Looking to a brighter future

There remains an atmosphere of optimism in the German investment sphere despite the market turmoil. Both investment consultants and asset managers agree that although there have been unavoidable losses in markets, the industry is coping well in the main. 

According to Watson Wyatt Heissmann's Ulrich Wittmann, Germany has not yet been hit in a very visible way by the financial crisis. Unemployment, he said, is still rather low because German companies for the most part have tried hard to keep their employees in jobs. 

Wittmann continued, however: "I think the broad visibility will start towards the end of the year because people will be laid off then and consumers will become more cautious. The domestic economy is still in a comfortable shape but the export market has suffered but this will change."  
Germany's resilience to the crisis can be explained by the stringently regulated and conservative attitude to investing in Germany and even prior to the crisis German investors were conservative enough to not buy toxic assets and thus avoided major problems when blow ups occurred in certain financial institutions. 

By way of illustration, in mid-2007 institutional investors in Germany had average equity ratings of around 10%, which is extremely low when you consider other markets, namely the US and Ireland, having on average 60% to 70% allocation. In addition, figures by Watson Wyatt Heissmann revealed that at the end of 2008 the total liabilities had decreased 8.4% to €194.4bn from €212.3bn the year before.

This is not to say German investors have not felt an impact recently because all asset classes have suffered in one way or another owing to the overwhelming volume of risk in many guises - counterparty, longevity, and risk budgets to name just a few. Even fixed income products, which heavily dominate most German investment portfolios, were not the safe haven they once were, particularly corporate bonds. 

According to JP Morgan Asset Management managing director in Frankfurt Jens Schmitt, the biggest problem institutional investors faced in 2008 was the widening of credit spreads. 

"Because the main investment was in fixed income," said Schmitt, "there was no real place to hide. The places you could hide were very low yield government bonds as well as cash which did not fulfil liabilities but they tended to overweight credit from 2006 onwards which led to problems in 2008."

Similarly, HSBC Global Asset Management head of asset liability and overlay management Sandra Güeth said: "The crisis was not restricted to equities, so even the regulated industries who were not heavily invested in equities suffered. Also, risk factors such as liquidity risk, default risk and spread risks had a substantial impact."  

Still cautious
The German law governing insurance companies and professional pension schemes - Versicherungsaufsichgesetz (VAG) - states that allocation of monies to all "risky" asset classes is not allowed to exceed 35%. The majority of pension funds and insurance groups however are not even close to this limit, especially not at the moment. They can also invest up to 25% in real estate but it is not seen as an alternative asset under this law.

Under the regulations, the likes of equity, private equity and hedge funds are deemed "risky", which explains why allocations to these asset classes are so limited. Having said this, German investors by their own admission are conservative by nature although it is no doubt mainly a consequence of the regulatory restraints that exist. 

Allocation to risky assets, namely equities, becomes more aggressive through contractual trust agreements (CTAs) because these arrangements are not regulated as stringently as insurance groups and pensions funds. 

CTAs are usually outsourced monies from companies who are more risk averse and often invest as much as 40% into equities. Generally speaking though, the German institutional market is conservative in comparison to other European and global markets.

If you take German insurers' equity exposure, it is typically 5% to 10% despite the fact they are allowed to invest up to 35% in risky assets. 

A survey conducted by Mercer showed a trend for general falls in equity markets during 2008, with Germany investing just 6% in equities compared with the UK (54%) and Ireland (60%). Furthermore, this year (2009) the average allocation to equities in Germany remained 6% while the allocation to bonds was a colossal 83%.

The impact of equity markets on some German pension funds can be seen in the example of the CTA of Daimler. According to Mercer investment consulting principal Carl-Heinrich Kehr, Daimler's CTA experienced a negative return of more than 20% in 2008, which is indicative of a "high equity weighting".

Risk budget
A big topic of conversation among German investors is risk budget, or more specifically the severe lack of, existing in the market at the moment. This is no surprise given the current economic climate coupled with Germany's tradition of conservative investment. 

The problem, according to Schroders director Robert Schlichting, is that most institutional investors gave up their risk budgets last year and found themselves stuck with less risky assets, namely government bonds, which have caught a lot of attention in Germany as with the rest of Europe and the US right now.

Indeed, like most pension funds, Versorgungswerk der Wirtschaftsprüfer und der vereidigten Buchprüfer (WPV) did not avoid this issue. It saw its risk budget slashed as far back as the beginning of 2006 so reduced its equity allocation accordingly to less than 10%. "I think it was a good time to do so," said managing director Hans-Wilhelm Korfmacher.

The average equity rating for German institutional investors in the middle of 2007 was 10%, so WPV were not alone in this. In order to combat this, WPV put a Constant Proportion Portfolio Insurance (CPPI) structure in place. It is an overlay structure built in order to reduce the risk of losing money especially to equity exposure. It is a mechanical system which says if your risk budget goes down your equity exposure is market neutral by futures. So if you don't have the money to afford the risk you are bearing you are forced out of the market.

Universal-Investment chairman of the management board Bernd Vorbeck believed a big question going forward will be whether or not funds have the risk budgets to be able to re-enter the equity market. As with WPV, Vorbeck agreed that a risk overlay was one solution. 

"Our answer is you should have a quantitative risk overlay to get into equity risk in a structured way," he said. 

Corporate bonds
In recent months, corporate bonds have been popular in the German market, as with others across the globe. The rally, according to some, started around September 2008 but as Schroders' Schlichting observed this peak period has passed. "The good names have already rallied and now good quality spreads have tightened and people are going back into the bad quality names," he said.

Fixed income is usually deemed a safe asset class but in a market where all asset classes have taken a hit it is not necessarily a secure option, as Watson Wyatt's Wittmann testified. 

"German pension schemes who invested in corporate bonds lost money," he said. "Naturally that is only a mark to market valuation. If you take the default rates the market prices in a probably much higher default into these bonds compared to the final result. Normally insurers of pension funds hold these bonds until maturity."

The WPV pension fund spotted this early on and decided in April 2007 to sell all its corporate bonds. At the time it had a corporate bond fund in its master Kapitalanlagegesellschaft (KAG) structure but sold them because, according to WPV's Korfmacher, the market was "ridiculous". 

"The risk was not paid and you didn't get any money for taking risk and therefore we decided to quit the market. This decision was not forced by risk budgeting but was a tactical decision to leave the market and of course it was the right decision."

UI's Vorbeck highlighted interest risk spreads as a high risk from an asset allocation point of view.
He said: "Risk from an asset allocation point of view comes from interest risks which currently comes from the bond side." Again, this goes to show that risk is prevalent even in fixed income.

However, Vorbeck continued to say that Universal-Investment experienced a negative effect but it was equalled by the net money inflows. "The markets went down but our volume has grown slightly throughout the crisis," said Vorbeck. "In 2008 our inflow was €13bn and in 2009 to date we have around €5bn so we have steady inflows against the market trend. At the moment we have €95bn assets under administration, with a significant proportion of pension investments."

Alternatives
As one might expect there is not a general appetite for alternatives in Germany. Right now German funds are largely not diversified because they decreased their equity weighting. A typical portfolio, according to head of Pictet Asset Management Frank Böhmer, would be 70% to 80% fixed income, especially in government bonds, and to a smaller extent corporate bonds because the spreads are more attractive and have a better risk profile than equities. Then there would be some real estate and some fund of hedge funds and private equity. Although looking ahead these may run into trouble as companies experience difficulties.

In terms of alternatives it seems investors are looking for special pockets of opportunity and making tactical asset allocations rather than entering the market wholesale. So, to this end each individual asset manager sees things in their own way.

Aberdeen Asset Management country head Hartmut Leser affirmed: "As a business developer you have a lucky strike once in a while with alternatives but that is it. It is very fragmented and does not offer systematic growth. People have been disappointed because correlations went up in almost all risky asset classes. Hedge funds can be expensive too because they are not transparent and may not offer protection when it is needed most."

As far as the outlook for alternative investments goes, Pictet's Böhmer believed emerging markets will shine through in the next few months. 

"You can see trends right now in emerging markets because the spread between emerging and developed markets is growing and is bigger than in the past. It used to be 4.5% to 5% but now it is in negative territory for developed markets and could reach between 5% and 6% for emerging, so the spread becomes even bigger. 

"I am convinced now medium-term emerging markets will outperform the older ones because the growth of populations and demographics are working in favour of emerging markets and it is tougher for the older ones to keep that pace."

HSBC's Güeth advocated the merits of a broad asset allocation that does not focus on specific asset classes but has a solid basis in the developed markets. She said: "If risk budget allows significant equity exposure and a number of satellite investments."

Property
Property, which is not viewed as an alternative asset in Germany, has been a regular staple in many investment portfolios for some time now. WPV's portfolio invests 14% in real estate (less than 3% is in alternatives, 7% in cash and the rest is in bonds) so real estate is clearly a valued asset class.

Aberdeen Asset Management is just starting to roll out its institutional property capabilities in Germany following the acquisition of a significant chunk of Credit Suisse Asset Management in a £250m deal at the end of 2008.

JP Morgan's Schmitt said: "We have discussed with our clients now is the time to analyse and look at US real estate. It is perhaps not something to invest in the next three months but you need to be positioned for the next 12 to 24 months so you have to start now to select managers for the future and start to diversify."

Active and passive
Passive management has seen an increase in Germany and this is something several investors believe will continue to grow. This is largely because when the downturn hit people saw active management was not necessarily delivering sufficient returns.

However, looking forward there remains a need for active management, especially if investors are to make the most out of opportunities. 

Vorbeck said: "We are seeing people move away from active asset managers because of the bad performers. Investors currently act in two ways: they are investing in passively managed funds and are looking for investment boutiques to deliver absolute return to get special features into their portfolio. We are the platform for boutiques to offer their own vehicles so we see inflows on the passive side which we manage, and on the boutique side."

Changing legislation
To add to the growing list of acronyms in the German investment industry is BilMoG, or Bilanzrechtsmodernisierungsgesetz, a new Financial Standard Reform Act passed on April 3 and to be implemented in financial years beginning in 2010.

It will be regulated by the Deutsche Bundesbank and is a piece of legislation to modernise the existing local accounting standards (HGB) of German corporates. 

Towers Perrin principal Michael Freisberg explained that on one hand assets will now have to be evaluated on the German mark to market value and on the other hand the liabilities evaluated on an average of over six or seven years. 

Freisburg said: "First conclusion is Germany is changing its accounting system significantly. In the past it had stable and predefined accounting rules now it is going in the direction of IAS where it has the liability on a more realistic basis and on the assets."

Another change likely to come into force this year is an increase in the insolvency insurance premium that German companies have to pay to Pensions-Sicherungs-Verein (PSV). The premium depends on the volume of liabilities and is set to rise from 18 basis points, set in 2008, to perhaps 80 to 100 in 2009. It will be very costly for enterprises. 

Mercer worldwide partner Stefan Oecking elaborated: "One of our clients paid €1m in 2008 and now does not know what to expect in 2009 - it could be €7m or €10m, which is a lot of money." 

"It has a direct cash impact," added Kehr, "that is why it is such a big concern, it is not like a liability in the balance sheet you have to pay it today and it is gone tomorrow, not in 50 years."

The premium is calculated on the annual volume of insolvencies and the level is the flat rate independent of the risk profile of the companies, so every company pays the same rate as last year. It is based on published numbers and there is not much of a political decision about it.

A shift to DC?
A pure defined contribution model is not possible in Germany because by law there always has to be a guaranteed minimum return. 

Mercer's Oecking affirmed there always had to be some minimum guarantee that has to be provided by the entity - the pension fund or employer. 

"This has to be recognised in the supervision and therefore also the asset allocation but what we see sometimes is that companies tend to provide only insured benefits. A lot of pension funds are internally financed by direct commitments which is often the case when the employer uses the money to invest and if there is a lot of cash required by the employer they would not prefer to allocate the money outside into an insurance company or a pension fund but those who don't need so much working capital tend to have it."

Towers Perrin's Freisberg said there is a lot of work being done in moving from final salary arrangements to more cash balance or defined contribution where companies try and link the performance of the fund to underlying funds. This is a trend taking place but the majority of payments are still not linked to the funds.

"We do not have trust law like you do in the UK but overall we do not have a clear 100% DC because mainly of labour law regulations which stipulate the ultimate liability is with the employer."

Oecking added: "We see a strong trend towards DC-type hybrid plans which have some low guarantees but share the risk between employee and employer. It can be done by a third party but it tends to be done internally."

Although not a pure DC arrangement, the industry has seen an increase in ‘lifetime working accounts', or Lebensarbeitszeitkonto, where an employee accumulates payments into their own account or fund for overtime or holiday pay. There is a tax incentive to put into these accounts too.

The money can be used in a similar way to a pension but an employee can use it to finance a sabbatical, for example, or to bridge the gap between retirement and when they start to receive pension payments. They are mainly offered by large companies but are not very prevalent as most German industry thrives on Mittelstand companies (medium-sized enterprises).

Germany is currently heading towards the end of the legislative term. As several people noted, Germany is holding a general election on September 27 so many minds in the industry have switched to election mode. This in turn means there is not a drastic shift in the national attitude to investing and it is unlikely that any major reform or change will take place in the industry between now and then. Afterwards, however, who knows? The chances are equity allocations will increase at some point, but one thing is for sure - Germany is likely to remain at its conservative best even when the crisis does pass.