Marketplace of discontents
As wary German investors emerge from the double-trauma of mistimed investments and stockmarket turmoil and decide how to move forward when their traditional haven of fixed income lies barren with yields at record lows, a well-meaning regulator is doing more harm than good.
As in other walks of life, being overprotective can have unexpected negative consequences. There is no shortage of these in Germany’s institutional market at present.
But as in other walks of life, burned fingers often turn into more nimble, savvy fingers. Germany’s institutional investors are a case in point. Here, as elsewhere, there has been a huge increase in the number of specialised mandates. Peter Schwicht, managing director at JP Morgan Fleming Asset Management in Frankfurt points out that while in the past a fund may have had an E1bn European equities mandate now it might have 15 diverse mandates totalling E1bn. “This is due to the high correlation of asset classes.” He points to an increasing interest in international real estate, precisely due to the lack of correlation.
But in terms of investor sophistication and confidence there is still some way to go. For example, the outlook for further investment in private equity is not bright. Keyword: inexperience. Schwicht notes: “the last time people moved into it in 1999 and 2000 they invested everything they wanted to invest in one or two years, whereas they should have invested in seven or eight tranches. It is a long-term business.”
In the recent stockmarket turmoil German institutional investors lost more than most. As Martin Theisinger, board spokesman at Schroders Investment Management’s Frankfurt office explains, “life insurance companies got involved in equities at absolutely the wrong time and lost big amounts. So the regulator forced them to reduce their equity exposure in order fulfill requirements regarding levels of risk reserves.”
Compared with investors in other markets Germans have had little experience of the ups and downs of the equities market with the result that the recent downturn has left the naturally cautious Germans even more ill-at-ease.
So the depletion of reserves and the low returns from both fixed income and equities has led to a shift of focus from benchmark-hugging to the other extreme. “There is now too much focus on absolute returns and risk,” says Hans-Jürgen Dannheisig, board member at Frankfurt-based BHW-Invest. “Some equities positions are well under 10% which doesn’t correspond to the long term asset liability model which requires a 25% allocation to equities. Investor behaviour in Germany is very driven by the balance sheet – they feel they must have a return to show at the balance sheet date.”
Carsten Eckert, spokesman for Allianz Dresdner Global Investors takes a similar line: “The move to absolute returns has been driven by the new sensitivity to the risk budget. Before the only sensitivity was cost.”
Investors have been remarkably insensitive with their risk sensitivity. “Some investors had benchmarks that had nothing to do with their liabilities,” says Bernd Scherer, head of investment solutions at Deutsche Asset Management headquarters in Frankfurt. “Most insurance companies and pension funds have liabilities that are interest rate sensitive with quite lengthy durations. So the absolute return product that hopes to deliver as much as possible independent of the market environment is not ideal for interest rate sensitivity; you maximise the chances that assets and liabilities will move apart.”
Historically risk aversion has been more pronounced in Germany than in most neighbouring countries. “This is due to the affinity with fixed income,” notes Schwicht. “Buy-and-hold 10-year Schuldscheine always trade at 100 even if the interest rate goes up. Other instruments have to be marked to market fixed income portfolios.”
He adds: “Most pension funds in Germany could afford a more diversified portfolio; they don’t take this route because the required returns tend to be a lot lower than in some other markets. Investors are testing the water, which is a well known concept here.”
Risk aversion is also an issue for Tobias Klein, chairman of the board of directors at Frankfurt-based boutique First Private Investment Management. “Investors prefer to buy risk in disguise,” he says. “It is easier to sell a costly structured product to the board to avoid having to confess a naked equity mandate. In most companies people think more of the career risk.”
He adds: “This is more of a German phenomenon because there is less experience of markets and prudence in Germany than in the UK, US or Netherlands for example. In Germany the industry is still very young.”
It is particularly due to this last point that education of investors is so important in Germany. Theisinger says: “We are now teaching investors how to make positive returns and where risks arise. But the investor will go back to the benchmark when the markets start rising again. It is a long road to learn.”
He points out that part of the problem is that investors tend not to use consultants; the penetration of consultants in Germany is just 15%. So why is this? “Traditionally the investor has always been with the ‘hausbank’ which has provided the full service,” he explains. “But for issues like absolute returns and liability-driven benchmarking investors need consultants but they are reluctant to pay.”
There is a feeling that the regulator, BaFin, has been a little overzealous. “Along with our clients we must now explain the situation to BaFin,” says Theisinger. “For example if we are only allowed to invest in triple-A treasuries we could never achieve the required return of 3.5%. But they are willing to listen, which is wonderful.”
Guy Stern, CIO at Credit Suisse Asset Management notes: “Often when a German institution wants to set up a Spezialfonds, the first consideration is the tax requirements and the idea of what might be the best investment comes after that, and that is counter intuitive. So investment strategies tend to be kept simple and conservative because there are so many requirements.”
The German regulator’s tentacles are doing overtime. Another area BaFin is focusing on is that of alternative investments, the new buzzword as Germans consider how to generate the required returns in an environment of low interest rates and a modestly – and unpredictably – performing stock market.
Hedge funds were by far the most talked about asset class in Germany last year. In August last year the regulator made it possible for institutional investors to invest directly in hedge funds. But inflows into hedge funds last year were disappointing – E705m according to BVI figures, compared with the E5bn to E10bn that the industry expected. This also compares with inflows of E3bn into real estate. Now estimates of allocations vary between 2% and 3%; 5% is allowed under German law.
According to data from Greenwich Associates, 24% of insurance companies and 11% of pension funds had invested in hedge funds by the end of 2004. The sample was the largest 120 pension funds and insurance companies in Germany.
One reason for the low levels of investment was that 2004 was a bad year for hedge funds. Rudolf Siebel, managing director at Germany’s Investment Funds Association (BVI) stresses the fact that the industry is still very young in Germany: “Asset managers are still in the product-building phase. We need to build up the number of funds as well as the assets under management.”
But there is a general feeling that the industry could add to the number of funds on offer were the regulatory climate not quite so onerous.
On the one hand the German authorities have been widely praised for the liberal approach adopted in the new law on hedge funds: liberal in terms of the variety of hedge fund instruments which institutions and their managers can now access.
On the other hand, requirements that hedge funds offered in Germany be tax transparent, intended as a protection for the German investor, are proving to be a logistical nightmare for both the supply and demand side of the equation. Dannheisig notes that “BaFin carries out a very thorough due diligence of asset managers wishing to offer hedge funds. From 80 managers I believe only 10 will obtain a licence to operate a hedge fund or fund of hedge funds.”
But more than that – will it be more trouble than it’s worth – both for investors and managers? Barbara Diaz, CSAM’s director of institutional marketing notes: “The new investment law for hedge funds is good in that it is flexible but the tax transparency rules are very complex and many single hedge funds are not interested in provide the necessary reporting for tax purposes.”
James Dilworth, head of the investment management division at Goldman Sachs’ Frankfurt office shares the sentiment: “The regulation makes hedge fund managers jump through 15 hoops,” he says. “The onerous rules regarding tax transparency have prevented some of the best talent coming to Germany. The concept is fantastic: to make Germany the most liberal regime for hedge funds in the world. But the execution could have been better.”
Theisinger agrees that the rules regarding hedge funds and related tax transparency need to be simplified. “The regulator and the industry need to do it together,” he says. “If we want to develop a hedge fund market in Germany we can’t just look inwards but must look outwards at what other markets such as Luxembourg and Ireland are offering. The current regulation in Germany puts up barriers and Luxembourg and Ireland are less restrictive. The German regulator has to accept this and not take an isolationist view.”
The issue of Germany’s competitiveness in this area is exercising many minds. Claus Sendelbach, head of institutional marketing at Deka Bank notes: “how can we generate the necessary know-how for a domestic hedge fund industry when through the restrictions imposed in respect of administration requirements, hedge fund activities will be administered abroad and Germany will be a place only for sales and marketing?”
The figures speak for themselves. Of the amount invested in hedge funds in Germany at the end of last year three quarters were invested in Luxembourg. Eckert: “Germany has not won a lot of ground in the hedge fund area due to the complexity of the regulations and also due to lack of experience on the investors’ side in that early phase.”
The inevitable result of the reluctance on the part of hedge fund managers to provide the necessary transparency is that only a very small part of the hedge fund universe is interesting to investors, mainly the long-short equity funds that have no tax implications. Diaz notes: “As a result, diversification through fund of hedge funds is limited.” Klein agrees: “The tax requirements for German investors produce a negative selection bias for the starting period.”
But he provides reassurance: “The bias will be irrelevant in one and a half to two years because the data will come automatically. Many auditors are perfectly equipped to offer the transparency and hedge funds - domestic and foreign - will be willing to use this service.”
Rainer Schröder, managing director of Invesco Asset Management’s Frankfurt office points out that some managers may take a more direct route: “We see asset managers work on tax transparency to make it easier to invest in these vehicles,” he says. “This is not that difficult to achieve - it’s just a matter of adjusting the reporting. I am convinced that foreign players will do the same when they see that Germany is an interesting market.”
The lack of know-how among the potential investors in hedge funds is most acute. Schwicht notes “one pension fund manager commented: ‘why should I spend 80% of my time on 3% of my assets?’ They need more resources, and with a very different knowledge base many feel that it is not worth it.”
As the market opened up less than a year ago it is bound to be a learning process. Tim Blackwell, CEO of UBS in Frankfurt notes: “Most institutions are just considering hedge funds: investors still need to get comfortable and understand the non-correlation.”
Currently an asset manager that offers Spezialfonds directly to its client must do so through a KAG whose function is administration and reporting. There has been much discussion about duplication of effort among KAGs and depotbanks in certain areas.
“KAGs provide reporting capabilities which custodian banks are now taking on themselves,” says Thomas Bauerfeind, managing director of Munich-based consultants Protinus. “The reason that KAGs still exist is not that clear any more. The whole market and especially custodian banks are waiting for KAGs to become less important and will take over their role when law changes.”
So it seems that KAGs will last as long as Spezialfonds exist and require a KAG for administration and reporting. Diaz points out that “if regulations change the KAGs may disappear” and the depotbank as the owner of the data could easily set up further reporting functions.”
IFRS will also influence the future viability of the KAG. The advantage of the Spezialfonds is that tax and profits can be booked whenever is most suitable, so tax payemnts can be deferred. On the other hand, IFRS requires that they be marked to market so the profits and tax would need to be booked each year. “So the advantage of Spezialfonds would go and the ease of mutual funds would become the overriding point because the fund prices are always shown,” says Theisinger. “The result will be a move to unitised vehicles and a consolidation among KAGs.”
The forces driving consolidation among KAGs are significant. Again our attention is drawn to an over-zealous regulator. Bauerfeind explains that the small and medium-sized German KAGs and Depotbanks are not keeping up with the larger players. “The new German law places additional requirements in terms of reporting and processing and this requires investment in IT which many of the smaller banks cannot afford,” he says.
The consensus is that the number of KAGs will fall significantly as a result of scale issues and resulting consolidation. Schröder believes that if KAGs survive there may be only 10 of them left in 10 years’ time.
So how should the medium-sized and small KAGs react in the meantime to the pressures they are facing? Eckert suggests a number of options: “They could outsource to big custodians or they could create joint ventures between friendly interest groups in the market. These developments have already started to take place. Or they could start to outsource their administration to large KAGs with the capacity.”
The problem with the KAG-depotbank structure was a lack of transparency in terms of administration and asset management costs. It also made it very difficult for the client to hire and fire asset managers, not least because each firing brought with it potential taxation considerations. In 2002 the master KAG structure was introduced to resolve these issues.
“Over time all KAGs will move to the master KAG,” says Schwicht. “It is very easy to have your asset managers under the one master KAG wrapper. You don’t have to worry about tax consequences of replacing a manager, so now when investors select a manager some select two standby managers as well because it is so easy to change.”
The master KAG would also take care of the administration. As Schroeder points out, “administration is not a differentiating factor, so for managers there is no incentive to do the KAG administration themselves. If we lose the administration to a master KAG we still manage the money. Today we win as many new mandates as a third party in a master KAG structure as we do directly through our own KAG.”
Like the KAG, the master KAG has similar cost issues. Alexander Poppe, managing director of INKA, a master KAG and part of the HSBC group, notes that “the smaller KAGs can offer the master KAG function too but are more likely to stick with their core competence of asset management on account of their more limited resources.”
But that depends on the state of the business overall, as Dilworth explains: “Many KAGs have chosen to become master KAGs because they have been losing market share in their core asset management business,” he says. “But master KAGs are administration platforms that offer low margin, low value services. A KAG with a strong asset management franchise should stay away from the master KAG business.”
Revenue is one issue; logistics are another. Dietmar Roessler, business manager of international investor services at BNP Paribas Securities Services explains: “Some KAGs try to perform the master KAG function manually,” he says. “But if you are dealing with multiple depotbanks and international asset managers this is impossible. Those that try are underestimating the connectivity issues involved in converting from a KAG to a master KAG. There is a danger that when the market shifts volumes will explode which will make it hell for those without strong IT infrastructures. Some asset managers try to sell whole package of master KAG and global custodian which takes us back to the conflicts of interest of the past.”
He adds: “Roughly 15 KAGs claim to be master KAGs but there are only five serious contenders.”
The separation of the value chain into its constituent parts of administration, reporting and asset management has also been challenging for third party asset managers. “It has been very painful and the inefficiencies will stay until standards emerge that improve communication,” says Klein. “When a master KAG outsources management to us it stays fully responsible for what we are doing so we need to have full transparency. We need to clarify the legal position between the manager and the master KAG. For example, in whose name is the manager trading at all? Legally it can not be the fund itself; it ought to be either the manager or the master KAG.”
He adds: “Master KAGs have not grasped that the investment manager is also a client. Some seem to hate us because they see us as competition. The master KAG operated by Universal is the exception; they do not pretend to have portfolio management skills. Chinese walls must be put in place to separate the functions in an appropriate fashion.”
Master KAGs are encountering competition from global custodians offering their service to German institutions. “Their advantage is that they are able to provide a global set-up with broad experience in subjects like reporting, performance analysis and transaction management,” says Poppe. “Unlike the master-KAGs, though, they do not offer tailor-made products specifically designed to serve German clients.”
Some, among them global custodian BNP Paribas, dispute this last point.
Those not wishing to deal with a master-KAG have a further option. BHW-Invest has developed a novel offering to cater for those constrained by size and available resources. “Some need partners for administration; service KAGs will be oriented to enable other KAGs to take part in the market,” says Dannheisig. “Unlike the Master-KAG, the relationship is with the asset manager and not the investor. We have invested to put the systems in place.”
But Siebel is skeptical. “The necessary scale in bookkeeping is not there. And you cannot disconnect this function from the KAG.”
Disconnect is perhaps the underlying problem in the German asset management industry. The ability of the various parties to learn and communicate effectively will be key as Germany tries to make up ground on its neighbours.