What are German pension funds really up to? Dirk Söhnholz outlines the findings of a recent survey
When talking to asset management and investment bank sales people, pension funds are permanently confronted with buzzwords like alpha, alternative betas, commodities, fiduciary and FX management, inflation hedging, LDI and structured products. How can they fulfil their governance obligations in this complex environment and what role do consultants play?
We found answers for the German market in the recent fourth biannual market study of German institutional investors’ asset management decisions, undertaken by our sister company, Feri Rating and Research. Data were collected by personal executive-level interviews in the second half of 2007. Of the 220 participants with a total of €1.2trn in assets under management 65 were pension funds, and they accounted for about 10% of those assets.
The executives were asked about their current investments and their plans for the period to 2010.
Pension funds emerged as more aggressive investors than insurance companies and banks, the other institutional investors covered in the study. They had the largest allocations of all German institutional investors to equities, at somewhat more than 19%, and in alternatives, here defined as private equity, hedge funds, commodities and currency investments, at 2%.
But German market experts agree that they have yet to see pension funds with equity allocations at the levels claimed. Nevertheless, the stated investments into these asset classes are low compared with similar institutions in Europe and the US. However, the claimed allocation of around 8% to real estate would appear to be about right.
Overall, about 70% of investments are in some kind of bonds. Therefore, the interest rate risk of German pension funds is very high and in general most of the funds should be open to new investment ideas.
German pensions funds also expect to have higher asset growth than other German institutional investors. They look for growth, especially in the areas of structured products, hedge funds and private equity but not quoted equity, and expect to reduce their allocations to bonds and currencies, an area in which they did not apparently have much investment success in the past.
The survey found that the respondents expected to increase the share of alternatives to about 4% and real estate to 9%, although it is to be questioned whether these plans will be realised. First, pension funds indicated similar asset shifting plans in comparable studies in the past but only implemented them to a very small degree. Second, the study was completed in November 2007 and the recent market problems may be expected to have had a significant impact on the asset allocation plans of German pension funds.
Already, German regulatory bodies are using the current difficult market environment to demand a reduction in so-called risk capital and are therefore actively discouraging further diversification.
Overall, we do not expect a revolution in the asset allocation of pension funds, but a rather slow evolution. Nevertheless, regulatory changes and requests for more transparency may lead to differences in portfolio implementation. It is no great surprise that the demand for externally advised investments is growing. There is also a higher acceptance of performance-related fees from 23% today to 27% in 2010 of assets in Spezialfonds mandates.
It is more astonishing that the demand for passive equity funds, with a current allocation of only 13%, is not expected to increase significantly. This is compatible with the less-than-expected increase in demand for structured products, since many of these are index-tracking products. Whereas 25% of pension funds are currently invested in structured products, 44% have no plans to buy such products at all.
Current structured product investors are mostly focused on corporate bonds, structured interest products and high-yield
bonds, with about 15% of pension funds also having some structured ABS products in their portfolios. Their exposure to the credit crisis appears not to be critically high. However, there does appear to already have been some reaction to the current situation.
Anecdotal evidence suggests that some of these direct investments in structured products will be replaced by indirect investments in funds of structured products. Also, recent changes in the German investment law that allow more investment freedom within the retail fund structure, may lead to more investments through funds compared with direct investments.
Alternative investments also have their supporters and detractors. Whereas some 30% of pension funds currently invest in private equity and an additional quarter say they are considering it, the remainder show no interest at all.
More than half of the respondents were interested in commodities, half in REITs and a third in currencies. Those interested in hedge funds, currently 18% of investors with a further 16% being potential investors, were at a similar level to currency investors.
Investment motives also vary. Private equity investments are mostly seen as return enhancers, which also shows in the unusually high 50% potential allocation to venture capital, while hedge fund investments tend to be seen as portfolio diversifiers. Hedge fund investment will almost entirely be through funds of funds, private equity is about two-thirds through fund of funds, currency is mainly through actively managed single funds while currencies is done directly.
If we add the difference in size of pension funds, the desired investment profiles become even more differentiated. These results show that marketing of products to German pension funds should be very carefully targeted and that a one-size-fits-all approach would be inappropriate.
Today, 35% of manager-selection tasks are conducted by external consultants. This is relatively high compared with the consultant usage by other institutional German investors but low in international terms. The most important selection criterion for these consultants is their expertise.
This raises the question of how this expertise is assessed. Recent mandate wins in the German market indicate that the number of similar searches is often seen as the most important indicator rather than, for example, the number of asset class specialists. This means that having conducted several fund of hedge fund searches, a consultancy may be on its way to gaining a leading market share in that segment even though it may only have a few hedge fund specialists. Already it can be seen that a rather limited number of the more than 2,000 funds of hedge funds worldwide are receiving much of the new German pension fund allocations.
Pension funds were not explicitly asked about future use of consultants, but given the allocation of more mandates to external managers and higher allocations to alternatives, one may expect the demand for consultant advice to grow significantly.
Most of the growth is expected to occur in the form of institutional shares in retail funds, perhaps because asset managers are promoting them heavily. Increased interests in retail fund investments will not necessary translate directly into investments, mostly because the ability to influence and control retail funds is close to zero.
Therefore, the use of German Spezialfonds will continue to grow while the demand for segregated or special accounts might be shrinking.
Contrary to common perception, pension funds are not on a ‘trip to Luxembourg’. The share of investors who use Luxembourg funds will only increase slightly, to 30% from the 29% at present. Given the plans to invest more in complex products and the relatively low level of German administrative and custody experience with such products, this seems a small shift.
The study also analyses the perceived strengths and weaknesses of almost 200 asset managers. Given the conservative, Spezialfonds-oriented investment culture of German pension funds, it is not surprising that the top five asset managers are German houses, with Allianz as the clear leader. Maybe the low German pension fund allocation to alternative investments can partly be attributed to the little and short experience of German asset managers and service providers with such products.
The perceived lack of corporate governance excellence of asset managers is another obstacle for growth. Only 6% of pension funds believe that asset managers have fully realised all required corporate governance activities. But almost 40% of pension funds state that corporate governance is an important selection criterion for asset managers.
The study indicates that the environment for Netherlands-style fiduciary management concepts does not yet exist for German pension funds. If anything, large German asset managers and very few large international players without outstanding corporate governance structures will succeed in selling such solutions to German pension funds.
Dirk Söhnholz is managing partner of Feri Institutional Advisors in Bad Homburg