What is behind the continued success of Spezialfonds in the German market and what is on the horizon for this German speciality?

According to the managing director of one large German insurance company, their individuality is an attractive feature of Spezialfonds. "When talking with an asset manager, I can exactly discuss our individual needs, for example, with regard to the amendment of sub-asset classes."

His observation highlights two of the advantages of using Spezialfonds as seen by investors in the German market: individual requirements and the outsourcing of administration.

It has been suggested that the complexity of reporting is a problem but investors with experience in the market say that, with the success of the master-KAG, this is no longer an issue.

These are some of the advantages of a Spezialfonds:

❏ Accounting advantages. Changes in investment strategy when investing in mutual funds are only possible by selling the fund, which results in a loss or a profit that might be taxed, whereas that could be done on a balance-sheet neutral basis with a Spezialfonds. As a result, an actuarial reserve, a so-called ‘stille Reserve', can be established.. Changes in investment strategy when investing in mutual funds are only possible by selling the fund, which results in a loss or a profit that might be taxed, whereas that could be done on a balance-sheet neutral basis with a Spezialfonds. As a result, an actuarial reserve, a so-called ‘stille Reserve', can be established.

. Changes in investment strategy when investing in mutual funds are only possible by selling the fund, which results in a loss or a profit that might be taxed, whereas that could be done on a balance-sheet neutral basis with a Spezialfonds. As a result, an actuarial reserve, a so-called ‘stille Reserve', can be established.

❏ Individual requirements. Spezialfonds mandates may be tailored to the needs of a single institutional investor. So strategy, dividends and consequently the returns can be optimised.. Spezialfonds mandates may be tailored to the needs of a single institutional investor. So strategy, dividends and consequently the returns can be optimised.

. Spezialfonds mandates may be tailored to the needs of a single institutional investor. So strategy, dividends and consequently the returns can be optimised.

❏ Costs. Compared with other op-tions, including the in-house management of assets, the concept of Spezialfonds has proved to be very cost efficient, for example with regard to economies of scale.. Compared with other op-tions, including the in-house management of assets, the concept of Spezialfonds has proved to be very cost efficient, for example with regard to economies of scale.

. Compared with other op-tions, including the in-house management of assets, the concept of Spezialfonds has proved to be very cost efficient, for example with regard to economies of scale.

❏ Outsourcing. In the framework of a mandate for a Spezialfonds, the administrative duties can be fully outsourced to a so-called master-KAG.

It is no wonder then that more than half of the money invested in the German fund industry, €788bn out of a total of €1,334bn, was still allocated
to Spezialfonds as at end June 2006.

However, there are threats to the Spezialfonds. For years, market players have been predicting a reduction in the influence of Spezialfonds. The changes have not been as rapid as anticipated but new factors are now expected to take effect.

These include the introduction of the new IFRS accounting standards under which Spezialfonds looses the ability to built up actuarial reserves, an argument often used for Spezialfonds where investors maintain the ability to optimise the performance of their portfolio. Also, mutual funds offer considerable advantages.

But where does the advantage lie between using these vehicles?

"We are quite stringent in using Spezialfonds for our core assets like European equity and government bonds on the one hand," the head of treasury at one German corporate said in our latest investors survey. "On the other hand, we were never able to use Spezialfonds for our satellites, like emerging markets or funds of hedge funds due to the volume we invest."

This explains the high volumes flowing into Spezialfonds last year as many German investors increased their core asset equities, using Spezialfonds. In addition, the incorporation of other vehicles like mutual funds or exchange traded funds (ETFs) into a special fund has been a common market trend.

"It is very easy and comfortable for investors to incorporate mutual funds into a Spezialfonds to optimise the allocation," Klaus Esswein, managing director at State Street Global Advisors in Munich told our survey. "With a Spezialfonds it is even possible to outsource the administration process. This is a strong argument for institutions in the German market."

Nevertheless, despite many threats and the fact that they have been around since 1968, the German form of Spezialfonds still attract investors. Currently, there is no question that the majority of investments will go into Spezialfonds, in particular core assets like equity and fixed income.

In the long-term, mutual fund or institutional shares will definitely grow their share of the market, not only because of the increasing internationalisation of the German asset management sector but also due to advantages like transparency and liquidity.

An indication that this process is already underway was given by our latest investors survey, which found respondents' preferences giving a similar ranking to mutual and Spezialfonds. The increasing common use of satellite assets like asset-backed securities, emerging market debt or convertibles with smaller investment amounts will heighten that trend. But it would definitely be wrong to declare the end of Spezialfonds. Obviously, the German market will always be something special.

. In the framework of a mandate for a Spezialfonds, the administrative duties can be fully outsourced to a so-called master-KAG.

. In the framework of a mandate for a Spezialfonds, the administrative duties can be fully outsourced to a so-called master-KAG.

Frank Schnattinger is editor-in-chief of the German institutional investors' platform Institutional Investment

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