In the past for German institutional investors the Spezialfond has been a well established vehicle to manage their assets in a professional way. This becomes obvious when looking at the development of the Spezialfonds market especially in the 1990s (see figure1).
Between 1991 and 2000 the market grew by 23.4% annually, reaching almost €480bn by the end of the decade. Even the market downturn of 2001 and 2002 could not end the success story of the Spezialfonds. Institutional investors continued to pour fresh money into the KAG market. By September last year the total volume of the market exceeded €500bn.
The diversity of institutional investors using a Spezialfonds mirrors its flexibility as an investment vehicle (see figure2). It is very capable of satisfying very diverse investment needs. The Spezialfonds is most heavily used by insurance companies, pension funds and trusts which are subject to, or voluntarily subordinate to the German VAG insurance law and its investment restrictions. The high standards of the VAG, regarding assets that qualify for the actuarial reserve fund, are fulfilled through a model contract which accords with the German federal financial supervisory authority’s (BaFin) requirements, and which enhances legal security for institutional investors.
The second largest investor group is commercial banks, especially savings and co-operative banks. They use Spezialfonds to outsource their asset management functions to reduce costs and enhance return.
Corporations and related entities represent the third largest group of investors in the Spezialfonds market. They are looking for cost reductions, a buildup of undisclosed reserves and a transfer of asset management know-how. Lastly, various private non-profit organisations (eg, endowments, unions, churches) use Spezialfonds to efficiently manage their assets.
In the last few years, single Spezialfonds have increasingly been merged into so-called masterfunds administered by master KAGs. Though not a new concept the demand for this product was stimulated by a circular of the BaFin, in December 2001 which allowed KAGs to outsource core competencies such as portfolio management, fund administration, or controlling functions to other companies.
It is difficult to provide exact figures on the volume of the market for master KAGs because there is no generally accepted definition of a master KAG. Some KAGs become a master KAG just by defining their service as their core business, others obtain master KAG certificates by a consultant and/or rating agency. Further matters of definition are whether segmented masterfunds are counted towards this market if the administrator is also the manager or if a fund is not segmented but advised by a third-party? Both skills, handling segmented funds and communicating efficiently with external advisers, with straight-through processing (STP), are core competencies of a master KAG.
We see the statistics of ‘funds advised by third-party’, collected by the BVI since June 2003, as a valid and meaningful indicator for this market. Combined with our own data, the tremendous growth the market has experienced over the last few years becomes apparent. The share of funds advised by external managers grew from about 3% in 1998 to 29% by the end of June 2004.
Currently 14 KAGs are offering master KAG services. Looking at the last three quarters, the Spezialfonds market grew slightly (+0.9% number of funds; +3.2% in volumes). Interestingly, it can be seen that the master KAGs are grabbing market share: they increased number of funds and volumes by 2.9% and 8.5% respectively, while the remainder of the KAGs were losing funds and volumes
(-3.2% and -4.7%). The respective market share (volume) of the master KAGs on the overall market increased from 59.9% to 63%.
The 10 master KAGs that took part in our last survey* on this market experienced even a slightly higher growth over this period. When looking at the funds whose management has been outsourced to a third party, the dynamics within this market become even more obvious. While externally advised volumes grew 29.9% since last September, the 14 master KAGs are administering 38% more assets while the rest of the KAGs grew by only 8.9%. The respective market share increased from 72.1% to 76.6% indicating the preference of institutional clients for KAGs that specialise in fund administration and interface management.
The master KAG market is bulk business. Investors still perceive fund administration as a commodity business where only costs matter. Yet, consultants assess many more aspects to value the services of a master KAG. They estimate that, on a long-term view, €25-50bn is necessary for a master KAG to operate with reasonable profits.
While some new entrants have emerged in the market over the last year, a couple of KAGs are already drawing back. They are not actively marketing a master KAG service to new clients, instead only offering it to their existing client base. The market will consolidate strongly in the next couple of years, leaving only between five and 10 companies offering this service.
In addition to the already strong competition among active master KAGs, a different kind of competitor is waiting to take a share of the industry’s profits. In the past mainly master fund solutions were implemented where master KAG and custodian were affiliates. However, if the client chooses different companies for the different services (asset management, administration, custody) there arises some potential for extra competition.
Custodians in the German market are increasingly not content to do just the traditional custody services. They are offering more and more value-added services (eg, transaction cost analysis, performance attribution), leveraging on the data they are collecting anyway. The institutional client’s willingness to pay for such extra services will be decisive for the success of either business model.
The future of the Spezialfonds market itself will remain competitive as an investment vehicle for institutional clients. However, the requirement by the legislator to use a KAG when establishing a Spezialfonds will cease to apply in the not too distant future. Custodians are anticipating this future development and repositioning themselves as a full service provider, will become the dominant players in the market.
Ulrich Kamm and Bodo Doose, are with GSC-PPCmetrics Investment Consulting AG, Wiesbaden.
*Die Master KAG-Landschaft in Deutschland 2004 - Mehr Schein als Sein?, GSC