German investors are beginning to draw their breath again. Especially now that they think they know where the equity markets are, but the pain equities caused is not forgotten.
The bolt hole of fixed income is where many investors bunkered down but this space could be growing increasingly uncomfortable on a forward view. Real estate and alternatives, especially in their hedge fund manifestation, are beckoning.
So where does Germany go when it comes to asset allocation? Unsurprisingly, that to an extent depends on where pensions investors are starting from.
Feri Institutional Management, the Bad Homberg based consultants have just completed their second survey of 232 German institutions, with E1,000bn in assets, covering 65 pension entities and 44 insurers.
Hartmut Leser of Feri says: “In 2001, the equity proportion of all organisations we interviewed was 17%, but that has gone down to 10%, due to both market falls and investors selling off equities. They were just not prepared to bear the risks any longer.” At around the end of last year, insurers held around 9% equities, while those involved pensions held over 16%, according to survey findings.
For all institutions, fixed income, loans and mortgages accounted for 77% of total assets, with insurance companies at almost 80% almost and pensions assets at 64% in 2003.
Claus Sendelbach of Deka AM in Frankfurt says: “Most investors are overweight fixed income.” But he believes there have been some significant shifts in investor attitudes. “No longer is it plain vanilla products, there have been moves to spread products, in addition to corporate bonds they have been interested in sub investment grade high yield, asset backed securities, and emerging market debt.” This trend is driven by the need to pick up extra yield, he believes.
But the other and almost reverse trend is the renewed interest in the Schuldscheine, the 10-year notes issued by local authorities, guaranteed by German banks, with a fixed rate of return. These suit Pensionskassen, for example, as they do not have to be marked to market for balance sheet reasons.
“The yield here is typically 4.5% per annum, so the smaller Pensionkassen and insurance companies see this as an attractive solution to invest for 10 years and longer,” according to Sendelbach. Leser says that the survey finds that there has been a trend back to have a higher weighting in “these non-depreciating and non-tradable instruments”.
These instruments have Patrik Röder at Henderson in Frankfurt scratching his head. “Five years ago, I thought these instruments would be dead by now. But investors still want them.” The lower guaranteed rates for new insurance contracts and Pensionkassen commitments can be met by the returns.
Röder reckons that as long as the accounting rules allow for the Schuldscheine and similar paper will be in demand. At consultants Mercer, Herwig Kinzler thinks any institution basing its longer term strategy on these 10-year papers has not got a proper grip on what is happening in the world of accounting standards, which is threatening the book value approach. Bafin, the German financial regulator, is looking at the question of marking to market. “If it finds that you are under-funded on a marked to market basis, then you could be in trouble. These balance sheet advantages are becoming irrelevant. The move to international accounting standards will hit these pension plans in the end.”
The knock on effect could be to end the love affair with the Schuldscheine. But in the meantime, Kinzler argues for more diversification within bonds into the credit area. There are signs that this is happening with asset-backed securities in demand from some investors in addition to corporates bonds, says Andreas Krebs at Cominvest, who adds that there is little new demand for Pfandbriefe, the German mortgage backed bonds.
“People are realising that that bonds alone won’t solve their problems,” says Sendelbach at Deka. A view that Leser echoes: “The intention is to increase the equity weighting. Everyone knows we cannot do without equities.” The question is by how much. The Feri survey the proportion of equities going up by 2.2 percentage points by the end of next year for all institutional investors, with the pension sector allocating just a further 1.3% bringing their total equity exposure to nearly 18%.
Anecdotally, Sendelbach reports: “Investors are moving from their low levels, and step by step as their risks reserves allow they can increase the equity exposures,” he says. “This gradual approach is good all around.”
Krebs takes a more sanguine view too of the prospects for equities. “With markets better, risk budgets are higher, investors feel they can tap in again, but it is not going to be an overwhelming development. Equities are still perceived as risky.”
Röder says that the whole equity debate has shifted from the scenario before the market collapse where people were complaining about the quantitative limits in Pensionskasse and hailed the virtually limit free arrival of Pensionsfonds. “Investors do not require anything like the 35% equity limits in PKs to meet their current needs. In fact people like the quantitative restrictions.” He puts the Pensionskasse allocation around 15 to 20% for equities.
Among the Versogungswerke, which provide occupational pensions for those in the professions, such as doctors, dentists and architects, Kinzler at Mercer puts the typical equity asset allocation at around 25%.
At the other end of the spectrum, are the contractual trust arrangements (CTAs), seen as the free spirits of pension schemes, unburdened as they are by the restrictions facing others. Some regard them as just clever financial engineering and by others as the closest German corporates can get to an Anglo Saxon model of a pension fund, with its off the balance sheet advantages, and complete freedom when it comes to asset allocation and investment.
“We reckon CTAs could have 40 to 60% on average in equities, depending on their circumstances,” says Dirk Popielas of the pensions group attached to Goldman Sachs asset management arm in Frankfurt. “The proportion will vary from CTA to CTA, and some will be as low as 30%.”
At the Morgan Stanley pensions group, Sabine Mahnert, who advises on CTA structures, points to the need for these assets to match liabilities on a scheme-specific basis. “As government bonds are a good (only if duration matched) but not perfect match for pension liabilities, diversification into other asset classes such as equities and credit is necessary. These provide the yield to keep down costs and diversification benefits for the non-matchable elements in the liabilities. What this amounts to will vary from scheme to scheme, depending on the structure of the liabilities and the risk tolerance of the sponsor. Currently, the risk appetite is such that sponsors are unwilling to allocated more than 30–40% towards equities, often in combination with downside protection strategies.”
The equity portfolios in themselves need to be revisited? According to Feri, portfolios are mainly anchored on European mandates, about which Leser observes: “There is a strong home bias and a need to diversify.” But there were some international mandates, including those for Japanese and US equities.
Röder sees equity portfolios rebalancing on a more diversified European basis, with an interest in passive investment as more funds move to core satellite strategies. The Feri survey picks up a definite shift to passive investing in equities. “There are two kinds of investor, the first has a high share of investments in passive, perhaps up to 30%, but many smaller investors are starting to think about it,” says Leser, who also notes some interest in core satellite and to enhanced indexing.
At JP Morgan Fleming, Peter Schwicht is optimistic on the changes of investor attitudes. CommerzInvest’s Krebs notes a change too: “When talking about equities, the emphasis is on more diversification and looking at specific areas.”
Schwicht points out that with the demise of the traditional balanced product, the move is down the specialist route, driven increasingly by the growing presence of investment consultants in the portfolio construction and manager selection. “The market is becoming much more specialist manager driven, whether at a global or European level depends on which consultants are used,” he says. He sees portfolios built-up of a wide range of processes as investors seek an increasing proportion of alpha to beta in their returns. “Alpha comes from managers’ processes.”
Schwicht regards this as a recognition that investors are moving away from a fixation with absolute returns. “Investors are open to a broader asset allocation and a multiple of products that are very specialised.”
The interest in tactical asset allocation is a reassertion of the function that was embedded in balanced mandates, but operating over a wider asset range.
Contrasting the developing scenario in Germany with that of the US, Schwicht points out that typically pension funds on the other side of the Atlantic would have a range of five to 10 products on offer, in Europe this could be up to 80 products. “All of our discussions are about specialised products. Consultants accept that this can mean multiple processes within different products of the same manager.”
Röder would like to see a move from the “tyranny of the two asset classes”, particularly to more consideration of real estate. This is a move that Feri thinks is under way. Up to five years ago, institutions could hold anything from 3 to 14% in real estate, usually directly held and based where the investor was located, with a bias to residential property. The pension sector’s allocation was just under 10% on average in 2003, according to the survey.
“This is now being revisited. The strategy is to sell off the direct investments and to invest the money in real estate Spezialfonds,” says Leser. “This market is growing very quickly.” The survey expects pension investors to allocate a full additional 1% of assets to real estate by end 2005.
Henderson’s Röder believes that real estate allocations could climb very smartly in the next few years, going to perhaps as high as 20% for some portfolios, depending on their ALM studies. “There is high demand for this.”
Popielas at Goldman Sachs sees a change in attitude from the tendency to spend more of the risk budget in the direction of bonds. “Is there a more creative use of their risk budget? Instead of moving more into pure equities go for more diversification” Investors should be looking for new sources of active returns, he maintains. “We suggest looking at overlay strategies, such as in currency or in global tactical asset allocation. Those area with high potential alpha returns such as small caps and emerging market equities. Then alternatives such as private equity and hedge funds.” In addition, there could be opportunities to match liability duration using derivatives to hedge balance sheet risks.” Then use whatever capital has been freed up to look for additional returns on a risk managed basis.
This message may indeed be falling on ears that hear, but minds that are not ready to respond. “In terms of hedge funds and private equities, investors are still cautious,” warns Leser. “Some think investors have 5 to 10% in alternatives. Our survey findings are that they have less than 1% even if both are counted together. Most investors have zero and a few have a little exposure.”
He adds: “While the intention is to increase this, we are still just talking about 1.5% in a few years’ time. That makes it an interesting niche for suppliers if business is going to double.”
To what extent have German investors returned to their traditional absolute returns mindset? “Our survey shows that few people seriously think about absolute return products. People certainly think about it, but to a much lesser extent that you think.”
The idea that once an investor gets the 7.5% return required for the year, then everything is sold, says Leser.“This just does not work. If you make 7.5% in January and the market goes on to make 40% in the rest of the year, this is what you need to have obtained from stocks to have normal returns for the next 10 years, ways Leser.
Much the same applies to the concept of positive total return year after year consistently, he adds. “This is doable but it won’t be high. Investment houses claim they can deliver high returns year after year. That’s not possible, they can deliver low return – year after year.”
As Krebs sums the up debate: “Investors are really looking for absolute returns from relative return products.” So it’s a case of investors eating their cake and still wanting it – and what’s so new about that?

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