Still getting over the surprise
“Everyone was taken by surprise,” is the view from the German asset management association on the decision to reduce restrictions on hedge fund investment that came into force in January.
This surprise was because on 6 February, 2002, Hans Eichel, German finance minister, had written in the Financial Times that the government “has included in its draft of a fourth Financial Market Promotion Act a clause enabling short-selling of shares to be temporarily banned in Germany”.
Eichel in the FT added that special attention should be paid by global supervisory body the Financial Stability Forum “to the recent increase in the sale of hedge-fund certificates to a broad range of investors”.
The value of these certificates is linked to the performance of a basket of different hedge funds. Up to E5bn were sold to German retail investors in 2001, leading to Eichel’s concern on transparency, systemic risk to the markets and investor protection.
Rudolf Siebel, managing director at the BVI, the asset management trade body, said because of Eichel’s comments the trade body had not even pushed for a relaxation in hedge fund laws. “Everyone was taken by surprise by the Treasury move as Hans Eichel had denounced hedge funds as a threat to capital markets but a year later he took the chance of Ucits III to push this through. We had not pushed for this because of Eichel’s comments.”
The law that came into force in January as part of the wider Investment Modernisation Act allows hedge funds to be created in Germany, any investor to buy funds of hedge funds and institutions and sophisticated investors to access single manager hedge funds – one of the most potentially liberal regimes in Europe.
Although the Finance Ministry declined to comment for this article despite about a dozen calls and emails, to the FT last year it said this was not a U-turn. “Hans Eichel still sees the risks involved in hedge funds. But he now also sees the opportunities, and so a compromise has been found. There has been no fundamental change of view on his part.”
The opportunities are both for investors and the German fund management industry. Siebel says: “As an industry feel the pressure as our wishes on hedge_funds have been taken into account.
“The Treasury was under attack by the EU on tax discrimination on_funds and took this to heart very forcefully. The new law, therefore, was very clean so there would be no more discrimination attacks. And the_Treasury realised that if it was level on tax then it should move on products to maintain Germany_as an attractive market as an investment funds hub; as attractive as Dublin or Luxembourg.
“The key is whether industry makes use of this law and stays in Luxembourg or returns to native soil. Now there is no reason to launch in Luxembourg. Over time, the next two to three years, the 50:50 balance in launches between Germany and Luxembourg will shift in favour of Germany to honour the good effort by the Treasury.”
Siebel also thought there was plenty of interest – more than 100 delegates have attended each of the BVI’s three seminars on the subject – but very limited institutional demand at the moment, apart to funds of hedge funds. He added that for the use of single strategy hedge funds institutional investors needed help of consultants unless they had a very large database to screen the funds. “This is an area international pension consultants can use to make in-roads in the German market.”
Klaus Stiefermann, general manager of the ABA, the association of German pension funds, was cautious as to whether Pensionfonds, Pensionskasses or direct insurance companies were that interested in hedge funds. He says: “Schemes are usually invested in traditional asset classes as they operate in cautious, safe way. They keep in mind German law for occupation pensions – that the employer promises to step in if there is_underfunding so safe investments are their concern.”
Peter Koenig, chairman of the investment committee at ABA but talking on a personal basis, said: “In the future we can expect deeper investigations into the hedge fund area. But at the end of the day, institutional investors will not invest in products they cannot understand, so transparency and proper due diligence are a must for both sides.
“The change in the investment law has been promoted by the fund industry, and not by investors in the first place. As such, it is more the introduction of a new type of product than a fundamental change of strategies. Basic questions of benchmarking of investment funds as compared with the matching of investors’ balance sheet requirements will likely not be resolved by this initiative.
“In the institutional market, we are moving more and more towards Prudent Expert standards. At the moment, there are still some asymmetries at work: it is, for instance, still easier for an investor’s agent to invest in a plain vanilla equity fund with one of the large fund managers, than in a boutique hedge fund managed offshore.”
Siebel says that although a lot of small and medium life insurers and pensionskasse had no practical experience to date, investors were moving up the learning curve and many of the bigger schemes had already formed partnerships with hedge fund providers. In addition, the industry was more aware of risks than in the derivative losses of 1993 and 1994, he adds.
Koenig says issues remained over how the law would be implemented. “As for hedge funds operating as mutual funds for retail investors, I am concerned about three issues.
“The hedge fund regulation looks softer with respect to transparency and liquidity as compared to what we require from ‘normal’ mutual funds. This may or may not turn out to be a problem in practice. In general, we should apply the same standards to target hedge funds as we do for target funds in the funds of funds section, or as we do for the insourcing of investment management services.
“The third issue, however, constitutes a significant breach of principles for mutual funds: The new legislation allows the custodian as gatekeeper of investors interests to be replaced by institutions like prime brokers, who will very naturally pursue their own interests. This will quite fundamentally change fund industry standards for this part, to the disadvantage of investors. The question remains, if funds under this regulation should still qualify as mutual funds at all?”
Volckmar Bartels, executive director for the investment department at BaFin, says this issue of custodianship had yet to be resolved and that no hedge funds had been licensed. “This is very new for us so a lot of questions are not answered, for example the role of the prime broker. There is a conflict of interest compared to custody bank. We are still in the process of talking to industry and prime brokers on_this.”
Ucits III has bought more risks to investors and the funds industry, such as collectives being able to leverage up to 100% of assets, although this was not the leverage of LTCM’s 40x, Bartels says. “Key is the process of risk management and how companies are evaluating that risk. Ucits III is very general so a lot of detail problems and our own law on hedge funds is very general. I hope to convince fund management companies to go into cash if they have lost 50%, although this is not in the law but they should have borderlines.
“I do not fear the fund management companies will start with complex or difficult strategies; it will be simple hedge fund strategies to start with.”
He says he hoped to issue the first license in the next few weeks, although had yet to receive any requests from foreign hedge funds to be distributed into Germany, and the department required three months’ notice. He was also building the up the department with two planned hires, including hedge fund experts, if salaries could be agreed.
As Siebel says, the regulator is hesitant, especially in the first year as it only has the downside risk, therefore, the first products will be not as dangerous as they could be. This attitude of caution is seen across the industry but the products are being created, which is less of a surprise now.