Institutional Asset Management: How are professional investors affected by legislature and corporate governance?

Table of Contents

Abstract

List of Figures

List of Tables

List of Abbreviations

List of Symbols

1. Introduction
1.1 Problem Definition
1.2 Objective and Scope of the Paper
1.3 Methodological Approach
1.3.1 Scientific Classification of Subject Area
1.3.2 Methodology of the Analysis
1.4 Composition of the Paper
1.5 Definitions
1.5.1 Asset Management and Institutional Investors
1.5.2 Investment Behavior

2. Principles of Institutional Asset Management
2.1 Scientific Approach
2.1.1 Investment Styles
2.1.2 Asset Allocation
2.1.3 Sustainable Outperformance of Benchmarks
2.2 Industry Examination and Classification of Funds
2.2.1 Pension Funds
2.2.2 Mutual Funds
2.2.3 Insurance Funds
2.2.4 Sovereign Wealth Funds
2.3 Recent Industry Developments
2.3.1 Aftermath of the Financial Crisis
2.3.2 Industry Trends

3. Asset Management in the International Perspective
3.1 Legal Environment in Germany and the USA
3.1.1 Investment Regulation
3.1.2 Compliance
3.1.3 Disclosure
3.1.4 Expenses
3.1.5 Taxes
3.2 Corporate Governance in the Insurance and Pension Fund Industry
3.2.1 Best Practices for the Insurance Industry
3.2.2 Best Practices for Pension Funds
3.3 Practitioner’s Perspective on the Impact of Regulation and Governance

4. Empirical Examination of International Differences
4.1 Description of Data Basis and Mathematical Approach
4.2 Results of Statistical Analysis
4.2.1 Asset Allocation
4.2.2 Risk
4.2.3 Performance
4.3 Analysis of Results
4.3.1 Asset Allocation
4.3.2 Risk
4.3.3 Performance
4.4 Conclusions of Empirical Examination

5. Implications of Findings
5.1 Implications for Regulators
5.2 Implications for Institutional Investors

6. Conclusion
6.1 Summary
6.2 Outlook

Appendix

List of References

Abstract

This paper examines the current legislature and best practice corporate governance for institutional investors in Germany and the United States. Differences in investment regulation, compliance and disclosure requirements, as well as expense and tax schemes are identified for insurance companies and the pension fund industry. Based on current academic literature, hypotheses about the impact of different regulatory regimes are derived and tested empirically in a comparison between Germany and the United States over the last five years. Differences in asset allocation between the two countries are determined for both industries. It is shown that the strict quantitative regulation of asset allocation in Germany has no negative impact on institutional investors’ performance, yet it reduces the realized risk measured through depreciation. A principal component regression reveals that asset allocation constitutes a relevant indicator for depreciation and performance in Germany. It can be inferred that the investment regulation in Germany poses little disadvantages for investors while it provides a significant risk reduction. This conclusion is confirmed by practitioners from the pension fund industry in Germany.

List of Figures

Figure 1: Thematic Composition of the Paper with Reference to the Respective Chapters

Figure 2: Example of Investment Style Application in Practice

Figure 3: Types of Funds and Their Average Global Asset Allocation

Figure 4: Global Fund Allocation in Trillion USD by Type of Fund

Figure 5: Development of Global Assets Under Management with p.a. Growth Rates

Figure 6: Asset Allocation of Insurance Companies between 2005 and 2009

Figure 7: Asset Allocation of Pension Funds between 2005 and 2009

Figure 8: Depreciation Quota of Insurance Companies and VWs from 2005 to 2009

Figure 9: Projected Volatility of Insurance Companies from 2005 to 2009

Figure 10: Projected Daily VaR at 99% of Insurance Companies from 2005 and 2009

Figure 11: Investment Return of Insurance Companies and VWs from 2005 to 2009

Figure 12: Average Percentage Allocated to an Asset Class in the US and Germany

Figure 13: Multiple R² of PCR with Depreciation as Independent Variable

Figure 14: Principal Component Regression Validation Plots, Depreciation FY 2006

Figure 15: Multiple R² of PCR with Investment Performance as Independent Variable

Figure 16: Principal Component Regression Validation Plots, Investment Returns FY 2008

List of Tables

Table 1: Differences in Range and Standard Deviation of Asset Allocations for 2005-2009

Table 2: Overview and Assessment of Hypotheses

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

1.1 Problem Definition

Institutional investors in Germany have not seen this many opportunities to invest in stock markets for a long time – yet only very few take the courage to actually buy equities.^[1]

(Hans-Jürgen Möhring)

With these words, Möhring summarizes a study conducted by Feri Eurorating Services among professional investors in Germany. The study shows that despite reasonable opportunities to earn money in financial markets, institutional investors are reluctant to take advantage of these. Obviously, other factors besides expected performance enter the equation that yields investment decisions of professional asset managers. This thesis tries to shed light on some of these factors, predominantly the legislative environment and corporate governance.

In the face of the aftermath of the recent financial crisis, the institutional asset management industry is confronted with several emerging challenges. Even as the falling asset prices have stabilized, managers are currently in stiffer market competition for investors’ money,^[2]which is not as available as it was before the crisis. On top of these challenges, the industry is facing the public’s outcry for tighter regulation, followed by policy makers’ decisions to chain financial markets.^[3]

Institutional investors are confronted with various inherent external circumstances that are part of the decision-making process aiming at utility maximization. Such circumstances include investment regulations, compliance standards, level of market competition, tax systems as well as disclosure requirements. These factors can differ greatly between single countries around the world or even between regions within one country.

At the same time, most institutional investors are also faced with internal restrictions for their actions. Especially in highly industrialized countries, such as the United States or Germany, corporate governance of the investment organization often times limits the leeway for asset managers.

When combining both external and internal constraints of the scope of action that an institutional investor encounters, clear differences in subsequent investment behavior between single investment firms and especially on an aggregated level between countries can be observed. The arising question is whether differences in investment performance between these investment styles can be measured and how exactly they can be explained.

1.2 Objective and Scope of the Paper

In the landscape of this status quo, the meaning of both internal and external restrictions for institutional investors’ behavior forms the focus of the following scientific examination. This paper aims at identifying the key reasons for differences in investment behavior and the adjacent performance in theory. Subsequently, the study tests the emerging hypotheses empirically in order to find the valid influences that can explain investment, risk and performance discrepancies of institutional asset management between Germany and the United States.

After a presentation of the principles of institutional asset management, the latter are put into an international perspective where both external and internal environments for decision-making are examined. Conclusions on the expected impact on investment behavior are drawn before these hypotheses are tested empirically. Finally, implications for regulators and asset managers as well as research gaps are presented.

Among others, the following important questions are to be answered in this paper:

- What is the scientific approach behind institutional asset management?
- How can investment funds be classified and what are major recent developments in the industry?
- What are differences in the legal environment for institutional investors in Germany and the US?
- How is internal decision-making influenced by corporate governance?
- What expectations towards investment behavior derive from such differences and how do practitioners perceive the regulatory environment?
- Does the expected behavior take place in reality and can it be empirically confirmed?
- What conclusions can be drawn from the analysis and what are the implications for theory and practice of institutional asset management?

For complexity reasons, this paper is limited to differences in investment behavior between Germany and the United States. The thesis aims at identifying factors that influence the asset allocation and the investment performance of funds in comparison to their risk taken, opposed to an overall satisfaction of investors or other measures of quality, such as service quality. The data analysis is limited to institutional investors on the sponsoring level, i.e. insurances and pension funds. Other fund types, such as exchange traded funds or sovereign wealth funds are not part of this analysis. Not all hypotheses derived from differences in regulation and governance between the US and Germany can be tested explicitly in this thesis. While indications on the validity of some of these hypotheses can be seen in the data, others remain to be tested in future research.

1.3 Methodological Approach

1.3.1 Scientific Classification of Subject Area

Asset management plays a vital role in the system of financial intermediation^[4]where it interacts with both private clients (retail management) and institutional clients (wholesale management)^[5]. It is part of the banking sector and is thus to be included to the field of finance in an academic context. Lately, there has been a trend in research to extend the banking sector by the field of financial services to which investment activities can be attributed.^[6]

Asset management further touches on other subcategories of finance that have recently evolved. Among others, one rapidly growing subcategory is Islamic finance, which increasingly gains importance as the client base and the investment focus of institutional investors have been shifting towards countries and investors that require conformity with Sharia (or Islamic law).^[7]Another category that asset management is connected to is the field of taxation, which itself is a part of accounting. Both accounting and finance are sub-disciplines of business studies, a practice-oriented empirical science.

1.3.2 Methodology of the Analysis

Two methodological approaches are used in this paper. A theoretical part determines the principles of institutional asset management and the international perspective on the topic deductively, based on primary and secondary literature. Interviews with practitioners and regulators are conducted in order to gain further insights on how theory and practice are linked and to validate the hypotheses drawn.

The practical part of this thesis aims at validating the derived suppositions of how investment behavior is affected by different external and internal circumstances in different countries. This is done through examination of primary and secondary empirical data on a scientific basis.^[8]The conducted analyses make use of descriptive statistics, principal component analysis, principal component regression and hypothesis testing.

1.4 Composition of the Paper

Figure 1 depicts the composition of this paper that is structured into three main parts – theory, practice and conclusion.

Figure 1: Thematic Composition of the Paper with Reference to the Respective Chapters

Abbildung in dieser Leseprobe nicht enthalten

Source: Own illustration

The theoretical part of this thesis is built on two major themes, asset management as well as regulation and corporate governance. Chapter 2 deals with the principals of institutional asset management and provides a basis for further elaboration on the topic. Its three core parts are the scientific approach of asset management, a comprehensive industry analysis and a look at recent developments in the field. The scientific approach compares investment styles of funds, elaborates on asset allocation and provides explanations for the significance of the industry. The industry analysis provides a classification of investment funds and explains major differences amongst them. Recent developments in the field include a recap of the financial crisis and a description of current trends in the industry.

Chapter 3 puts the institutional asset management industry into an international perspective. It deals with differences in the legal environment of funds between countries and corporate governance. The legal environment includes comparisons and analyses that institutional investors from the US and Germany face concerning market regulations, compliance rules, disclosure restrictions, expenses and taxes. Internal decision-making processes for both countries are highlighted on the base of corporate governance best practices for the insurance industry and pension funds.

Chapter 3 also bridges the gap between theory and practice by including two of the three main blocks of the practical part of this thesis. Experts’ perspectives on the impact of investment regulation and corporate governance are voiced by both a regulator and asset managers. The subchapter on the expected impact on investment behavior draws conclusions to the theoretical circumstances described previously and provides hypotheses that are to be tested in the third, practice-oriented part of this paper, the empirical examination of the data. This analysis is conducted in chapter 4.

Chapter 5 and 6 conclude the thesis and recap the findings. In addition, they provide implications for theory and practice and show future research opportunities in the associated scientific environment.

1.5 Definitions

The core terms of this work are investment behavior, institutional investors and asset management. Before a deeper dive into the topic in chapter 2, the terms are defined and separated from neighboring topics.

1.5.1 Asset Management and Institutional Investors

The terms asset management and investment management are used interchangeably in this paper. Asset management is generally used in the context of pooled investing, whose origins date back to the late 18th century.^[9]The original idea of investment pooling was to provide a means of diversification for private investors with common financial goals.^[10]While diversification is still one of the key elements of asset management, the range of investors is now broader than ever, including individuals, companies and trusts.

According to the National Association of U.S. Investment Companies^[11], registered investment companies in the United States can currently be classified as one of four of the following types: open-end mutual funds, closed-end funds, exchange traded funds (ETFs) and unit investment trusts (UITs). In addition to retail or wholesale-oriented companies such as banks, insurances or independent fund management firms, the term asset management also refers to organizations whose sole purpose is to invest its assets.^[12]All of these organizations are summarized as institutional investors. Further examples of such investors include pension funds, hedge funds and sovereign wealth funds. Insurance companies, pension plans and pension funds for professionals in private practice play an outstanding role in this paper as they form the foundation of the international comparison and empirical study.

1.5.2 Investment Behavior

Investment behavior in this thesis is defined as the specific asset allocation chosen by an institutional investor in conjunction with the applied risk management and the resulting investment performance. Investment behavior is thus closely related to investment styles, a more frequently used term in finance. Ever since Sharpe^[13]as well as Fama and French^[14]introduced the notion of investment or equity style to practitioners and academics in the early 1990s, the idea has been widely accepted in the investment community.^[15]This is due to the fact that numerous researchers, e.g. Grinold^[16], Davis^[17], He and Ng^[18]or Fama and French^[19]have confirmed the original result that investment styles have larger explanatory power for cross-sectional variation in equity returns than the beta factor.^[20]According to Keim and Madhavan^[21], the investment style of an investor is also one of the two determining factors for investment performance. Coggin, Fabozzi and Rahman^[22]validate the segregation by Haughton and Christopherson into four basic investment styles that are largely based on asset allocation^[23]: Earnings growth, market-oriented, price-driven and small capitalization. These four investment styles have set the foundation for future research in the field and thus a more detailed description is provided in chapter 2.1.1.

2. Principles of Institutional Asset Management

After defining the key terms of this paper, the following chapter provides a detailed description of the principles of institutional asset management. Based on this depiction, the regulation and governance of the institutional asset management industry will be put in an international perspective and compared across countries.

2.1 Scientific Approach

A definition of the term asset management has been provided in section 1.5.1 of this thesis. In order to be able to understand the value proposition of asset management funds and compare their behavior in the light of different external environments and internal guidelines, it is important to take a look at different investment styles first.

2.1.1 Investment Styles

Barberis and Shleifer identify two major reasons why both institutional as well as private investors might pursue style investing. First, categorization of funds into investment styles reduces the problem of choice and allows a more efficient processing of information. Second, benchmarking is made easier and the performance of asset managers is more observable since the classification inevitably creates a peer group of funds.^[24]

A brief definition of investment styles has been given in chapter 1.5.2 of this paper. A closer look at these so-called Frank Russell style portfolios is now taken following Haughton and Christopherson^[25]:

- Earnings Growth:This strategy focuses mainly on earnings and revenue growth of investment targets and tries to identify above-average growth prospects. These prospects can stem from a historic trend as well as other circumstances including momentum based on company, industry and economic factors.
- Market-Oriented:The market-oriented strategy aims at representing either the whole spectrum of the financial market or sub-sectors, such as certain industries. Thus, in general, market-oriented funds are highly diversified.
- Price-Driven:Also known as value investing, this strategy focuses on the low price proportion of the market, i.e. securities with low valuations relative to the broad market.
- Small Capitalization:As the name already suggests, this strategy covers companies with a small market capitalization. They may be unseasoned and rapidly growing, or sometimes simply small businesses with a long history. Characteristics include below-market dividend yields, above-market betas and high residual risk compared to the broad market.

Many investment managers work along two of these categories, namely the market size of their fund and the classification as value or growth. For the latter, academic research (e.g. Fama and French^[26]or Chan, Karceski and Lakonishok^[27]) identified the book-to-market ratio of a firm as the most important ratio. In their analysis, Chan, Chen and Lakonishok^[28]include past stock performance and find that it is closely related to the investment strategy based on book-to-market ratios.

Fama and French^[29]developed a three-factor model with which funds can be classified concerning their investment style. This is done by estimating the following regression:

where ;equals the return of fund ;for month , ;the risk-free return for month ;and ;the market return of month . ;is the realization on the capitalization factor for month ;and ;is the realization of the value factor for month . The factor loading ;on ;tends to be positive for small stocks and negative for large stocks. Similarly, a positive factor loading ;indicates sensitivity to the value factor of stocks, whereas a negative loading indicates a growth tilt. Thus, it is possible to categorize funds as small or large cap-oriented as well as value or growth-driven based on their ;and ;slopes respectively. ;is the regression’s intercept and ;refers to the error term.

While much research effort has been spent on determining whether certain style characteristics dominate others and whether the classification into the size and value-growth dimensions is empirically valid, only little attention has been drawn to the effect of style consistency of a fund. Brown and Harlow started to fill this gap and come to the conclusion that indeed style consistency, i.e. a low tracking error towards the benchmark and/or model-based style consistency, leads to lower portfolio turnover in the fund, a positive relationship to future actual and relative returns as well as a higher persistence of fund performance over time.^[30]

These results emphasize the importance of investment styles in asset management.Figure 2 depicts an example of the application of the two-dimension investment style in practice.

Figure 2: Example of Investment Style Application in Practice

Abbildung in dieser Leseprobe nicht enthalten

Source: Own illustration after Sionna Investment Managers^[31]

The Fama and French three-factor model and the underlying benchmark factors have been affirmed many times by other researchers and are widely accepted in the academic research community. However, their model has so far exclusively been used for equity-only portfolios. An application to a multi-asset portfolio appears possible, yet the model would be overly specified for the purpose of this study.

2.1.2 Asset Allocation

Having introduced the predominant investment styles in both practice and academic research, the topic of asset allocation builds the core of this chapter. Knowledge on asset allocation is essential to understand the differences in investment behavior of funds that shape the asset management industry in all parts of the world.

Sharpe defines asset allocation as the allocation of an investor’s portfolio among a number of major asset classes. These major asset classes include bills, intermediate-term government bonds, long-term government bonds, corporate bonds, mortgage-related securities, large-capitalization value stocks, large- capitalization growth stocks, medium- capitalization stocks, small- capitalization stocks, non-US bonds, European stocks and Japanese stocks.^[32]This list is not absolute; nevertheless, it presents a good overview of the range of asset classes generally used in academic research.

The mean-variance analysis of Markowitz^[33]has provided a strong foundation for asset allocation by emphasizing the ability to reduce financial risk through diversification. However, several critically important factors are left out in Markowitz’ analysis, including the dynamics of financial markets. Since Samuelson^[34]as well as Merton^[35]introduced their multi-period portfolio optimization models, it has been understood that the solution for optimal long-term investing can be a different one compared to the optimal solution of the static mean-variance analysis. The common denominator of these models is that the addition of an asset to a portfolio decreases the unsystematic risk of the portfolio, as long as there is no perfect correlation between the new asset and one already existing in the portfolio. Also, the risk in these models is always measured in terms of variance. However, this leaves a gap for investors who want to optimize their portfolio and whose risk is composed of other factors than variance, e.g. asymmetric risk measures. Harlow addresses this issue and introduces portfolio optimization with a downside risk approach; yet he affirms the intuition of risk reduction through the addition of non-perfectly correlated assets.^[36]In this context, asset allocation is of crucial importance to investors since in general, the correlation among different asset classes is lower than that of assets within one asset class. Therefore, optimizing a portfolio can generally be done with little complication through the use of various asset classes. In doing so, two types of asset allocation have to be distinguished: strategic asset allocation and tactical asset allocation.

The strategic asset allocation, a term coined by Brennan, Schwartz and Lagnado,^[37]describes the far-sighted response to time-varying investment opportunities. Thus, it can be seen as the fundamental policy mix that a portfolio follows. Tactical asset allocation, in turn, refers to adjustments of a portfolio’s asset allocation in the nearer term. This can be done either systematically or with discretion. The latter is based on the asset manager’s judgment of the near-future market development, whereas the former uses quantitative investment models to systematically exploit inefficiencies or temporary imbalances to the equilibrium state among different asset classes.^[38]

The popular opinion among asset managers is that there is no optimal asset allocation among cash, stocks and bonds, which is inconsistent with the mutual-fund separation theorem. The latter states that all investors should hold the same composition of risky assets.^[39]So far, no satisfactory explanation has been found for this inconsistency between practitioners and academic research.

An interesting discovery in the light of the topic of this paper has been made by Ang and Bekaert.^[40]Ang and Bekaert found that correlations between international equity markets tend to increase in times of highly volatile bear markets, which leaves doubt about the importance of asset allocation, especially in the international context. The conclusion of their paper is that, even with such correlation changes in regime shifts, international diversification is a valuable part of asset allocation. Furthermore, the costs of ignoring the different regimes increase when a conditionally risk-free asset can be held.

2.1.3 Sustainable Outperformance of Benchmarks

One major reason for the existence of the double to triple-digit trillion Dollar industry of asset management is the belief of capital sponsors, that asset managers can consistently outperform financial markets and their respective benchmarks. Brown and Goetzmann^[41]analyze fund performance while accounting for a survivorship bias and find that relative performance persistence exists. However, it turns out that the outperforming funds have a high correlation among each other which suggests the possibility that they are loading up on a macroeconomic factor unassociated with the major components of equity returns. Using Fama-French factors, Carhart^[42]provides evidence for short-term persistence in equity fund returns. He discovers that the reasons for the top decile funds’ outperformance are due to the momentum of stocks, differences in expense ratios and differences in transaction costs. However, the discovered outperformance of 8 percent of the top decile versus the bottom decile is mostly accountable to the extreme underperformance of bad funds. Elton, Gruber and Blake^[43]blame the bad performance of the lowest decile on the very high expenses of these funds. They conclude that funds that did well in the past tend to do well in the future, also on a risk-adjusted basis. They further discover that using modern portfolio theory to form optimal portfolios based on past information leads to the selection of mutual funds with a positive return compared to a portfolio of funds with equal amounts invested in the funds considered. This outperformance is both economically and statistically significant. Finally, Grinblatt and Titman^[44]also confirm that there is positive persistence in mutual fund performance. In addition, they find persistence differences in fees and transaction costs across funds, yet state that this is not the only explanation for performance differences. In their opinion, the past performance of an asset manager provides useful information for capital sponsors concerning their choice of funds in the portfolio.

The evidence of the sponsors’ belief about outperformance of benchmarks through professional asset managers can be described as mixed. However, certain patterns can be observed when creating rankings of fund managers. Some managers consistently appear near the bottom of such rankings and it is the goal of the sponsor to reduce the likelihood of realizing abnormal returns by selecting these managers.^[45]

An interesting addition to the mentioned research is provided by Davis,^[46]who conducted an empirical analysis to identify a potential relationship between consistent outperformance of asset managers and their investment style. Using the Fama-French portfolios as benchmarks over a 33-year period, Davis concludes that no investment style generates positive abnormal returns. The performance persistence among the best-performing growth funds is not sustainable beyond one year. Among small cap managers, he discovers a persistence of poor performance in the United States. Similar results have been reached in a study conducted in the United Kingdom by Quigley and Sinquefield.^[47]Davis further states that not even the value premium in common stock returns produced by the market in the analyzed period was captured by funds; even the extreme decile of the HML (value) factor funds ranking failed to do so.

Although the evidence of asset managers’ outperformance towards the benchmark is not a clear one, Davis states that to a certain degree it depends on the style of the fund. So, there should be an implication for sponsor behavior concerning their choice of funds. The following chapter will provide an overview of the the industry makeup and also contains additional information about four important types of funds that are actively managed by asset managers.

2.2 Industry Examination and Classification of Funds

One way to categorize the asset management industry is according to the type of funds managed by the investment manager. Figure 3 depicts the most important types of funds, as well as their average global asset allocation. Real estate investment trusts (REITs) and exchange traded funds (ETFs) are beyond the scope of this thesis and will thus not be discussed explicitly.

Figure 3: Types of Funds and Their Average Global Asset Allocation

Abbildung in dieser Leseprobe nicht enthalten

Source: Own illustration; data from ICI^[48], IMA^[49], Judd and Yin^[50]and Maslakovic^[51]

Concerning asset allocation, the global investment management industry observed both a decline of money invested in the money market of 2.2 percent and an increase of 2.2 percent in equity investments. Fixed income assets increased by 1.4 percent while balanced hybrids, structured products and alternative investments all declined by around 0.5 percent each compared to the end of 2008.^[52]The current asset allocation structure worldwide categorized by fund type according to the Fund Management 2010 Report by TheCityUK^[53]is depicted in Figure 4.

The variable that measures the absolute size of the asset management industry is called assets under management. Since this variable highly depends on what the author of a survey considers a professional asset manager, the actual number is hard to assess. Estimates for the global industry range from 52.6 Trillion USD^[54]to 105 Trillion USD^[55].

Figure 4: Global Fund Allocation in Trillion USD by Type of Fund

Abbildung in dieser Leseprobe nicht enthalten

Source: Own illustration after Maslakovic (2010)^[56]

The industry has seen a strong rebound of assets under management globally following the financial crisis. As depicted in Figure 5, the recovery has taken place in all regions of the world, led by Asia ex Japan and Latin America. However, this astonishing development is based on the recovery of asset prices rather than an inflow of new sponsor money. In fact, only one percentage point was coming from fresh money according to the Global Asset Management Report 2010 by The Boston Consulting Group.^[57]The recent developments of the industry are summarized in section 2.3 of this paper.

Figure 5: Development of Global Assets Under Management with p.a. Growth Rates

Abbildung in dieser Leseprobe nicht enthalten

Source: Own illustration after Kramer et al. (2010)

Having provided a short overview of the classification of funds and the current state of the industry, the following four sections will dive deeper into the four most important types of funds and summarize the current academic literature in the field.

2.2.1 Pension Funds

Pension funds are generally established by a company to provide retirement income for its employees. They pose the largest type of fund, ahead of mutual funds and insurance funds, and can be important shareholders for both private and public companies. Besides the fund management through a sponsoring company, there are various different types of pension fund schemes used worldwide. In Germany, a system of pension funds for professionals in private practice, such as lawyers or doctors, constitutes a form of private financial precaution. Corporate pension funds also do not have to be defined as such, but can choose to operate as a Contractual Trust Arrangement (CTA) instead, which is accompanied by advantages like additional insolvency security, improved credit ratings for the parent company and less regulation through the insurance supervision, also towards investments. In the United States, most pension money is managed on a private basis, even though companies are often times involved in providing funding through the 401(k) plan.

According to Vittas^[58], pension funds are not only a source of long-term savings to support the development of bond and equity markets, but can also be a positive force for innovation, corporate governance and privatization, assuming the interplay between pension funds and financial markets is set in the right frame by policymakers. The advantages of a functioning pension fund system can be especially beneficial to emerging countries. Here, pension funds can act as catalysts for the development of efficient trading and settlement systems, the adoption of modern accounting and auditing standards as well as the promotion of meaningful information disclosure.

As pension funds can be major shareholders of a listed company, many of them have pursued an active role in corporate decision-making. Del Guercio and Hawkins^[59]took on the subject of pension fund activism and discover that for the most activist funds, shareholder proposals are often followed by significant additional corporate governance activity and broad corporate change, such as a restructuring or sale of assets. While they conclude that the shareholder proposals are effective in promoting change at the target companies and that pension fund activism is not inconsistent with fund value maximization, there is no evidence that this activism has a significant impact on stock returns or key accounting measures.

One common phenomenon observed in the pension fund industry is called window dressing. Window dressing occurs towards the end of a quarter, especially towards the end of the fourth quarter of a year. At the end of a quarter, fund reports including the current holdings of shares are published and “nobody wants to be caught showing last quarter’s disasters. […] You throw out the duds because you don’t want to have to apologize for and defend a stock’s presence to clients even though your investment judgment may be to hold.”, as a fund manager is quoted by Jansson.^[60]The easiest and most common way to execute window dressing is the sale of loser shares that have crashed during the preceding quarter. Pension funds can also reduce the pace of sale of winners, increase the purchase of winners and reduce the purchases of losers to impress the sponsors with the current constitution of the portfolio.^[61]Lakonishok et al. confirm that the phenomenon of window dressing is certainly an issue in the pension fund industry, especially among small funds.^[62]

Unlike the performance of mutual funds, pension funds’ performance has not been vastly analyzed. Coggin, Fabozzi and Rahman^[63]are among the few academic researchers that entered into the area of pension funds performance. They discover that, regardless of the choice of the benchmark portfolio or estimation model, the selectivity measure is positive on average, whereas the timing measure is negative. When managers are classified by the Fama and French investment styles, both selectivity and timing appear to be more sensitive to the choice of the benchmark. Coggin, Fabozzi and Rahman however cannot explain why some active fund managers are able to provide substantial risk-adjusted outperformance while most of them fail to do so. Blake, Lehmann and Timmermann^[64]discuss that market timing and the asset selection of a pension fund tend to be far less important for a pension fund’s performance than the strategic asset allocation discussed in section 2.1.2 of this thesis. They discover that the weights of different assets in their studied funds have a slow mean-reversing tendency to a common strategic asset allocation, which in turn can explain most of the time-series variation of portfolio returns.

Also focusing on pension fund performance in his paper, Davis^[65]examines the potential and actual role that international investments play in the pension fund industry. He shows that despite caveats and restrictions on international investments for pension funds, they would allow the funds to achieve superior performance in terms of risk and return. In fact, additional government regulation is undesirable and even unnecessary since there is a natural home bias for investments by pension funds.

2.2.2 Mutual Funds

The mutual fund structure is a very common one for a fund that collects and pools money from investors and typically invests the sponsors’ money in securities such as equities, bonds, the money market, commodities etc. Even though this study is not focused on the mutual fund industry, it is pivotal to provide a substantiated state of knowledge in this field, as mutual funds mark an important investment vehicle for institutional investors, e.g. German insurance companies invested around 25 percent of their capital assets into mutual funds in 2009.^[66]

Mutual funds play an important role in the retail part of asset management. For retail investors, performance is a crucial decision criterion for a fund. Thus, as mentioned in section 2.1.3 of this thesis, researchers have analyzed the performance of funds thoroughly. Sharpe as well as Treynor laid the base for analyzing the performance of mutual funds in the mid 1960s. Both Sharpe^[67]and Treynor^[68]are pioneers that revolutionized the way mutual funds’ performance is examined today by including simple risk measures and putting the absolute performance of funds into perspective to the risk taken to achieve this return. The Treynor ratio ( ) relates the outperformance of the fund versus the risk free rate to the portfolio’s beta: where ;is the return of portfolio , ;is the risk free return and ;is the beta of portfolio . The Sharpe ratio ( ) is very similar to the Treynor ratio, but uses portfolio volatility instead of beta as the relevant risk measure:

Both the Treynor and the Sharpe ratio are still used widely in the industry today.

The topic of investment styles mentioned in chapter 2.1.1 of this thesis is another important topic when differentiating mutual funds. Even though Fama and French and the following researchers have largely determined the most important investment styles for mutual funds, doubt remains about the granularity and the informative value of this classification. Brown and Goetzmann^[69]find that the existing classifications do a poor job at forecasting differences in future performance. Avoiding the pitfalls and limitations of the statistical estimations used to analyze the traditional classifications, Brown and Goetzmann show that their applied switching regression technology dominates other style classifications and does a better job than classifying funds according to observed factor loadings.

Aside from looking at mutual fund performance, it is interesting to analyze other factors that impact capital flows between mutual funds, such as the cost of search. Sirri and Tufano^[70]studied the flow of money into and out of mutual funds in order to better understand the behavior of the retail market on both the buy and sell side. They find that investors behave irrationally in the sense that they invest too heavily into well-performing funds and at the same time miss to divest from badly performing funds at a similar rate. In addition, investors’ behavior towards fees appears to be highly irrational, which is also reflected in capital flows. A third point mentioned by Sirri and Tufano states that investors respond to risk in their portfolios, which may offset mutual fund managers’ incentive to increase fund volatility. In contrast to Gruber^[71], who claims that investors’ behavior to invest in mutual funds with net inflows and divest from those with net outflows is rational since this strategy beats passive index funds, Sirri and Tufano separate a fund’s marketing effort as a key driver for net inflows. Funds with large marketing expenditure enjoy a much stronger performance-flow relationship than competing funds.

2.2.3 Insurance Funds

Insurances are a form of hedging for risk, mostly in form of an uncertain loss. For capital investments, life insurances are especially interesting due to their longevity, the subsequent need for adequate long-term capital management as well as liability issues they face. A life insurance thus serves two purposes, the cover against risk of death or survivance and the investment service involving guarantees of future capital security and long-term yield.^[72]

Wehrle^[73]adjusts the portfolio theory by Markowitz and Tobin to examine the actual portfolios of life insurance companies. The theory is modified appropriately to account for the particular investment risks associated with the liabilities of life insurance companies. He identifies three different types of life insurance investments:

- The Capital Security Portfolio:Setting the investor and manager in a principal-agency framework, Penman determines the three most important traditional objectives of the trustee investment as safety, yield and liquidity.^[74]This type of life insurance investment caters to exactly this ranking of investor needs by prioritizing risk minimization to yield and taking appropriate investments.
- The Income Security Portfolio:While the first portfolio type is defensive towards default risk, this second type is defensive towards income risk. The emphasis of the life insurance’s guarantee of a long-term yield lies on the long-term solvency position of the company. The general aim of the portfolio manager in this case is “keeping long”, suggesting the purchase of long maturities.
- The Competitive or Yield Portfolio:The competitive portfolio type affirms the advantages of increased yields while not denying the importance of default and income risk. Wehrle suggests sizeable liquidity holdings as a transactions balance to facilitate opportune purchases.

Adams^[75]examines the suggestion that contracting incentives for managers to increase investment earnings are dependent upon organizational factors, such as ownership structure and firm size. He indicates that return on invested assets is positively associated with stock companies; large and highly levered companies and entities engaged in riskier activities. Life insurance companies holding relatively more financial to nonfinancial assets have a low investment yield, contrary to theoretical predictions.

More recently, the issue of pricing of various insurance products has been the major focus of research in this field, for example Frantz, Chenut and Walhin,^[76]who compare the Black-Scholes method to the actuarial approach for policy pricing.

2.2.4 Sovereign Wealth Funds

The following section is devoted to a rather new type of fund in the financial market. Even though sovereign wealth funds have existed since the 1950s, they have dramatically gained importance over the last 10-15 years. Yet, the absolute market size of sovereign wealth funds is of no comparison to mutual, pension or insurance funds, as depicted in Figure 4. Due to their uniqueness and projected importance in the future, they are a highly interesting investment vehicle to look at.

Sovereign wealth funds are state-owned investment funds that invest into a broad range of assets. Due to their relatively small investment restrictions, sovereign wealth funds show a greater diversity in their asset allocation than other types of funds. Since many times these funds are held by the central bank of the respective country, investments in foreign exchange are common. The tendency to have large proportions of the money invested in commodities can be derived from the origin of many of these funds in the Middle East, as well as the investment into gold by the central banks. Sovereign wealth funds are based on current account surpluses and will become less important only if the countries with large surpluses begin to run prolonged current account deficits. There are presently more than 20 countries that run a sovereign wealth fund and six more have expressed interest in starting such a fund. However, the asset holdings of the current funds remains very concentrated, with the top five funds accounting for 70 percent of total assets.^[77]

Sovereign wealth funds differ from other funds in such a way that very few of them publish information about their assets, liabilities or investment strategies. Traditionally, sovereign wealth funds are long only, but there is anecdotal evidence that some sovereign funds have placed investments with other leveraged funds.^[78]The danger of sovereign funds comes from their sheer size combined with their nebulous actions that have the potential to disrupt international financial markets. In addition, the fact that the funds are government-owned adds the risk that investments are politically motivated and not solely financially or economically driven. Thus, Truman^[79]proposes that an international standard on cross-border investments by sovereign wealth funds should cover the topics of objectives and investment strategy, governance, transparency and behavior. Truman^[80]also recommends a blueprint for best practices for sovereign wealth funds as suggested by the IMF and OECD. Such a best practice guideline would include factors like structure, governance, accountability and transparency as well as behavior. Truman rates the funds on each of these criterions and ranks them accordingly.

Fotak, Bortolotti and Megginson^[81]are among the first to research the impact of sovereign wealth funds on listed companies. They discover that contrary to the public perception, the funds mostly buy minority stakes directly from the targeted companies, roughly half of which are unlisted and in the fund’s home country. Another interesting finding shows that around the announcement date of the transaction, there is a 0.8 percent abnormal positive return of the target company’s share price. However, two-year abnormal returns of sovereign wealth funds average a significantly negative 14 percent, suggesting that equity acquisitions of sovereign funds are followed by a price deterioration of the target company.

Balding^[82]also analyzes portfolios of sovereign wealth funds and develops three key conclusions, which are contrary to the public opinion about these funds. Applying direct and indirect statistics, Balding discovers that estimates on the size of funds are based on inconsistent calculations and thus not reliable. Secondly, he proves his hypothesis that sovereign wealth funds are rational investors, driven by economical and financial impact. In his analysis, Balding finds that the funds are diversified by both asset class and geographic region. His third point concerns the impact of sovereign wealth funds on international financial markets. According to Balding, there is little evidence that this impact is negative and thus, there is little need for regulatory restrictions of cross-border investments.

Having summarized the four most relevant types of funds for this thesis, the next chapter will provide an overview over the recent developments of asset management, the impact of the financial crisis and current industry trends.

2.3 Recent Industry Developments

According to Garvey et al., one megatrend of the asset management industry is the shift in saving behavior among retail clients. As they found out in a survey, plans to increase personal savings in the future are widespread among the population.^[83]

Another major trend in the industry is the increased importance of ETFs. While in recent years they have mostly been used as passive investment vehicles, they are now set to become the fundamental building blocks of active asset management, specifically for mutual fund management.^[84]

For the pension fund industry, 2009 ended in a 13 percent rise of assets in the 13 largest pension fund markets. However, the absolute levels are still below their 2007 values. In terms of pension assets to GDP ratio, the industry is back to its 2003 levels. The global market of pension assets has seen a significant change over the last ten years, with the three largest markets (USA, Japan and UK) each losing share in global pension assets due to a slower growth rate relative to other countries. When comparing DC to DB assets, one can see that the former have grown at a rate of 6.4 percent p.a. over the last years versus a much slower rate of 1.6 percent p.a. for DB assets. The trend shows an established provision towards DC funds, which now make up 42 percent of total pension assets compared to 32 percent in 1999. These values differ substantially between countries, but can be seen in almost all countries with significant pension fund existence. Japan is the only exception by remaining 100 percent DB. Concerning asset allocation, two trends can be identified over the last year: a sizeable shift into equity investments and further diversification of portfolios into alternative assets.^[85]

The financial crisis that started in 2007 has left its marks on the global asset management industry. The following chapter briefly states the challenges that arise from the crisis and what impact the newly imposed regulations of governments and exchange commissions will have on asset managers.

2.3.1 Aftermath of the Financial Crisis

The principal issues that the financial crisis left with pension funds are diverse across the globe. For the largest pension fund markets, the new challenges include liquidity concerns, the management of credit and collateral risk, the underperformance of asset managers and new challenges in the strategic asset allocation.^[86]

Another current issue that surfaced during and after the financial crisis is the exposure of poor governance across the asset management value chain. According to Saluzzi and Hage^[87], asset managers as well as intermediaries need to improve their due diligence standards and make clear that effective oversight is part of the value of their services provided.

Sovereign wealth funds were also hit by the financial crisis, with the best performing funds coming from the Middle East and North Africa, where average losses amounted to 20 to 25 percent of the value of the known equity portfolio. These funds, however, played a special role during the crisis: As the crisis unfolded, they initially rushed in to help, pouring billions of dollars into banks in the United States and Western Europe during the winter of 2007–2008. These investments provided liquidity that at first seemed to stabilize uneasy markets. As conditions deteriorated, however, the funds began to retreat from developed-market equities, engage in fewer transactions and invest locally. This was done to both prop up struggling banks and companies and continue development and diversification of their domestic economies.^[88]

After the financial crisis, a more pronounced divergence between institutional and retail investment management markets can be observed. According to Seymour et al.^[89], this is due to factors such as different investor needs concerning the level of sophistication, knowledge and risk appetite between the investor groups. Another big factor contributing to the divergence phenomenon is the new regulatory landscape after the crisis. Much of the regulation is aimed at the retail market, which forces many smaller asset management firms to go down the institutional route where compliance costs and burdens are less onerous. However, Seymour et al. do not expect these developments to be a long-term trend, as the influencing factors driving investment managers’ attitudes and behavior today – such as the economic crisis, high-profile fraud cases, the perception of certain types of asset managers contributing to systemic risk and the regulatory changes arising out of these issues – are based on events with a relatively short time frame. As the market situation improves, focus will shift away from regulation back to result-driven performance again.^[90]

Stier et al.^[91]also discover that the new regulatory environment following the financial crisis is becoming increasingly complex for asset managers and investment companies. Extensive le­gislation requiring most private fund advisers to register with the SEC, a greater emphasis on enforcement and fraud prevention as well as stringent new tax proposals are combining to create new challenges for mutual fund managers.

2.3.2 Industry Trends

In this chapter, three trends that recently emerged in the asset management industry are presented. These trends include the demand for social, ethical and sustainable investments (SRI) as well as Sharia-conform products. The third trend deals with the lowering of management cost in the industry.

Socially responsible investors are concerned about social, ethical and especially environmental issues in enterprises. They invest mostly with clear mandates to their asset managers to invest responsibly. The idea originally stems from church-related sponsors that demanded their assets not to be placed in certain companies. This negative screening developed into a range of eight strategies that are used and combined to select investment targets.^[92]These strategies include ethical inclusions, positive screening of committed companies, best in class per sector, thematic investment propositions, norms-based filtering, simple exclusions, investor engagement and integration by asset managers of corporate governance risk into traditional financial analysis.^[93]

The growth rates of assets under management of ethical funds reached double digits at the beginning of the new century and are currently at 15-20 percent per year.^[94]Especially in the United States, where pension funds have been facing governance regulations to invest in ethical companies, the percentage of socially responsible investments is large. Similar regulations have been passed in the UK and Germany recently. The importance of ethical investing has reached the point where indices that catalyze the growth of assets under management in the field are created to reflect the performance of sustainable, ethical or eco-friendly companies. The strategy that includes ethics, performance and risk in asset management is considered “triple bottom line investing”.^[95]

Islamic finance is a new area in the field of finance that has emerged in order to serve clients that require products with conformity to Islamic law and is now one of the fastest-growing segments in finance. Among other restrictions, the Sharia prohibits interest on investments as well as gambling, risk and uncertainty. This leaves the Islamic investor with two basic options to manage his funds. He can empower his asset manager to invest funds in conditional or limited investments; that is, specific companies or sectors. The second option is to give the investment manager unconditional authorization to invest in a suitable project. Both investment categories are also compliant with the law that company profits are to be shared among investors.^[96]The total number of Sharia-compliant funds is currently estimated at 950. The asset allocation is impacted by Sharia restrictions in a way that the fixed income allocation is reduced whereas the equity and alternative investment allocations are increased. The idea of Islamic finance is not restricted to, but prevails in, the pension fund market of the Cooperation Council for the Arab States of the Gulf (GCC) with estimated AuM of $63 billion. Recently, global mutual funds have picked up on this investment strategy.^[97]

In Europe, the asset management industry continues to be an immensely profitable one according to Hoyos-Gomez, Huber and Schachner. However, their study finds that cost margins have increased over the last years, which leaves the risk of setbacks in this cyclical industry. The critical dependence on capital market performance combined with inflexible cost structures of most asset management companies threatens profits. Operating costs have increased especially in sales and marketing as well as fund management over the last few years, which ultimately can lead to a new composition of the competitive market in Europe.^[98]The general approach of asset managers to high cost levels in a downward market is to cut discretionary spending and right-sizing. Lately, the activities to cut costs have been less familiar but more constructive. Through product proliferation, the market is flooded with funds that are not necessary or desirable and the consolidation of such funds results in increased efficiency. Remuneration is an additional topic that asset management companies have set focus on recently. Especially in the light of the new regulations on their way to the market that target additional stress testing, liquidity management etc., flexible cost structures are inevitable for investment managers. This also has the potential to change the current market structure, if small asset managers are unable to cope with the new wave of regulation.^[99]

3. Asset Management in the International Perspective

After having examined the asset management industry as an executive force of the investment schemes of institutional investors, the following chapter aims at providing insights to differences in legislature and governance of institutional investors between Germany and the United States. Differences in market regulation for pension funds and insurance companies by the authorities, compliance and disclosure standards, fees as well as taxes are highlighted and implications for asset allocation, performance and risk management are derived. These hypotheses will then be tested empirically in the next chapter.

3.1 Legal Environment in Germany and the USA

3.1.1 Investment Regulation

Investment regulation for pension funds and insurances can be done in two alternative approaches, namely prudent person rules and quantitative portfolio restrictions. Both approaches aim at ensuring adequate portfolio diversification and liquidity of the asset portfolio, but are radically different. They are not, however, polar opposites and studies have revealed that there are gradations between the two.

A quantitative portfolio regulation is simply a quantitative limit on holdings of a given asset class. Typically, those instruments whose holding is limited are those with high price volatility and/or low liquidity. For pension funds, there are also often limits on self-investment of the fund in the assets of the sponsoring firm to protect more directly against the risk of insolvency of the sponsor and appearance of conflicts of interest. Meanwhile, self-investment by life insurance companies is generally forbidden. Furthermore, there are commonly restrictions on the proportion of the assets of an investor exposed to a single borrower or piece of real estate.^[100]The focus here is placed on the investment itself and its riskiness is measured instrument by instrument according to a fixed standard.^[101]

The prudent person rule is a concept whereby investments are made in such a fashion that they are considered to be managed prudently. Prudently is defined as handling the investments, as one would do in the conduct of his or her own affairs. Often times, the prudent person rule is accompanied by an asset-liability management exercise.^[102]The focus here is placed on the behavior of the person concerned and the investment process forms the key test of prudence. It needs to be assessed whether, for example, there has been a thorough consideration of the issues and there is not blind reliance on experts. It is essential to have undertaken a form of due diligence investigation in forming the strategic asset allocation prior to any change or variation to it. The institution is also expected to have a coherent and explicit statement of investment principles.^[103]

Until May 2002, there was no single authority supervising the German asset management industry. Based on the Financial Services and Integration Act (FinDAG), the Federal Financial Supervisory Authority (BaFin) was founded by merging the three current supervisory authorities: the Federal Banking Supervisory Office (BAKred), the Federal Supervisory Office for the Securities Trading (BAWe) and the Federal Insurance Supervisory Office (BAV).^[104]Among other responsibilities, the BaFin now supervises insurances through the Insurance Supervision Law (VAG), which requires insurance companies to receive and maintain their business approval of the BaFin. The BaFin includes pension and burial funds in their insurance supervision.^[105]Pension funds for professionals in private practice in Germany are regulated on state level, generally by the ministry of finance or ministry of the interior. In most cases, the regulators maintain the power of supervision, yet model their regulation on the federal guidelines for insurances, namely §54 VAG in conjunction with §§1-7 AnlV, operationalized by the BaFin in circular letter 15/2005. Exemplary states that are explicitly following the BaFin regulation are North Rhine-Westphalia and Bavaria, arguably the two largest markets for pension funds for professionals in private practice.^[106]

The VAG aims at reaching an adequate allocation and diversification of an insurance’s capital investments in order to reach high security and performance while maintaining the company’s liquidity at any time.^[107]Circular letter 15/2005 prioritizes security of investments and states that bonds and loans have a maximum maturity of twelve years. The cash equivalent of the capital guarantee needs to amount to at least 50 percent of the principal and investments into non-fungible assets that cannot be liquidated at any time are prohibited. This means that e.g. many closed funds are not an investment option for insurance companies. Assets that are rated by the established agencies (Standard & Poor’s, Fitch and Moody’s) have to show at least investment grade. Where different ratings across agencies occur, the worse rating is pivotal. Exceptions to the latter rule are restricted to assets that show sufficient risk-bearing ability despite their speculative grade rating by one or more of the agencies.^[108]Circular letter 15/2005 also specifies the maximum investments into certain asset classes as defined in §2 AnlV. It states that loans on securities may not exceed 5 percent of coverage assets. Similarly, loans given to foreign governments with uncertain or no priority claim may not exceed 10 percent of coverage assets. Asset backed securities and credit-linked notes as well as structured debt securities that possess significant credit risk in addition to their market risk are limited to 7.5 percent of coverage assets. Positions in bonds that are traded outside of the Eurozone must be smaller than 10 percent. Other bonds not yet covered by paragraph V. may not exceed 5 percent of coverage assets. Shares of companies headquartered outside the Eurozone are limited to 10 percent of coverage assets. Investments into hedge funds are restricted to 5 percent of coverage assets. Up to 10 percent of coverage assets may be invested at will upon request to the BaFin.^[109]Risky assets, defined as shares, profit participation rights and subordinate debt may not exceed 35 percent of coverage assets.^[110]Holdings with limited fungibility may not exceed 10 percent of coverage assets unless the holding company’s sole business purpose is stock investments, in which case paragraph V.2.a) takes effect. As for debt investments, up to 10 percent of coverage assets may be invested into risky assets at will upon request to the BaFin.^[111]Finally, real estate investments are limited to 25 percent of coverage assets.^[112]Furthermore, circular letter 15/2005 states that at least 80 percent of assets have to be invested in the same currency as the insurance company’s liabilities, which leaves up to 20 percent of assets to be invested incongruently concerning the liabilities’ currency.^[113]As the AnlV has been renewed in 2010, the BaFin is currently drafting a new circular letter to update the asset allocation limits. The new recommendations are expected to be published in spring 2011.^[114]

In the United States, the setting for regulation is a very different one. The 50 states regulate the insurance industry themselves, which through the history of insurance regulation has brought federal-state tensions. However, the National Association of Insurance Commissioners (NAIC), a voluntary association of state insurance commissioners, has played an essential role in the centralization process of insurance regulation. Through the successful work of the NAIC, the single states show a high congruence concerning insurance regulation across the United States.^[115]Pensions in the United States are invested on an individual level through the 401(k) retirement savings plan and regulated through the Employee Retirement Income Security Act (ERISA).

Due to investments being made on individual level, the rules for pension fund investments are fairly lax. There are no quantitative restrictions on domestic assets in place and a restriction on foreign asset investments is non-existent. However, the prudent person rule is in place and provides a general requirement for diversification. For defined benefit funds, the self-investment limit is 10 percent whereas there is no limit on self-investment for defined contribution funds.

The life insurance market is regulated on state level, generally through quantitative restrictions. One example is the state of Delaware that limits investments into capital and surplus in shares to 25 percent, investments into real estate to 25 percent and investments into fixed income to 50 percent. New Jersey sets its limits for shares, real estate and loans to 15, 10 and 60 percent respectively. Many states limit the per-issuer exposure of issuers other than the U.S. government to 3-5 percent. Currency matching is not enforced, whereas there is an aggregate 0-10 percent investment restriction on foreign assets.^[116]In general, the quantitative limits that many states impose on insurance companies are not as specific and detailed as the counterparts in Germany are and leave more room for the asset managers’ investment decisions.

The hypotheses that can be drawn from these different regulation designs are as follows

H1:Portfolios in the United States should exhibit a broader range of allocation fractions within asset classes and

H2:higher variance of allocation among companies, as limits are less strict than in Germany and quantitative restrictions are not imposed, or on a higher level than in Germany.

H3:This could, at times, lead to the dominance of certain asset classes across the whole industry in the US, due to a more liberal strategic and tactical asset allocation and

H4:increase overall portfolio volatility as well as VaR through reduced diversification.^[117]

H5:Prudent person rules as used in the United States should result in superior performance of funds compared to strict quantitative restrictions, due to the greater amount of investment opportunities.^[118]

H6:Assuming that the quantitative restrictions imposed by German commissioners are efficient, they will reduce the portfolio risk measured by asset depreciation by limiting various exposures, such as to credit risk or concentration risk.

H7:Despite the prudent person rule, one can expect less diversification in pension assets in the United States due to a “naïve diversification” behavioral bias.^[119]

H8:The home bias^[120]should be overemphasized for insurance investors in both countries compared to non-regulated investors due to limited regulatory tolerance on foreign investments.

3.1.2 Compliance

Information is required in order to examine whether the German institutional investors comply with the regulations provided by the respective controlling institution (BaFin or a state ministry) – in other words, whether they are capable of identifying, managing and monitoring risks of their investments. Even if the insurance company outsourced at least parts of the investment management and/or risk management, it remains responsible for the provision of this information to the regulators. The German institutional investors have to provide the following information to the BaFin at the end of each calendar year:

- A general description of the intended investment policy and the planned asset portfolio for the current fiscal year, including a depiction of the portfolio risks.
- The current internal investment guidelines for capital investments that highlight changes from the previous year.
- A description of the asset-liability management. Smaller insurances may be exempt from this requirement.

The focus of these reports lies on the changes compared to the previous year. If the latter are of substantial impact, they have to be reported immediately.^[121]Regulators of pension funds for professionals in private practice again take a leaf out of the BaFin’s book and adopt compliance standards.^[122]

As for the compliance of U.S. pension plans, the before-mentioned ERISA plays the most important role. The ERISA is a federal law that sets minimum standards for retirement and health benefit plans in private industry. It does not require any employer to establish a plan; yet those who do establish plans must meet certain minimum standards.^[123]Among other things, ERISA demands that those individuals who manage plans (and other fiduciaries) must meet certain standards of conduct. The law also contains detailed provisions for reporting to the government and disclosing to participants. There are provisions aimed at assuring that plan funds are protected and that participants who qualify receive their benefits. Business owners are responsible for ensuring that their 401(k) plans comply with federal law and should rely on other professionals to assist them with their plan duties.^[124]ERISA compliance can be divided into three parts. Documentary compliance ensures that the plan and trust documents, summary plan descriptions, employee communication materials and enrollment forms are reviewed to ensure their consistency and compliance. Operational compliance refers to the requirement that the plan is operated in accordance with its written plan documents. Verification must be made so the plans are being operated according to their written terms. Fiduciary compliance includes an analysis made to determine who the fiduciaries are, what their obligations are and what each must do to comply with those obligations.^[125]

The quantitative restrictions on investments for insurance companies in the United States are monitored and enforced by the state commissioner of the respective state.

H9:The compliance requirements should have no direct impact on investment behavior, but can partially be measured through expenses occurring to the investor, since in most cases, compliance cost is passed on to the investing institution.^[126]

3.1.3 Disclosure

The disclosure requirements for insurance companies in Germany are regulated through a by-law (RechVersV), in addition to the code of commercial law (HGB). This by-law describes the different design of financial statements as well as details to the valuation rules for actuarial accruals in comparison to other, non-insurance companies.^[127]The periodicity of publicity, however, is not affected by the by-law and remains regulated by HGB §325. The latter states that all incorporated companies and registered partnerships without sole proprietors or natural persons as liable partner need to publish financial statements (electronically) within twelve months of the fiscal year.^[128]The same rules apply to pension funds in Germany that are also additionally regulated through a by-law (RechPensV). Pension funds for professionals in private practice disclose their information to the respective state regulator.

Insurance companies in the United States have to respond to state law regulation concerning the publication of financial statements. In general, statements have to be made public on a yearly basis in compliance with IAS. The most important standard with regard to the topic of this thesis is IFRS 7. The latter states that insurance companies need to disclose enhanced balance sheet and income statement details by category and class, a liquidity risk maturity analysis showing the remaining contractual maturity for financial liabilities, information relating to the credit quality of financial assets, quantitative disclosures illustrating the sensitivity of profit or loss and company equity to changes in key market risk variables and finally the processes that the company uses to manage and measure risks.^[129]

As for the pension plan industry in the United States, companies with a scheme are required to publish annually under IFRS 7 whereas private investors do not disclose their pension investments. However, pension funds are required to summarize information to participants and beneficiaries.^[130]

H10:One hypothesis that can be concluded from the disclosure regulation of insurance companies and pension plans is that due to a given choice on how detailed the balance sheet of a German insurance company (or pension fund) needs to be published, a bias might exist where only successful investment results are disclosed and companies may not provide detailed information on failing investments. Compared to the insurance regulation in the United States that meticulously describes the disclosure systematic, this might lead to a skew of investment performance of German institutional investors to the better, based on data availability. However, this effect is expected to fade over time since with regulation EC 1606/2002, the European Union has decided that all listed companies should apply the International Financial Reporting Standards for annual accounts starting on or after January 1, 2005. The impacts of this transition on pension schemes have been studied by Swinkels.^[131]

3.1.4 Expenses

The expense scheme applied by insurances does not differ between the United States and Germany. Four basic types of expenses are charged to the insurance taker:

- Administrative expensesdescribe the loadings for expenses as a percentage value of the premium. They are traditionally used to cover administrative costs of the insurance company.
- Collection expensesare calculated as a percentage value of the premium and traditionally used to finance the cost of premium collection.
- Additional premiumcharges for installments are imputed if the premium is not paid as an annual premium in advance, but rather as monthly installments.
- Acquisition costsdescribe the percentage value of the premium that is used to cover one-time costs such as risk analysis, provisions or other costs of acquisition.

Additional expenses are charged to the insurance taker when the insurance policy is terminated prematurely. Cost of actual asset management is generally not disclosed.

The largest expense blocks are generally administrative and acquisition costs. The average German insurance currently reports administrative expenses of 3.29 percent and acquisition costs of 5.12 percent.^[132]In the United States, acquisitions expenses are amortized on a proxy basis, which is referred to as deferred acquisition costs. Based on the specific insurance contract, these can range from 1.75 percent to 7.7 percent.^[133]

[...]

^[1]Cf. Möhring (2010)

^[2]Cf. Lannoo and Levin (2003), p2

^[3]Cf. Tartler (2009)

^[4]Cf. Walter (1998), p10

^[5]Cf. Davis (2002a), p2

^[6]Cf. Tilmes (2002), p9

^[7]Cf. Gait and Worthington (2007), p1 et sqq.

^[8]Primary data from company reports and news services as well as secondary data from the EBRI is used

^[9]Cf. Rouwenhorst (2004), p5 et sqq.

^[10]Cf. ICI (2010), p218

^[11]Cf. ICI (2010), p187

^[12]Cf. Davis (2002a), p2

^[13]Cf. Sharpe (1992), p7 et sqq.

^[14]Cf. Fama and French (1992), p427 et sqq.

^[15]Cf. Hwang and Satchell (2007), p598

^[16]Cf. Grinold (1993), p28 et sqq.

^[17]Cf. Davis (1994), p1579 et sqq.

^[18]Cf. He and Ng (1994), p599 et sqq.

^[19]Cf. Fama and French (e.g. 1993, 1996)

^[20]Cf. Faff (1999), p3

^[21]Cf. Keim and Madhavan (1997), p265

^[22]Cf. Coggin, Fabozzi and Rahman (1993), p1043

^[23]Cf. Haughton and Christopherson (1989)

^[24]Cf. Barberis and Shleifer (2003), p162

^[25]Cf. Haughton and Christopherson (1989)

^[26]Cf. Fama and French (e.g. 1992 and 1993)

^[27]Cf. Chan, Karceski and Lakonishok (1998), p159 et sqq.

^[28]Cf. Chan, Chen and Lakonishok (2002), p1428

^[29]Cf. Fama and French (1993)

^[30]Cf. Brown and ;Van Harlow (2002)

^[31]Cf. Sionna Investment Managers (2010)

^[32]Cf. Sharpe (1992), p11

^[33]Cf. Markowitz (1952)

^[34]Cf. Samuelson (1969)

^[35]Cf. Merton (1969)

^[36]Cf. Harlow (1991)

^[37]Cf. Brennan, Schwartz and Lagnado (1997)

^[38]Cf. Stockton and Shtekhman (2010), p1

^[39]Cf. Canner, Mankiw and Weil (1997), p181 et sqq.

^[40]Cf. Ang and Bekaert (2002)

^[41]Cf. Brown and Goetzmann (1995)

^[42]Cf. Carhart (1997)

^[43]Cf. Elton, Gruber and Blake (1996)

^[44]Cf. Grinblatt and Titman (1992)

^[45]Cf. Davis (2000), p27

^[46]Cf. Davis (2001)

^[47]Cf. Quigley and Sinquefield (2000)

^[48]Cf. ICI(2010), p23

^[49]Cf. IMA (2010), p25

^[50]Cf. Judd and Yin (2010), p5

^[51]Cf. Maslakovic (2010), p4 et sqq.

^[52]Cf. Kramer et al. (2010), p8

^[53]Cf. Maslakovic (2010), p1

^[54]Cf. Kramer et al. (2010), p4

^[55]Cf. Maslakovic (2010), p1

^[56]Cf. Ibid.

^[57]Cf. Kramer et al. (2010), p7

^[58]Cf. Vittas (1996)

^[59]Cf. Del Guercio and Hawkins (1999)

^[60]Cf. Jansson (1983), p139

^[61]Cf. Haugen and Lakonishok (1988)

^[62]Cf. Lakonishok et al. (1991)

^[63]Cf. Coggin, Fabozzi and Rahman (1993)

^[64]Cf. Blake, Lehmann and Timmermann (1999)

^[65]Cf. Davis (2002b)

^[66]Cf. BaFin (2010b), p88

^[67]Cf. Treynor (1965)

^[68]Cf. Sharpe (1966)

^[69]Cf. Brown and Goetzmann (1997)

^[70]Cf. Sirri and Tufano (1998)

^[71]Cf. Gruber (1996)

^[72]Cf. Kirton and Haynes (1953)

^[73]Cf. Wehrle (1961), p70 et sqq.

^[74]Cf. Penman (1933)

^[75]Cf. Adams (1995)

^[76]Cf. Frantz, Chenut and Walhin (2003)

^[77]Cf. Johnson (2007), p56

^[78]Cf. Johnson (2007), p57

^[79]Cf. Truman (2007), p7

^[80]Cf. Truman (2008), p6 et sqq.

^[81]Cf. Fotak et al. (2008)

^[82]Cf. Balding (2008)

^[83]Cf. Garvey et al. (2010), p20

^[84]Cf. Saluzzi and Hage (2010), p4 et sqq.

^[85]Cf. Judd and Yin (2010), p4 et sqq.

^[86]Cf. Judd and Yin (2010), p4

^[87]Cf. Saluzzi and Hage (2010), p17

^[88]Cf. Barbary and Chin (2009), p4

^[89]Cf. Seymour et al. (2010), p9

^[90]Cf. Seymour et al. (2010), p11

^[91]Cf. Stier et al. (2010), p4

^[92]Cf. Figeac (2007), p23

^[93]Cf. Eurosif: European SRI Study (2006), p3

^[94]Cf. Abdallah et al. (2009), p3

^[95]Cf. Schäfer (2001)

^[96]Cf. Gait and Worthington (2009)

^[97]Cf. Abdi et al. (2008)

^[98]Cf. Hoyos-Gomez, Huber and Schachner (2008)

^[99]Cf. Rolt, Young and Lofts (2009)

^[100]Cf. Davis (2000), p20

^[101]Cf. Goldman (2000)

^[102]Cf. Davis (2000), p20

^[103]Cf. Goldman (2000)

^[104]Cf. Franks and Mayer (2001), p124 et sqq.

^[105]Cf. Prabhakar (2009), p86 et sqq.

^[106]Cf. VAG NRW §3, VersAufsVO NRW §§6-7, DVVersoG §9

^[107]Cf. VAG §54 Para. 1

^[108]Cf. BaFin (2005): Circular Letter 15/2005 II. 1. a)-d)

^[109]Cf. BaFin (2005): Circular Letter 15/2005 V. 1. a)-h)

^[110]Cf. BaFin (2005): Circular Letter 15/2005 V. 2. a)

^[111]Cf. BaFin (2005): Circular Letter 15/2005 V. 2. e)-f)

^[112]Cf. BaFin (2005): Circular Letter 15/2005 V. 3.

^[113]Cf. BaFin (2005): Circular Letter 15/2005 VI.

^[114]Cf. BaFin (2010a): Circular Letter Draft, reference number VA 54 – I 3200 – 2010/0008

^[115]Cf. Randall (1999), p629 et sqq.

^[116]Cf. OECD (2000, 2003) as well as Dickinson (1998)

^[117]Cf. Markowitz (1952)

^[118]Cf. Davis (2002c)

^[119]Cf. Benartzi and Thaler (2001)

^[120]Cf. French and Poterba (1991)

^[121]Cf. VAG §81 Para. 2, VAG §7 Para. 2, VAG §54d and AnlV §6

^[122]Cf. e.g. DVVersoG §11

^[123]Cf. ERISA – 29 U.S. Code Chapter 18 Subtitle B Part 5 – Administration and Enforcement

^[124]Cf. U.S. Department of Labor (2010)

^[125]Cf. Jackson (2007), p28

^[126]Cf. e.g. DVVersoG §12, VersAufsVO NRW §4

^[127]Cf. RechVersV Chapter 3, Subchapter 1 §§6-21

^[128]Cf. HGB §325 (1)

^[129]Cf. IASB: IFRS 7 as well as Ernst & Young (2008)

^[130]Cf. ERISA – 29 U.S. Code Chapter 18 Subchapter I Subtitle B Part 1 – Reporting and Disclosure

^[131]Cf. Swinkels (2007)

^[132]Cf. Poweleit (2009)

^[133]Cf. Shuster (2009), p4