Fennell Betson reports from Germany

The last few years were an easy ride in Germany, with the stock market rising and money to invest, so everything was very pleasant," says Christoph Dahm of WestLB Asset Management. He has just moved back to Dusseldorf from a stint on the marketing side at WestLB's London subsidiary Quorum, so this may be said with a tinge of envy.

He is right. The German asset management industry grew rapidly in recent years and nowhere more fast than on the institutional side as represented by the huge jump in the assets under management in Spezialfonds, the major vehicle for institutional asset holding. According to the figures in the Kandlbinder Report (see analysis page 26), their assets under management were DM555bn($328.4bn) at the end of 1997, and had risen to DM660bn by May this year. These funds are a firm favourite with insurance companies, pension funds and corporates. And with good reason as Patrik Roeder, who formerly ran the Hoechst-Pensionskasse and earlier this year joined Deutsche Bank to head up Deutsche Asset Management marketing and sales in Frankfurt, notes. From an institution's point of view Spezialfonds are cost effective and advantageous, he says. "Clients set up their individual funds with just DM20m of assets upwards because of their administration advantages, with the possibility of forming undisclosed book reserves. They are a very convenient tool."

Klaus Esswein, Munich-based managing director of State Street, which has just obtained permission to start its own KAG, the investment management company needed to run Spezialfonds, very much agrees with this assessment. He points out that investors may hold realised investment gains within their fund without tax until such time as they are distributed. "It is extremely useful for an insurance company to have any extraordinary gains held within the fund and released at a convenient time. It helps mutate extraordinary income into ordinary income." He considers this feature to be the key to why insurance companies invest in these funds to the extent they do. "Even though insurance companies have now to disclose the size of their hidden reserves, they do not have to show where they are hidden." And there are the other tax, accounting and administration advantages that make them popular with other investors, he adds.

The KAG market is dominated by the large commercial banks, with Deutsche, Dresdner and Commerz running around 30% of the 3,600 funds and some 30% of their assets. But other segments of the banking market are important such as the Landesbanks, the state regional banks which are part of the savings banks operations. The biggest of these WestLB has a 4% share of the Spezialfonds market, while Bayern-Invest, the KAG of Bayerische LB, runs 125 funds with some DM20bn of assets. Similarly, the co-operative banks, through DG Bank's DEVIF operation runs over 250 funds. The foreign owned KAGS were in control of just under 5% of Spezialfond assets at the end of last year. The other notable players are the private banks, including Merck Finck & Co, Metzler and Oppenheim.

According to consultants Greenwich Associates research, the top 75 sponsors in Germany, with assets over DM1bn individually in Spezialfonds, account for 80% of the total market. The assets of these largest funds have been growing more rapidly than the total market, says Berndt Perl of the US-based researchers, by 135% as against 82%.

The KAGs look destined to maintain if not increase their momentum having received a boost last April, with a significant widening of powers. In addition to running Spezialfonds and mutual funds for the public market, KAGs can now run discretionary accounts and offer funds of funds, called Dachfonds, and the new Third pillar pension product, The AlterSondervermögens (AS). Stéphan Rey of DG Bank asset managementin Frankfurt, believes this widening of KAG powers will attract a wider number of providers into the market.

Certainly, newcomer State Street sees real opportunities in the new discretionary accounts. Esswein says they will make it easier for mandates to be awarded without going to the trouble and expense of setting up a fund. "It also allows the KAG to give advice to portfolios in funds run by third party KAGs, which they were not able to do previously. This has a big potential." Spezialfonds sponsors will be able to reduce the number of KAGs and funds they use and concentrate on perhaps just one fund, with sub-portfolios advised by different managers.

Munich-based Merck Finck, the private bank owned by UK bank Barclays, decided to merge its asset management company which ran discretionary accounts following the legal changes with the bank's operations and transfer the institutional business to its KAG, run by Josef Kaesmeier, its joint managing director. "The KAGs are becoming a more powerful weapon to manage clients' money," he says.

Another entrant to the marketplace, UK group Schroders believes the new mutual fund of fund products (Dachfonds) could prove very powerful. Alan Crutchett, who joined Schro-ders in Frankfurt from Chase at the beginning of the year, sees these as being very promising at both a retail; and institutional level. "Insurance companies will be a major user for their own purposes, in order to diversify risk in small portfolios."

Philipp Zenz-Spitzweg, managing director of JP Morgan's KAG in Frankfurt, which has DM8bn in a number of Spezialfonds, says: "We always consider whether the Spezialfond is the best vehicle for clients or whether we can deliver the same strategy through mutual funds." The new Dachfonds, will increase the choice for clients. But he thinks the regulations need to be modified somewhat before it can be really used for institutional portfolios. The 20% current limit per fund is too restrictive, he says and he would like to see currency and index hedging allowed.

Irrespective of the legal changes, what the really big draw for foreigners and others to German asset management is the sea change in investor attitudes and behaviour. "The biggest change in client demand has been the shift to equities and the diversification internationally," according to Roeder. "There has been a move from balanced to specialist mandates. Before the asset manager was given the money and told to get on with it, now we are seeing greater sophistication of clients, who are choosing managers for their strengths and mandates are becoming more focused."

Dahm at WestLB thinks the sophistication of the German institutional investor has increased, though the spectrum is wide, with some investors "very sophisticated" indeed. "Ten years ago it was very different."

A pioneer of investment practice in Germany, Ralf Bendheim, head of Dresdner's DIT, remarks on the change: "Five years ago most clients did not accept relative management, did not want a benchmark, and really believed that managers had a crystal ball about markets. Now they understand the concepts better. We see a tendency for what were balanced mandates heavily biased to bonds and with just 10 to 20% in stocks, to raise their equity stakes and accept international diversification, and with the euro are mainly buying European equities."

He hopes that by the beginning of next year the new market performance presentation standards DGFA PPS will be in use. "If these are agreed, it will give the German market another push to be more professional and move along the lines of the US market."

But in one way the market does not appear to be emulating the US is in investors' use of investment consultants, which seems to be minimal. At Bayern-Invest, which runs 120 Spez-ialfonds and has DM20bn under management, Peter Kolossa, says that not one of their clients has used a consultant, while Rey at DG Bank says: "There are less consultants than you would think with the size of the market. If 10% of our requests for proposals came from consultants, I would be astonished." The big German sponsors and the international companies certainly use them, but outside that charmed circle they seem to be starting from starting from "low base", as Dahm puts it, adding; "They can play an important role in educating the cli-ent." Roeder detects an increase in their number outside the biggest groups. "In the middle segment of in-stitutional investors, there are some German consultants who are being successful."

But that does not mean that the institutions are not choosing their KAGs after beauty parades, as there has been a cross over of specialists from the asset management side to the investors, who know what to ask of potential managers.

One group who thinks their time has come is the foreigners, particularly those like JP Morgan and Mercury, who have had KAGs for a number of years. JP Morgan is expecting the Spezialfonds market to take off in a big way. "The German groups are being faced with investors who want to go into equities and go international," says Zenz-Spitzweg, pointing to the way the major groups have tried to build up their global expertise very quickly by acquiring managers across the world. The question, for him, is will they be able to match the global processes of the international groups. Those rumoured to be setting up KAGs include Bankers Trust, Goldman Sachs and Chase. So the market is preparing for an onslaught. Zenz-Spitzweg comments: "We could see the share of foreign managers double or triple in the next three to five years."

Crutchett at Schroders says that after six years in the Germany "the rationale for our establishing a KAG was to be nearer the market as you are limited as to what you can do otherwise." He speculates that "the cadres of global asset managers are currently revisiting their German strategies."

Before obtaining the go ahead for the KAG, State Street had been operating as as a sub adviser to portfolios placed within Spezialfonds being run for clients by other KAGs, and it had built up assets of DM2.3bn under advice . "You are always seen as an outsider by German clients unless you have the domestic operation," says Esswein. "German investors feel the need for the euro investment, but as local KAGS have not really gone international, so this is very positive for us."

There are local groups who would dispute this resolutely, from the big commercial banks down to the private banks. Dresdner's Bendheim does not accept this assessment. "The only place with investment opportunities now is Europe. The continentals know Europe better and can compete better with the big American companies, who do not have the European record that continentals have."

Alexander Schindler managing di-rector of Oppenheim KAG in Col-ogne, says their clients are well on the road to euro portfolios. "The transition from single market to regional started last year."

It is the biggest banks, with assets often from the largest investors, that initially have most to fear from the incursion of the overseas groups, with their investment process and good marketing stories. Roeder regards international competition as the biggest challenge facing DAM on the institutional side.

Further down the market, the issue of distribution may make the re-pelling of foreign boarders easier, but it still leaves the question of international investment expertise open. Moves, such as the formation of a joint venture KAG by DG Bank and US manager PanAgora, may be a logical step. "Our aim is to provide a structured asset management ap-proach to the larger institutions and provide best execution," says Rey. "We do not think many German groups are able to offer this kind of product in a consistent way."

There are signs that the appetite is increasing for new products and processes. Bendheim points out that the group was one of the first to build up a quantitative team in Germany and develop its own proprietary technology in constructing portfolios: "We can deliver in a passive way, in an enhanced indexed way, we are active managers who use quant techniques in our overall approach."

As the Barclays Global Investors outpost in Germany, Merck Finck sees things moving in this direction. Kaesmeier says: "We believe quant and indexation will become fashionable here." Many of the banks are not interested in indexation and this could be because of the lack of transaction fees, he adds. But as Commerzbank points out indeed funds have taken off at a retail level, and Oppenheim says that its Euro Stoxx index fund attracted institutional as well as private client funds.

But clients will expect their KAGS to deliver the international expertise, but how ready and able are they to do this? The problems that may hit some KAGS is that they have been starved of resources by their parent banks, who let them fend for themselves on a narrow margin, while they feed off the much bigger transaction fees paid by clients (see page 20). As one smaller KAG says: "For handling international business we go outside Germany to the big investment houses. The margins in our business are so small that it is not possible to establish a group of analysts, so we have to go outside." Now these big international houses are coming to Germany as the new competition.

Other groups like WestLB intend to build an integrated group capable of delivering international expertise from the different international units within the group. From its perspective, the competition to its client base will not be the foreigners primarily, it comes from another source, the move by insurance groups into asset management (see page 23). Dahm says: "From the midst of our client base competition is coming in a big way - the insurers. We will not be getting their business anymore to the same extent, also they will be trying to compete in our market." And, of course, there could be the third whammy, should the insurance companies repatriate the massive assets they currently have with the banks' KAGs to their new asset management groups.

The market is undergoing concentration and restructuring, with some pundits predicting that the final the scenario will the 'large and powerful' versus 'the small and beautiful'. While undoubtedly, Oppenheim would be delighted to be counted as one of the beautiful, Schindler says: "As a private bank, we have no doubts that consolidation would provide us with real competitive advantages."

Whatever the pressures, the whole institutional market is aware of the potential open cast mine they are sitting on top of and the vast riches that can be pulled to the surface, if only the politicians will fall into line. As Kolossa puts it plainly: "The political parties must know that the social security system is no longer available to all and cannot continue as it is. It is almost bankrupt. We must develop the new pension fund system very quickly."

"German pensions assets need to be three to five times bigger to be the same size relatively as in the US or the UK, we have great prospects for growth," says Rey at DG Bank.

Roeder is hopeful that there will be movement in the next couple of years both on the tax and pensions issues. "We may even see funding for state pensions, as in the UK or Sweden. Funding of the second pillar will increase."

Corporate Germany is also caught up in the social security trap. Few new Pensionskassen have been set up for example, and the employee numbers covered by second pillar pensions are in decline. Employers are waiting for the new legislation for pension funds, incentivised by some tax advantages, and on a defined benefit and defined contribution basis. Once this happens, the asset wells could gush as never before for the KAGs, domestic and foreign owned."