After the sharp fall in receipts since the record year 1998, from €66bn then to barely one-third of that in 2003, Spezialfonds suffered a real slump in 2004. The last time that receipts were less than the €3.7bn collected was back in 1985. But the sector was still able to console itself with the fact that assets under management rose by €23.8bn, or 4.5%, even though this rise was mainly due to the continued recovery on the capital markets.
There is, however, little probability of the appeal of the Spezialfonds being further eroded. That is indicated by again very positive underlying sentiment in the investment sector, and by the receipts in the first five months of this year, already almost three times as high as for the whole of 2004 (figure 1).

Sharp rise in target funds
The most interesting change in the composition of Spezialfonds investing in securities (as against real estate), relates to investment in other investment funds (target funds). Although it was already the case under the Investment Management Company Act (KAGG) that Spezialfonds were allowed to invest up to 5% of their assets in other investment funds’ units, very little use has been made of this facility.
Because of the 5% limit, an investment fund management company (KAG) had to reserve resources for a direct investment in relevant securities for all investment markets in which one of its Spezialfonds intended to invest more than 5%. The use of target funds as an alternative to direct investments is linked to the setting up of additional procedures, that is with additional expense, which was for many KAGs not worthwhile, as target funds could only be used in exceptional cases, and with insufficient flexibility, because of the 5% limit.
Since 1999, investment in target funds has in any case been recorded by the Bundesbank; at that time it amounted to just 0.1% of total volume. Only since mid-2003 have Spezialfonds begun to show a sustained rise in interest in using target funds. Their share increased to 0.2% at the end of 2003. During 2004, this share trebled to 0.6%, and by May 2005 had risen to 1.0% or €5.3bn. The value in absolute terms of the target funds held by Spezialfonds has therefore roughly trebled within 12 months.
Behind this meteoric growth is the new system for classifying fund types under the Investment Act, which unlike the KAGG no longer differentiates between securities-based funds and funds of funds. Now, ‘directive-compliant special assets’ (richtlinienkonformes Sondervermögen) are free at any time to choose between investing entirely in traditional securities (especially equities, bonds, etc), entirely in investment funds, or in any combination they wish, just as ‘mixed’ (gemischtes) Sondervermögen are – provided the respective contract terms allow them that freedom. This new flexibility enables fund management companies, for example, to cover selected investment markets for all of the Spezialfonds managed by them exclusively by using target funds, and no longer to offer any direct investment in these investment markets.

Investing in open-ended Immobilienfonds, hedge funds and hedge fund certificates
In addition, it is now possible for Spezialfonds to invest in open-ended real estate (Immobilienfonds) units, and in hedge funds and hedge fund certificates. Because of the low level of correlation between these fund categories and the investment markets already covered by the Spezialfonds, there is likely to be some corresponding utilisation of this diversification potential. Taken altogether, the use of target funds could rise to well over 5% of total Spezialfonds volume.
The other changes to the composition of Spezialfonds’ assets are less spectacular, as may be seen in figure 3. The proportion of domestic equities has fallen once again by 0.5 percentage points to 5.9%, in line with the trend over a number of years, and the proportion of foreign equities has remained stable at over 20%. In the bond sector, too, the trend to international diversification is unchanged. Domestic bonds have fallen from 31.5% to 27.7% in favour of foreign bonds, whose share has increased from 33.7% to 37.9%. This means that foreign bonds have finally achieved the status of the most important class of Spezialfonds assets. What the figures do not show is whether from this development the Spezialfonds are solely dependent on foreign eurobonds, or are simultaneously operating a policy of international currency diversification. Liquidity (cash holdings and money market instruments) has been cut back, and at the end of 2004 amounted to just 5.0% (end of 2003: 6.2%).

KAG closures trend goes on
With four Spezialfonds KAGs having already withdrawn from the business in 2003 (BNP, GWA, MLIM and SLAM), the same happened in 2004. The closure of Mannheim Asset Management on 30 June 2004 has been reported previously. On top of that Julius Bär and Asecuris Asset Management have now surrendered their KAG licences, in order to cater directly for institutional investors with asset management services.
Although in the case of Julius Bär strategic considerations were paramount, for Asecuris, itself a management buyout of the former Swiss-Re KAG, the reason might have been its lack of success in the market. In any event, the mandate taken over at the outset had been very quickly withdrawn by the investor, and shortly before the decision was taken to surrender the KAG licence, just one single new mandate worth about €10m was acquired. And finally, State Street also no longer offers any Spezialfonds, and now manages customers’ money in the form of ‘segregated accounts’ instead.
No new Spezialfonds KAGs have appeared on the scene, apart from in the real estate Spezialfonds sector. In the review (cf, table 3), only Dit has begun to operate as a Spezialfonds manager, as does its sister company DBI.
In 2004, too, there were certain shifts between the various provider groups, occurring against the background of the market overall growing by 4.5%. One particular example were the KAGs of the private banks, which raised their share of the market by three percentage points, from 14.7% to 17.7%. This rise was due mainly to Universal Investment and Inka, which increased their managed Spezialfonds volumes, €13bn and €6.5bn respectively. Both of these companies had growth rates in 2004 that were well above the market as a whole, with Universal at 36% and Inka at 43%. A sizeable proportion of these volumes covers so-called ‘master funds’, run by the KAG and with responsibility for management of the fund covered by one or more external account managers.

Private banks’ KAGs expand
The KAGs of the savings banks (Sparkassen) and central savings banks (Girozentralen) also reported a gain, and at 20.8%, their share of the market is now the biggest since this survey began in 1977; at that time they were managing just 5% of Spezialfonds. Another point worth mentioning is the increase by the co-operative banks (Genossenschaftsbanken). At 0.3 percentage points, the increase was well below that of the Sparkassen companies, but in relative terms the increase is just as significant, because of the smaller starting point of a 6.4% market share in 2003. So, although the co-operative banks’ investment companies have not yet recovered the position they held in 2002, when their share of the market was 7.2%, they nevertheless seem well on the way to doing so.
The investment companies of the major and regional banks have lost 1.2 percentage points, giving them exactly one-third of the total market. The most serious, however, was the 2.6 percentage point loss suffered by the insurance companies’ KAGs; these are now managing just 11.9% of the total Spezialfonds volume. This decline cannot be linked to one particular company; it is rather that a number of insurance KAGs have all lost smaller amounts of the volume managed by them

Differences from the Bundesbank statistics
The survey established and carried out for many years by the original author of the report, Dr Kandlbinder was carried out again this year, with no changes. For each individual KAG, the survey covers the managed year-end Spezialfonds volume, the number of Spezialfonds and the structure of investors who were investing in these Spezialfonds on the qualifying date. Although the Bundesbank also publishes the structure of Spezialfonds holders in its capital market statistics, our own survey not only enables a rather different methodology to be used, but also provides a more detailed evaluation in which the structure of Spezialfonds holders, based on the different provider groups, can be analysed. This would not be possible using the Bundesbank statistics.
The findings of the Bundesbank statistics and our own survey differ in a number of respects. While the methodology established by Kandlbinder has always distinguished between the insurance sector, that is insurance companies established under private and public law, and institutionalised pension providers, ie the pension funds, benefit funds, occupational, official and/or industry/professional schemes (Versorgungswerke). The Bundesbank has always amalgamated these two investor groups into a single category.
Since 2004, however, the Bundesbank has also made the distinction between the two groups referred to above, which means that it has adapted its statistics to the Kandlbinder methodology. This not only corroborates the subdivision used here; it also means that the cost to the KAGs of taking part in this survey is again reduced, as they can simply pass on their reports to the Bundesbank to this author without changing them.
However, some companies have quite obviously not done so, as otherwise there is no explanation for the fact that our own survey shows a much higher proportion of institutional pension providers, and the Bundesbank statistics a correspondingly higher proportion of insurance companies. In this respect a number of companies still seem not to have made the Bundesbank aware of the difference.
In other respects, the obvious differences can be explained by a different methodology for classifying mutual funds (Gemeinschaftsfonds). In Form 10 380, for ‘type of unit holder’ , the Bundesbank allows the reporting KAGs under heading 08 ‘Type of Unit Holder’ only a single response, even for Gemeinschaftsfonds. Accordingly, if several investors from different investor groups are investing in one Spezialfonds, the total fund assets are attributed to the group that includes the investor with the largest stake. This means that the volume of that group may be overstated, and the volume of the other investor groups in a Gemeinschaftsfonds understated.
Following the methodology of the Kandlbinder study, however, we endeavour to ascertain the exact level of participation by the different investor groups in a KAG. This is regardless of whether the investors concerned are investing in an individual fund (Spezialfonds with just one investor) or as a majority or minority investor in a Gemeinschaftsfonds (Spezialfonds with several investors). This is done from the point of view of determining the exact sales of Spezialfonds units among the different investor groups, whereas the Bundesbank is more interested in structural market issues at the level of the instruments, for example the special assets (Sondervermögen).

Full survey participation
One again it was pleasing to note that all 55 KAGs took part in the 2004 survey; according to the Bundesbank’s statistics, on the qualifying date these were managing a total volume of €552bn in 4,914 Spezialfonds. So once again the whole Spezialfonds market was included in the survey.
In evaluating the survey findings there is once again – as there was the year before – a rather higher total volume than the volume determined by the Bundesbank, and also a different number of Spezialfonds. The relatively minor variations are, however, within the range seen in previous years, and are partly based on subsequent corrections by individual companies and partly on calculation errors. Such variations can probably never be avoided altogether, but fortunately they do not detract from the meaningfulness of the survey.

Institutional pension provision gaining in importance
During 2004, there were also discernible shifts within the investor groups. Although still the largest investor group, at the end of 2004 the insurance companies held 35.9% of the total Spezialfonds volume, almost two percentage points down on the previous year. In view of the net units repurchased from this group observed by the Bundesbank, this is not really surprising.
Investors from the institutional pension providers group, namely, the pension and benefit funds and industry schemes have increased substantially; this investor group has grown by four percentage points to 19.5%. Three other major investor groups have each lost almost one percentage point: the credit institutions, which now hold just 23.7% of Spezialfonds; other commercial enterprises, with just 11.4% now; and the churches, foundations, religious-charitable organisations, associations, trade unions and other Spezialfonds investors with just 7.5% now.
The changes in the investor groups of the various KAG groups can be seen in figure 4. What is particularly striking here is that virtually all institutional groups have managed to increase the proportion of institutionalised pension providers among their investors. In fact, for the private banks’ investment companies, this investor group now holds 32.9%, making it the most important. Furthermore, in these KAGs, the proportion of insurance companies has fallen very sharply, from just below one-third to just over one-quarter.
The churches and other licensed Spezialfonds holders do play a key role in the investment companies of the major and regional banks, along with the KAGs with foreign parent companies, each holding 10%; however, the year before each had a share that was higher by around 1.5 percentage points. Once again, it must be pointed out that this investor group is able to make its own decisions on Spezialfonds investments, independently of all fiscal and accounting considerations, and that changes in such framework conditions will not therefore lead to the redemption of fund units.

Insurers part with €8.8bn
The Bundesbank uses the same methodology to calculate how receipts are distributed across the different investor groups as it does to calculate fund volume. This is proof of the marked influence that the insurance companies continued to exert on the Spezialfonds branch in 2004, albeit in the sense that they have redeemed unit certificates with a value of over €9bn. The social insurance institutions, too, cashed in a net total of €1.4bn, thereby shedding 10% of their investments in Spezialfonds. Net receipts, however, came from credit institutions, as well as from the churches and other investors, each with €0.7bn, and, in particular, the other enterprises with €8.8bn. The non-resident investors, too, again made a small but positive contribution of €0.3bn.
What is interesting, however, is a look at the gross receipts; in 2004, the KAGs still managed to issue new unit certificates valued at €95bn to Spezialfonds investors. Sales of unit certificates therefore seems to be going nearly as well as in the record years; in 1998, the total was €170bn, but since 1999 gross sales have fluctuated between €90bn and €110bn. However, in the case of the gross receipts reported to the Bundesbank in 2004, these are generally not completely new Spezialfonds investors. It is more the case that, for example, the switching between different KAGs is recorded as receipts, for instance in the amalgamation of several funds into one master fund. Nevertheless, the figures do show that it is still possible to acquire new investors for one’s own KAG.
The insurance companies have redeemed about 4% of their Spezialfonds units. As a result, the volume of Spezialfonds investments by insurance companies has fallen in overall terms, and at the end of 2004 amounted to €196bn, according to this survey, and €240bn according to the Bundesbank. Figures from the German Financial Supervisory Authority (BaFin) also point to a fall, both in absolute and in relative values. In 2004, the significance of Spezialfonds for the total volume of insurance investments decreased by a full percentage point to 21.2%; in the first quarter of 2005 it rose again, albeit only slightly, to 21.3%. In parallel to that, the proportion of Spezialfonds in the insurers’ securities holdings fell by 1.2 percentage points, and at the end of 2004 stood at only 63.9%. Thirty years ago, this figure was just 6.0%, and peaked at 67.7% in 2002.

Increasingly unattractive for insurers
The figures indicate that the attraction of investing in Spezialfonds is no longer as great as it was a few years ago for insurance companies. The fact that a proportion of the redemptions in 2004 were due to special circumstances, and that the insurance companies had already allocated a further €5.4bn to Spezialfonds in the first quarter of 2005, does nothing to alter this view.
The reasons why investors are looking for alternatives to Spezialfonds were suggested last year. First and foremost among these is a certain degree of market saturation, as a proportion of just below two-thirds of the entire investment portfolio is a very high value (among the credit institutions, fund units make up only 10% of the investment portfolio).
But saturation is no reason for reducing Spezialfonds investments. The IFRS in particular could well play a key role here, as their rules for the reporting of Spezialfonds are very different from those of the German Commercial Code (HGB); for example, investors who hold more than half of a Spezialfonds – and that applies to about 80% of them – have to consolidate gains and losses just as if they were dealing with a controlled subsidiary. Gains and losses on disposal realised by the fund, for instance, consequently have to be taken fully into account.

New possibilities
If, as in the past, fund managers act without considering the effects their actions might have for an investor’s tax or accounting, this can produce some surprising effects on the balance sheet that give the overall picture of the group a very unusual appearance. This can only be avoided if the KAGs not only seek to comply with the sometimes very costly reporting requirements, but also proactively endeavour to control the accounting effects of fund management. Many KAGs have yet to resolve these problems, with the result that the investors concerned either have to involve themselves restrictively in fund management, or wind up their funds.
When investing the capital assets managed by them, insurers are subject to detailed regulations. That is understandable enough, as the assets concerned are either cash funds entrusted to them by policyholders under the terms of capital formation agreements, or cash funds that have to be made available to policyholders in the event of a claim (known as ‘restricted assets’).
Risky speculation where there is a possibility of total loss would be counter to the whole concept of insurance. The basic idea of investing policyholders’ funds securely, profitably and with spreading of risk is described in § 54 of the Insurance Supervisory Law (VAG), the investment ordinance (Anlageverordnung, AnlV) and other Circulars from the German Financial Supervisory Authority (BaFin).
The investment ordinance was amended in 2004, in order to track the changes in the Investment Act from the Investment Management Company Act (KAGG), in particular the removal of the difference between Wertpapierfonds and funds of funds (Dachfonds) by creating the richtlinienkonformes Sondervermögen and the gemischtes Sondervermögen.

Any funds insurers like in future
The BaFin Circular R 29/2002, directed at insurance companies, also includes additional ‘instructions’ on investing restricted assets. This circular is now to be cancelled and replaced by a new one. The present draft of the new circular, which has been sent to associations and companies for comment, provides for a number of changes to the existing legal position.
One key change, in the case of transparent investment funds, that is funds whose composition is sufficiently well known to the investing insurer, is the possibility for insurance companies only to apply those risk assets that are actually present to their risk ratio. There is no longer any need for a special contractual clause to safeguard their eligibility as cover funds (Sicherungsvermögensfähigkeit, formerly Deckungsstockfähigkeit), which means that insurers can now in effect acquire any fund they wish, and no longer have to differentiate between purely bond funds (Rentenfonds) (formerly: set off against the bond quota) and mixed, or equity-based funds (Aktienfonds) (formerly: offset against the risk ratio).
The figures for net receipts from the insurance companies’ group in the first quarter would seem to indicate that the repurchases seen in the past year were only a temporary phenomenon.

Banks cannot afford any balance sheet rejections
The banks and other credit institutions also reduced their fund investments in 2004. From the peak of 12.1% of the whole securities portfolio in 2002, the proportion of investment funds has been falling continuously, and at the end of 2004 stood at just 10.1%. This trend persisted into the first few months of this year (2005), so that at the end of April 2005 investment units represented just 9.6% of the credit institutions’ securities. Like the insurers, credit institutions are very much affected by the introduction of IFRS, and cannot afford any surprise rejections of their consolidated balance sheets as a result of fund managers directing their trading solely at the capital market.
Investment in Spezialfonds is naturally extremely sensitive to the tax treatment of investors compared to investors in other vehicles, such as certificates or even direct investment.
Under the law covering implementation of EU Directives (EURLUmsG), with effect from 1 January 2004 the legislature has extended a provision which had previously applied only to private investors to Spezialfonds investors.

Questionable tax regulations
Under these regulations, 10% of the costs incurred by the fund can no longer be taken into consideration when calculating the investment income chargeable to tax. This change was ostensibly a “rule to simplify the allocation of advertising costs”, and is presumably (the legislative rationale is silent on that point) based on the consideration that the KAG provides part of its management service, not with the aim of increasing taxable income, but with the aim of realising tax-exempt price gains; accordingly, part of its costs may not be deducted as advertising costs from income chargeable to tax.
Prohibiting such a deduction is a decidedly questionable move for private investors anyway, but the burden of the deduction ban is nevertheless to be placed on those private investors who have invested in money market funds or other funds whose income is exclusively chargeable to tax. In the next interest-raising phase this will also include bond-based funds (Rentenfonds).
Nevertheless, the extension of the deduction ban to Spezialfonds investors that has now been implemented seems completely arbitrary and unsystematic, because for those investors any eventual price gains were, and are, chargeable to tax in any case at the latest when the units are redeemed. This is a graphic example of how every possible means is used to generate tax revenue. ‘Streamlining’ is the argument used to justify it, and it is pointed out that tax does not have to be paid on price gains before a payout, even by corporate investors.
The legislature has therefore expressly confirmed its awareness that these price gains will be chargeable to tax in any case. By prohibiting the deduction of costs, the legislature is therefore consciously violating the principle that all costs expended to generate taxable income can be made chargeable to tax.

The hidden agenda
The effects of the regulation are lessened by the fact that where fund units are redeemed at a later date, a corresponding balancing item can be reversed to reduce tax, so that the disadvantage is non-permanent. However, a regulation whereby costs can only be claimed when the corresponding taxable income flows in is unknown in this form elsewhere in tax
Ultimately, this creative regulation can only be aimed at raising tax revenue. And to conceal this intention, the sums expected are described as “unquantifiable” in the legislative rationale. Surely it would not be so difficult to ask the Bundesbank about the volume of Spezialfonds held by tax-paying investors and then to calculate 10% of an estimated cost ratio.
The reaction of the German Federal Finance Ministry (BMF) to the protests from the investment sector tops it all. Rather than removing the anti-system provision as quickly as possible, the BMF refers to a simple way to circumvent the deduction ban, namely to invoice investors directly for the fund’s costs.
It does not seem to bother the BMF that such a procedure is contrary to the very concept of a fund, involves myriad further problems (claims against investors could constitute large exposure for the KAG; accounts and collection departments would have to be set up, etc.) and could be treated by the tax authority as unlawful evasion within the meaning of the fiscal code.
For investors, albeit only for tax-paying investors, the ban on deducting costs represents a liquidity handicap in the region of one to two basis points, putting Spezialfonds at a disadvantage against other vehicles. In the end, the loss of interest suffered by the investor because of this liquidity handicap will not, of course, crucially influence the decision for or against a Spezialfonds, but it is nevertheless extremely annoying and cannot be accepted permanently.

Rise in volumes because of rises in value
In 2004, the total volume of Spezialfonds assets rose by 4.5% to €552bn. This is less than the year before, when managed assets had increased by 9.5%, but there was not so much help from the capital markets as in 2003.
Because only €3.7bn of the €24bn increase in managed assets was attributable to receipts, the €20bn rise in value, plus the €16.5bn earnings payouts are therefore due to the price gains achieved by the fund managers on the equity and bond markets. The average rise in value of Spezialfonds was about 6.7%.
Simultaneously with the very moderate growth in volume, the number of Spezialfonds fell again, by 337 to 4,914, at the end of 2004, still below the five thousand mark that had first been passed in April 2000.
The peak level of 5,592 was in fact recorded in August 2001, and the fact that this peak level is likely to stand for some time says quite a lot about the situation. The possibility of tax-neutral pooling of Spezialfonds means that a key inhibitor to the increased use of so-called ‘master KAGs’ has disappeared. The corresponding regulation in the Investment Tax Act has been in force since 1 January 2004, which explains the increased fall in numbers over the past year.

Wave of mergers
Nevertheless, for individual audit companies, the detailed wording of the law is cause for some uncertainty about interpretation, which was only removed by the explanatory letter from the BMF in June 2005. Accordingly, in the next few months there is likely to be a fairly sizeable wave of fund mergers in the Spezialfonds sector.
Because of the development described above, average fund volume has risen once again, and at the end of 2004 stood at €112m, a full 10% above the previous year’s level. And four months later, the average actually totalled €117m. The average volume of Publikumsfonds has also increased, albeit only slightly, from €180m to €182m. This trend should have a positive effect on the earnings power of the Spezialfonds KAGs, as part of the operating cost arises for the individual mandate irrespective of the value of the managed asset.

Derivatives ordinance and master KAGs
On the other hand, although to some extent it is the reason for the rise in average fund volume, using a master KAG construction often involves considerable additional cost. That is because orders, and the exact composition of the segment for which an external manager is responsible have to be continuously coordinated between the external portfolio manager and/or adviser and the master KAG. This requires the intensive use of fax machines or the setting up of functioning electronic interfaces.
With funds being reorganised to comply with the Investment Act, which is, incidentally, a prerequisite for the tax-neutral pooling of several Sondervermögen, the KAG is also faced with the task of applying the derivatives ordinance. The KAG has a choice here between the ‘simple’ and the qualified approach. For the simple approach, as under the KAGG, the investment ratio of the Sondervermögen is calculated by adding the value of the existing securities to the ‘value-at-risk’ of the derivatives employed.

Calculation of value-at-risk
The value-at-risk is an equivalent securities value, determined using the delta method; this value expresses how much would have to be invested directly in the securities underlying the derivative to incur the same market risk as with the derivative employed. The investment ratio may amount to 200% of the value of the Sondervermögen.
Under the qualified approach, a ‘comparative asset’, that is a virtual comparative fund, is created, and the amount of the value-at-risk (VaR) calculated. The VaR is calculated, just as for the actual Sondervermögen; this may be twice as high as the VaR of the virtual comparative fund, so that the 200% limit also applies in this case.
It has now emerged that this new rule has certain challenges in store for master KAGs and external segment managers. Specifically, various combinations of circumstances are conceivable, where the KAGs and the managers of the individual segments calculate the 200% limit using different approaches or methods.
If the KAG then discovers a violation of the 200% limit for the whole fund, each of the managers responsible for an individual segment may well insist that they have stayed completely within the 200% limit in their own segments. It is even conceivable that the disposal of a security will result in a reduction of the VaR calculated at segment level, and at the same time to a higher VaR at total fund level.

Risk-reducing transactions non-dependent on segment
It will be difficult in this case to blame the segment manager concerned for violating the 200% limit at total fund level. In practice, this challenge can be resolved, for example by applying generous safety margins that would have to be agreed between the master KAGs and the segment managers. The downside of this solution is, of course, that the earnings opportunities from as complete a utilisation as possible of the 200% limit are non-productive.
Another possible solution would be for the KAG to specify risk-reducing measures suited to the segment managers, such as doing without the regrouping. Then, however, the segment managers would no longer want to take full responsibility for the investment performance of their segments. So in the end, the only remaining method is for the KAG to arrange suitable risk-reducing transactions for the whole fund, independently of the segment managers; those transactions would not be allocated to the performance of any one segment.

Strong demand in 2005
In the first few months of this year alone, almost three times as much money has flowed into Spezialfonds as in the whole of 2004. If this trend continues, the branch will see a return to the level of 2003 or 1995. So, while the record inflows of 1998 are still some way off, the area can still hope for a return to healthy growth.
Till Entzian is a lawyer based in Frankfurt and consults on Spezialfonds