These explain why managed accounts-based index tracker products often significantly underperform a simple basket of offshore funds which corresponds to the funds in the index tracker products. Firstly, one needs to add the direct cost of the managed accounts platform that is usually between 50 and 100 bps. Secondly, there are sometimes additional costs for index fund of fund administration, custody and index ‘management’ and the cost for the structured product.
However, more important is that there is sometimes a significant negative tracking error between the managed account and the offshore fund. This may be due to the inability of the managed account provider to replicate the positions in a timely manner, especially for illiquid, complex and/or privately negotiated trades of the offshore fund.
This is particularly relevant to German investors who have purchased significant amounts of hedge fund index-linked products. Also, some of the German compliant funds of funds are managed accounts-based. Furthermore, the first solely managed account-based German transparent hedge fund of funds is being closed due to the low return potential offered by managed account-based products.
Some managed accounts are also to be considered questionable investments for other reasons. For instance, some managed accounts offer higher liquidity terms than their respective offshore funds. Subsequently, in a crisis the investors in the managed account can liquidate their holdings faster than the offshore investors. Sophisticated investors will not be willing to accept inferior liquidity terms than other investors and therefore may not invest in the offshore hedge fund. This may reduce the attractiveness of managed accounts for quality offshore fund providers .
The second type of transparent product which has been offered to German institutional investors under the new law are funds of funds based only or mainly on in-house funds. Pioneer led the way and others at least pre-marketed such solutions. Since no one single investment house is permanently best in every hedge fund strategy and since early mover Pioneer did not perform too well, this strategy does not appear to be a solution for German institutions.
Other fund of funds providers focused on small and new hedge funds, because such funds are rather easy to convince to provide German transparency. At least one such funds of funds so far has generated good returns, partly because its equity long short long (German) bias has performed strongly. However, funds of funds with unproven managers are not the natural first choice for institutions.
Since mid-2005 there is a second generation of German transparent funds of funds available. German regulations impose very few restrictions on offshore funds to be eligible for German transparent hedge funds of funds – no direct commodity or real estate exposure and a limit of a maximum investment of 30% in private equity type transactions, which are simple requirements for most offshore funds to fulfil.
Tax transparency has now became much easier to fulfil and the cost for tax compliance certificates is currently being quoted at about €10,000 per fund per year plus initial set up costs, which is an acceptable level for most institutional investors. Feri recently completed a survey of its top rated offshore hedge funds, with almost all of them willing and able to comply with German regulations. This is also true for large and successful funds. These funds have a significant interest in diversifying their investor base to include German investors.
German insurance companies are now allowed to invest up 10% in hedge funds. The risk reporting and internal insurance oversight requirements are acceptable, as long as they only invest in fund of funds-type products and not in single hedge funds directly. Risk management can be outsourced to consultants or hedge funds of funds managers but other issues remain open for German institutional investors: IAS/IFRS requirements and other structuring requirements.
Institutional investors using IAS/IFRS standards, do not want to show every single hedge fund investment position in their books. To achieve this, they are not allowed to have a controlling interest - often defined at less than 20% - in a hedge fund of funds or single hedge fund. Currently, the largest German compliant hedge funds of funds have assets of a few hundred million euros, while most have less than E50m. Customised funds of funds are not an option under this scenario.
Another German requirement is the suitability for Spezialfonds. These are not allowed to invest in hedge funds of funds. But there are ways to structure customised hedge fund multi-manager portfolios for such investors. For example, they can apply portable alpha strategies using swaps on investable hedge fund indices.
All this assumes the willingness to invest in hedge funds in the first place. Most German institutions are very heavily dependent on bond returns. Institutional investors know very well that they need to diversify their portfolio. They also understand that carefully selected low-risk hedge fund portfolios can be structured that offer attractive returns. Some products being offered in Germany show annualised returns of about 5-6% with low volatilities.
Our experience in creating successful German compliant solutions has shown the importance of selecting the right business partners – the fund of funds managers, the lawyers, tax consultants, custodians, administrators and client advisers or distributors, who all need hedge fund experience and German legal and tax knowledge in order to create successful solutions for German institutional investors.
Who will benefit most from future German hedge fund demand? In the short run, not the standard international large hedge funds of funds with long track records but rather the international (mutual fund or long only) brand name organisations with hedge fund experience, institutional processes and the willingness to create new and separate German-compliant hedge fund solutions.
But the general public and media still need to be educated in the hedge fund world. For instance, hedge funds were regarded as being “locusts” after the TCI investment in Deutsche Börse and continued calls for tougher hedge fund regulations from uninformed sources are not helpful. Negative stress tests of some German insurance companies have been publicly but, according to the insurers, wrongly blamed on their hedge exposures. Allianz Leben, the opinion leader in the German institutional market, has yet to officially endorse hedge funds even though Allianz Hedge Fund partners is already a few years old. The Bundesverband Alternative Investments, the German association that promotes additional investments of German institutions in hedge funds, does not possess sufficient resources to cope with all these issues at the same time.
As a matter of interest, non-German institutions are already attracted to some German compliant funds of funds. These funds are rather free in which single offshore hedge funds they can invest but there is significant investor protection and oversight from the German authorities, the fund manager, the custodian and - if the fund is set up in Luxembourg as many of them are - also by the Luxembourg authorities.
These investors like the fact that leverage and the use of derivatives are basically prohibited at the funds of funds level; that there is a minimum of quarterly liquidity; that risks have to be clearly identified and reported on; and that fees also have to be made transparent. They sometimes only wait for Germans to invest first.
Dirk Söhnholz is managing director of Feri Institutional Advisors in Bad Homburg