Since the German Investment Modernisation Act (InvG) was enacted on 1 January of this year, Germany’s fund management industry has entered a new stage in its evolution. The new law combines the previous legislation governing both German and foreign fund management companies, specifies the information requirements for and taxation of German and foreign investment funds, and implements the new EU directives. It contains a number of improvements for German investment managers and will substantially enhance their competitiveness. It thus heralds the dawning of a new era for the German fund management industry.
The German Market
At the end of 2003, Germany's mutual fund market was worth around €950bn. This makes Germany one of the three largest fund management markets in Europe and, with an annual growth rate of 13% over the last ten years, one of the fastestgrowing. This situation is all the more impressive if one considers the relatively conservative, risk-averse way in which the German mutual fund market has been regulated to date by the country’s fund management legislation. The new, more liberal legislation is therefore likely to boost the growth of Germany’s mutual fund market in the future. Also, this will most likely have a major impact on the rapidly growing institutional fund market in Germany.
Broader investment universe
A cornerstone of the new legislation is the addition of hedge funds as an asset category to the investment universe. In the past, this product category, which is one of the fastest growing worldwide, could only be bought in the form of surrogates (certificates and structures). If we take the global hedge fund market - which is worth approximately €750bn and accounts for roughly 6.5% of the total assets under management worldwide - as being representative, this translates into a potential hedge fund market of more than €60bn in Germany over the next few years.
The regulation of investment funds ‘with particular risks’ (ie, hedge funds) under the new legislation is very liberal. For example, hedge funds are not restricted at all in the investment instruments they can use, which is a first for the German market. Hedge funds are therefore free to invest in the international markets in any way they choose. Long/short strategies and (unlimited) leverage are permitted, as are investments in the commodity and precious metals markets and dormant equity holdings. The only restrictions are on investments in companies that are not listed on a stock exchange or integrated into an organised market; no more than 30% of the fund's assets may be invested in such companies. Direct investments in real estate are not permitted.
Under the new legislation, investment in single hedge funds and funds of hedge funds is allowed, although only funds of hedge funds can be marketed to the public. In restricting the general public marketing to funds of hedge funds - which are not allowed to hold more than 20% of any single hedge fund - the new legislation seeks to protect private investors against the considerable risks of single hedge funds.
Furthermore, the rules governing investment funds have also been modified. The new arrangement abolishes the separate categories of investment fund and replaces them with the generic term ‘funds’, which are allowed to invest in equities, bonds, derivatives and investment fund units within the limits placed on issuers. One significant improvement here is the more liberal rules on the use of derivatives for portfolio management purposes1. These rules not only considerably extend the range of derivatives that may be used - now permitting credit default swaps, for example - but also allow more efficient strategies, such as overlays, to be used in active portfolio management . The much-criticised restriction of the investment ratio to 100% has also been abolished. By using derivatives, portfolios can now increase the potential market risk to 200%.
Broadening the product range
These changes, which represent a significant break with the past for the German market, create a wide range of new potential products as well as more efficient portfolio management techniques. They facilitate active portfolio management in various respects, eg, currency derivatives can now be used for active currency management, rather than merely for currency hedging purposes2. Germany’s previous fund management legislation restricted the use of currency derivatives to hedging. This meant that a number of ideas could not be implemented.
For example, investors could only express a positive view about a currency by purchasing a bond, share or cash in this currency. It was therefore impossible to clearly distinguish the overweighting of a currency from the investment decision. Consequently, for a long time currencies were hardly regarded as an asset class in their own right within the German investment community.
Use of derivatives
The new legislation will enable investors to better exploit the potential for alpha in various asset classes, especially currencies. A basic law of asset management states that the anticipated information ratio is closely correlated with the freedom of action enjoyed by investors. This applies both to the number of positions they establish and to the level of restrictions. Reducing these restrictions - as the new legislation does - is therefore likely to generate substantial potential for alpha.
The legalisation allowing pure derivatives portfolios gives rise to a number of new product possibilities. For example, pure overlay portfolios can be used to manage the asset allocation process for multi-asset portfolios. This enables a portfolio to manage its country and currency allocation as well as the market risk in a separate sub-fund without physically selling an investment, and the transaction costs it pays are lower.
The new law also permits a broader use of enhanced money market funds, which may be structured in the form of a money market investment plus a derivative overlay. This strategy enhances money market returns with an alpha from the overlay. Ideally, the amount of anticipated alpha can be steered according to the assumed level of risk3. Portable alpha and dynamic alpha strategies are a continuation of this theme. This concept is based on the idea that investors select from a menu the strategies they would like to pursue. For example, they can combine an equity index fund with alpha strategies based on instruments such as corporate bonds, currencies, mortgage-backed securities or commodities. The trend towards separating alpha and beta, which is not least being driven by consultants, is therefore compatible with the new legislation.
These developments are likely to considerably broaden the range of investment funds available. Hedge funds provide investors for whom the new investment legislation is still not attractive enough with a largely unregulated product category that offers considerable potential. These products provide efficiency gains over conventional long-only portfolios. For instance, the anticipated alpha on unconstrained funds, such as hedge funds, is roughly 50% higher than that on constrained long-only portfolios for the same active risk of 2%. As the active risk increases, this gap widens disproportionately4.
Focus: credit derivatives under the new law
In the credit area, the impact of the new law is likely to be most pronounced in the sector of credit derivatives, especially with respect to Credit Default Swaps (CDS). So far, for asset managers in Germany (Kapitalanlagegesellschaften), it has been close to impossible to invest in CDS under the old law. With the new law and the accompanying derivatives regulation (Derivateverordnung), this could change.
The credit derivatives market
The market for credit derivatives, and CDS in particular, has evolved dramatically over recent years. Apart from yearly jumps in volumes regularly reported by the BBA, several improvements are noteworthy. While initially, the five-year segment was the only one really available, now for the more liquid names, whole curves have emerged. Also, the data availability is much greater than in the past: it is now possible to obtain data for almost all traded investment grade names on a real time basis from several frequently providing sources. Finally, synthetic (CDS based) credit benchmarks have arrived with the launch of the Dow Jones iTraxx family (the consolidation of iBoxx and TRAC-X), which for credit markets could have the potential to become an equivalent to the Bund future in the Euro government bond market.
Different degrees of instrument eligibility
The law differentiates between ordinary funds (Sondervermögen) and hedge-funds ‘with particular risks’ (Sondervermögen mit zusätzlichen Risiken). While the latter type of fund is not subject to restrictions on the use of credit derivatives, the former applies strict rules. These rules again differ according to the method of risk control the asset manager has in place (specified in the Derivateverordnung): the simple approach, or the qualified approach (which is based on VaR).
With CDS, three basic strategies are of interest as an extension to currently available credit strategies: 1. Short credit via CDS with underlying; 2. Long credit via CDS; and 3. Short credit via CDS without underlying.
1. Under the simple approach, only the most basic CDS-transaction will be possible: There, a fund would buy a bond of an issuer and insure the credit risk with a CDS referencing the same credit name, ie, buying credit protection. Such kind of transaction, called a basis trade, would make sense if the credit spread of the bond was higher than the CDS premium. This strategy, however, constitutes only a limited improvement in the scope of strategies. The following two further strategy routes should be much more wide-ranging
2. Once a qualified approach to risk management is in place, the selling of credit protection (which is the same as buying credit risk) could be possible. This is equivalent to a long position in a credit bond, without the need of funding. Such a strategic option is relevant in the case where the underlying bond is not available, or difficult to obtain, or has unfavourable characteristics (as tenor, currency, etc.). In addition, this CDS-based long-credit strategy could be extended to the newly available DJ iTraxx credit indices. The selling of index protection (essentially the selling of a pre-specified basket of single name CDS) allows the quick and cheap gaining of exposure to a broad credit market sector, currently 0.5 basis points bid-ask spread for the main index
3. The buying of credit protection, which is the same as selling credit risk (as in strategy 1) without holding an underlying asset, can be considered the most powerful enhancement of the investment possibilities for German institutional investors. This allows a manager to express a negative opinion on a credit name, and to capitalise on its downfall. So far, the only option for a manager was not to own the credit, or underweight it vis-a-vis a benchmark. Short-selling the physical asset has not been and will not be permitted for ordinary funds, but even for a hedge-fund which could do so, physical short-selling can be a cumbersome endeavour due to liquidity issues. The reason why a short-credit strategy is so powerful lies in the asymmetric risk profile of a credit investment. While equities have unlimited upside (and thus unlimited downside with a short position), the same is not true for fixed income instruments. During the life of a bond, the price can increase significantly due to interest rates and credit spreads falling below the issuance level. (Since CDS bear no interest rate risk, we must only be concerned with credit spread). This does pose some loss potential for a credit-short position. However, because the credit protection premium cannot be negative (eg, even CDS protection against the default of a AAA government like France costs five basis points), zero is the tightening floor for a CDS spread. This in turn means that the loss of a short-credit position is limited, the limit depending on the tenor and premium of the CDS. As an example to illustrate the asymmetry, take a five-year CDS on a highly-rated French utility. To go long credit, one could sell protection at a premium of 14 bps. In the - very remote - event of financial distress, assuming a spread widening of 1000 bp (which is not uncommon in a crisis situation), this could result in a market value loss of more than 30% of the nominal value. On the other hand, when taking a short position on the name, and therefore buying protection at a premium of 21 bps, if the market premium went down 20bps to 1 bp in the worst case, all one was to lose is less than 1% of nominal. Of course, the wider the spread, the higher the potential for loss: the strategy becomes less asymmetric for lower-grade names.
Although under a hedge-fund regime, there are no problems with this strategy, in an ordinary fund, certain issues could arise. These stem from the fact that the new law - as mentioned - still forbids short-selling. The German regulator’s comments on the Derivateverordnung make clear that short-selling of cash instruments is to be considered different from using short-directional derivatives. However, the Verordnung does not yet give specifics on how exactly this difference is to be accounted for, because a clarification by the EU commission on that subject is still pending. What might be possible, however, even in the current situation, is the use of short-directional derivatives that do not impose the obligation to deliver physical assets. Although CDS usually use physical delivery, the contractual use of cash settlements could be a first step towards implementing short-credit strategies.
Outlook for credit derivatives
Once the required risk systems are in place at German institutional players, significant extensions to the currently possible credit strategies can be expected. Whether strategies 2 and 3 can eventually be implemented in a non-hedge-fund framework will depend on the regulator itself and the auditors’ interpretations of the law, as well as on the particularities of the strategy itself. But at least for clients willing to accept a hedge-fund framework (even if the do not want a full-fledged hedge-fund), a wide range of tools will be available. The credit derivatives market has evolved to an extent where being allowed to take advantage of it could really add value to credit portfolio management.
The new legislation thus constitutes a new era for the German market and will improve its competitiveness significantly. Against the background of the new trends in asset management, such as the separation of alpha and beta using portable alpha strategies, its liberal implementation should ensure that Germany keeps pace with the Anglo-Saxon investment community.
1 The use of derivatives is governed by the derivative regulation.
2 Although short-selling is still not permitted, this only applies to transactions in which the fund is not the sole owner of the exercise right, such as with short calls. The sale of currencies using derivatives is, however, allowed.
3 Provided the investor can achieve a relatively consistent, positive information ratio.
4 See Grinold, Kahn (2000), The Efficiency Gains of Long-Short Investing, Financial Analyst Journal, p40-53.
UBS–expanding its presence in Germany
UBS Global Asset Management is a business group of UBS, one of the world’s leading financial firms, which also includes the world’s leading wealth manager and a premier investment banking and securities firm.
We provide traditional and alternative investment products and services for private clients, financial intermediaries and institutional investors around the globe.
With some 2,600 employees, of which over 580 are investment professionals, located in more than 20 countries, UBS Global Asset Management is a truly global business. Our main offices are in Chicago, London, New York, Tokyo and Zurich.
As at 30 June 2004 invested assets totalled CHF 595bn, making us one of the largest global institutional asset managers, the second largest mutual fund manager in Europe, and by far the largest mutual fund manager in Switzerland.
By launching specific growth initiatives, UBS intends to continue expanding its presence in Germany. Its aim is to become one of the leading international players in the German market in both the institutional and mutual fund businesses. To this end, it strengthened its Fixed Income Management capability as of 1 July 2004. This larger team will enable UBS to offer innovative solutions across the entire fixed-income spectrum. Both authors of this article, Alexander Nagel and Wolfgang Kuhn, are members of the new Fixed Income Team in Germany.