Nicholas Watson and Ben Aris -

"I think pretty much everyone can agree that the [fund] industry has not fared that well in the last 12 or so months," says Topi Tajakka, head of international business development at Hansa Investment Funds.

True, but then everything is relative: while fund data provider Lipper Feri was reporting that a collapse in the money market sector in June had sent European mutual fund flows spiralling into the red for the first half of 2008, four of the top five markets for fund inflows during the month were Central and Eastern European countries. The other, Sweden, perhaps not coincidentally, invests heavily in the region.

The ability of CEE countries to maintain inflows into mutual funds while all around them saw money flee is a consequence of the booming economies there. While places like the US, UK and Italy flirt with recession, CEE countries like Russia, Romania and Slovakia are putting in growth rates in excess of 8%. This is cutting unemployment and putting more money in people's pockets. Not all of this is being spent, but a growing proportion is being stashed away in more sophisticated saving instruments than bank accounts. "Three years ago, just 8% of Polish society had any savings; now one-third declare they save every month," says Tomasz Korab, board member of Poland's Opera Investment Fund. "It's now a completely different situation and means people are making completely different economic choices."

Looking at bne's survey of funds that cover the region, some of these savers are being rewarded for their fortitude. While the re-rating that characterised the emerging European markets during 2004, 2005 and 2006 is all but over, the onus is now on earnings growth, which is still buoyant from that strong economic growth. "Hereon in, it'll be much more about earnings growth, which makes it more difficult to see the types of return like the 66% [of our Invest Emerging Europe fund] seen in 2005," says Gus Robertson, senior portfolio manager of emerging markets equity at ING Investment Management.

After a difficult year, the question is where the industry goes from here. The slump in the US housing market and the subsequent credit crisis, which in turn caused a loss of faith in the banking sector and sharp drops in liquidity on the world's equity markets, may have been brewing for years, but it still took many portfolio managers by surprise. To adjust to the new environment, many fund managers moved into more liquid stocks in more liquid markets. "In the short term, given the positive environment for commodities and the current trend where large caps tend to outperform small caps for reasons of liquidity and risk aversion, we will have a strong focus of about 80% on large caps," Angelika Millendorfer, head of equities emerging markets, says of Raiffeisen Capital Management's new Russia Equities fund, which was launched in May.

Not a PIFfling amount

In fact, Russia has been singled out by many fund managers as a key market going forward, wars in the Caucasus notwithstanding. That might not seem obvious given the recent roiling in the markets there. In August, Russian stocks sold off heavily on the double whammy of a boardroom showdown between Russian and British shareholders of Russian oil major TNK-BP, followed by Prime Minister Vladimir Putin's call for an investigation into New York-listed metals and coal company Mechel. Analysts were just starting to say that the sell-off was overdone and this didn't presage a repeat of the Yukos affair, when Russia went to war against Georgia in the Caucasus. More than $5bn of Russian equity investment made for the door as the fighting broke out. "Over the seven days to August 13, investors withdrew $239m from Russia-dedicated funds - a figure topped only by the $245m taken out in the week to July 30 as the market reacted to Putin's comments on Mechel," says Chris Weafer, head of strategy at UralSib. "If this doesn't stop by the end of August, then we will see more redemptions from funds and the start of forced selling."

While it's been a terrible year for foreign investors in Russia, beneath the fizz of this relatively hot money flowing in and out, the locals seem a lot more confident of Russia's long-term prospects. The Russian retail investor has shown himself to be savvy in the past and is starting to put money back into mutual funds, or PIFs as they're known in Russia. In July, PIFs showed a net inflow of capital for the first time in six months, taking in more than RUB1.7bn of fresh money, Russia's National League of Management Companies reported. Most of the money - some RUB1.1bn - went into equity funds, however, the bond funds continued to see outflows that reached over RUB800m over the same period. The most popular funds were those targeting the oil, gas and metals sectors; the least popular with investors were electricity sector funds, which saw an outflow of capital on par with that from bond funds.

PIFs are now the fastest-growing segment of organised investment. The Moscow Interbank Currency Exchange, or Micex, estimates that the total retail investor base is something like 5m-6m people, not including those who invest into the markets via pension, mutual and other investment vehicles. If these types of investment are included in the total, then domestic retail investors already for 20% of all investment capital flowing into the equity market. Still, the same survey found nine out of 10 Russians admit they don't really understand what investing is all about. "The number of Russians who have invested money in Russian equities is still very low and in China a higher percentage of the population are involved in the stock market than in Russia, although Russian GDP and income per capita is three to five times higher than Chinese. Part of our job at Micex is to educate the people to the benefits of investing for their long-term future," says Micex president, Alexander Potemkin.

Balkan cheese

That other huge market in the region, Turkey, confounds foreign investors to the same degree as Russia and is also having a terrible year. But it too looks set to benefit from local buying and is being touted (yet again) as an increasingly attractive market.

Looking at our survey's Turkey-dedicated and Balkan funds, you can see just how much the country's political problems have taken their toll on the performance. Most have suffered double-digit falls in the first half of the year; DWS' Turkey fund was down 30% at end-June. The biggest problem has, of course, been the potentially explosive court case against the mildly Islamist, ruling AKP, which has styled itself as the reformist, pro-market party since it came to power in 2003. But on July 30, Turkey's highest court pulled the country back from the brink when it narrowly rejected calls for the AKP to be closed down for alleged anti-secularist activities. Instead of that nuclear option, the court contented itself with a sharp slap on the wrist for the AKP, with all but one judge voting to remove half the party's state funding.

The upshot of the court case, plus the fact the economy remains in what the Organisation for Economic Co-operation and Development (OECD) calls a "difficult transition period," is that valuations of what are widely acknowledged well-run companies have been pulled down to a level that many analysts now find attractive. One of those is no-less an expert than Mark Mobius of Franklin Templeton. "Turkish companies look very cheap, you could almost throw a dart at the market and hit something worth investing in," he tells bne in an interview.

But for Turkey to finally meet expectations, the AKP needs to drop its antagonistic stance over divisive issues like headscarves and concentrate on what the electorate voted overwhelmingly for it to do: press on with reforming the economy and freeing its vast corporate sector from the shackles of the statist past. The OECD, in its latest review of the Turkish economy in August, identifies the three main areas for action: On the fiscal front, the government needs to keep a rein on spending while reducing distorting aspects of the tax system; on monetary policy it must have a tight focus on reducing inflation, backed by structural reforms to enhance competition and moderate prices, particularly in the service area; and it must revise labour market regulations to reduce barriers to formal employment and allow firms to move out of the informal or "grey" economy and into the formal sector.

According to the Baltic fund manager, the market is already seeing a boost as Turkish residents increase their exposure to Turkish assets after reducing it at the start of the latest political spat. For foreign investors to do likewise, "we'd like to see more privatization and reform of the tax system. Simplification and reduction are the watchwords," Mobius says.

Looking at the prospects for funds as a whole in the region, most experts believe the bottom of the US housing market will be hit in the last quarter of this year or the first quarter of next, and that should be a clear signal for the global markets that the worst is over. "Until then, however, it's expected to be a bumpy ride," warns Hansa's Tajakka.

And the winners are...

bne launches its annual "Best Funds in New Europe" ranking in this issue, which lists many of the funds with a significant proportion of their assets invested in Central, Eastern and South¬east Europe, as well as the Caucasus and Central Asia. We asked fund managers working with the region to submit their funds and mixed all different types of funds together on the basis of which are making the biggest returns. As so many funds have only been set up within the last year, we chose the winners based on the simple criterion of best perfor¬mance from the beginning of the year to June 30.

bne 2008 best overall fund in New Europe:

Renaissance Capital's RenFin Fund is the clear winner in our survey, returning 26.7% over the first half of the year by playing on the popular financial theme. Commenting on the fund's performance, Sergey Nazarov, the RenFin fund manager, said: "Renfin's success stems from the inherent growth and earnings opportunities of the Russian financial sector, in conjunction with a cherry-picking of best investments in the region. The fund's proactive involvement with the portfolio companies contrib¬utes a great deal to their value growth."

bne 2008 best equity fund:

Renaissance Capital took the top-two equity fund slots with funds that target the two main current investment themes of the Russia story: banks and infrastructure. Renaissance Capital's RenFin Fund that buys minority stakes in mostly second-tier banks returned 26.7% over the first half of the year, while the second best performing fund, up 14.2%, was the Renaissance Infrastructure fund, which is a story that is just getting going. Third place went to newcomer, Alisher Djumanov's Eurasia Capital Management's Central Asian Real Estate Fund, which returned 13.3% over the same period - proof that the frontier markets are already able to com¬pete with the more established investment stories.

bne 2008 best balanced fund:

Balanced funds typically combine large stock hold¬ings with a sleeve of fixed-income securities and cash. That composition prevents them from hitting the high numbers when the market takes off, but their conservative approach also means investors won't lose their shirts when the market tanks. Most of the balanced funds in our survey were in the minus column during the first-half of the year, so the winner in this category is the only one that remained in the positive column, Parex Asset Management's Eastern European Balanced fund, which returned 1.31%.

bne 2008 best fixed-income fund:

In such difficult conditions as we see today, fixed-income funds have performed relatively well. Of note was Erste Sparinvest's ESPA Cash Forint fund, which was up 8.23% in the six months to June 30. The winner, though, was Raiffeisen Eastern Euro¬pean Bonds fund, which returned 9.51% during the period. Commenting on the fund, managers Ronald Schneider and Stefan Grünwald said: "The fund did perform very well, as it has been invested to a large extend in the CE4 [Czech, Hungary, Poland, Slo¬vakia], whose currencies appreciated significantly against the euro. Investments in political or funda¬mental markets like Turkey and Romania have been kept low in the first half of the year. The increase of the exposure to theses markets and to local bonds in CEE has helped the fund performance recently."

bne 2008 best real estate fund:

The property market in many parts of the globe suffered another difficult six months, so GILD Bankers' ability to provide a return of 15.5% from its Eastern Europe Real Estate Investment Trust was an outstanding performance and was the out-and-out winner in the real estate category. "The achievements of the GILD real estate fund EEREIT indicate the competence and strength of our team. By combining the best expertise in real estate with experience in active fund management, we know the expectations of investors in that asset class. Surely, the positive market cycle during the past year contributed to the performance of the fund, but we clearly focus on being efficient fund manag¬ers in the long term and in all market cycles," says Jaanus Juss of GILD Real Estate.

To see the full list of over 100 funds bne has compiled, please go to the pdf that accompanies the CEE funds special report found here.

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