Shunning the black box
Imagine you are at a cocktail party by Lake Geneva on a warm summer evening, perhaps in Lausanne or Montreux. And as you sip a drink and enjoy the view of the sun setting behind the mountains you are aware of an ambiance of good feeling, you see people networking and you hear the murmur of them exchanging the latest ideas about hedge funds.
What you will not see in this picture is many Germans. Despite your geographical closeness to Germany, you will find Anglo Saxons from the US and from the UK, and even from the Cayman Islands and Bermuda.
So why are Germans so shy when it comes to hedge funds?
Well, hedge funds face considerable opposition in Germany. First, opponents feel that the incentive model for hedge fund managers, which sees them take 25% of the profit, is exorbitant. Second, there is a liquidity problem - it is hard for an investor to get the money out. And third there is the issue of transparency - a manager will not tell you exactly what he is doing. The hedge fund is a black box and that is simply too dangerous.
The recovery in equities last year and earlier this encouraged many German investors to hope for a revival of the bull market of the late 1990s. So they stay heavily invested in stocks and certificates. More recently some investors have taken the view that they should avoid giving money to funds that are potentially destroying German industry, a view that emerged from the political arena.
In last year’s general election campaign German politicians, most prominently chairman of the then-ruling Social Democrats Franz Müntefering, blamed hedge funds for manipulating the economy, destroying the German industry and causing the high unemployment rate.
Such comments are less than helpful because in a global economy money can decide where it goes and investors demand at least an open climate of give and take so that business can grow.
But to be honest hedge funds do not have much influence on large- and medium-sized industrial companies. Instead, increasingly they engage in an activist investing style, as typified by Soros Fund Management or Pirate Capital.
Over time these activist hedge funds have created more jobs than all the major DAX firms together. Tensions arise when their approach seems to be aggressive as in the Deutsche Börse case in which the UK-based Children’s Investment Fund (TCI) played a role. But when you cherish the good you have to accept the less than good.
Activist hedge funds do not only stand for corporate governance but also for flexible restructuring. They lend money to companies in trouble when no other financial institution is willing to take the risk. And it is not in their interest to destroy a company but to restructure it. This means that cost-cutting measures have to be implemented so that over time the company will again be profitable and new people hired. Hedge funds have a very high success rate in such exercises.
There might be a clash of cultures when it comes to comparing the views of a politician and a hedge fund manager. Hedge fund managers chase every cent, they risk their own and their clients’ money; if they do not perform well they lose assets. However, politicians have job security for at least four years and their primary concern is to satisfy their voters.
But politicians forget that hedge funds, like all other investment firms, have a mandate. In an increasing number of instances they get it from long-term thinking international pension funds that have a fiduciary mandate to invest for those who contribute to the schemes and do not rely on the state for their savings. How ironic.
Why is this relevant? It prevents a considerable proportion of the investment community from allocating money to hedge funds.
Very often pension funds and Pensionskassen from large industrial firms will not give money to someone who could buy into a company and destroy it. Legislation and regulations are tough and risk controls discourage many pension funds and institutional investors from going directly into single funds. But it would be better to let them decide independently. When it is your own money or when you have a fiduciary mandate you think very carefully before giving it away.
Germans have to see that in the current economic and, more importantly, demographical environment flexibility is the name of the game.
We have to avoid the errors of the past. It is easy to focus on the singular successes but to overlook the millions of failures or average performances that form their backdrop.
The demographic changes will have a more severe impact on our lives than the climate changes that everybody from is aware of. The population shift from the young to the elderly will overwhelm the pensions system or reform it completely. Pension funds from all over the world will restructure their portfolios in an attempt to generate enough return.
As a recent Goldman Sachs study across most major markets has shown, pension schemes have faced significant losses in asset portfolio values primarily because to stock losses, the declining interest rate environment, falling contributions to defined benefit plans and a duration mismatch between assets and liabilities.
These factors have contributed to wider pension schemes deficits as pension plan assets have become more inadequate to fund future liabilities.
Capital preservation is one of the major regulatory requirements. In addition, pension funds have to reallocate the assets in their portfolios due to new definitions of risk-based capital. This will trigger an increase in fixed income instruments, especially in UK funds, and a demand for $2trn (€1.6trn) 30-year swap equivalents over the coming years. This is exactly the environment where hedge funds, especially those that offer intermediation services, will help.
To sum up, Germans are not familiar with dress-down Fridays. They are systematic thinkers. In many cases it takes longer than expected but if Germans are convinced by an idea it will spread by word of mouth. The government’s latest forecast of a cut in pensions and a prolongation of working hours and a working life has shocked public opinion.
German investors will come to see that in such an environment flexibility is one of the most important tools to handle positive and negative surprises. Hopefully, we will hear a few more German voices at Lake Geneva cocktail parties in the future.
Marcus Friedrich is managing director of Cologne-based Hedge Pensions Ltd and can be reached at email@example.com. His book ‘Hedge Funds: Die Gralshüter des Kapitalismus’ was published in March