Ben Aris in Moscow -

On April 1, Fund Management Group (FMG), a small frontier specialist fund manager, launched what is one of the first funds dedicated to investing solely in stocks listed on the Mongolian Stock Exchange (MSE), hoping to tap into what could well turn out to be one of the last chances to make thousands of percent return in a few years from the emerging market catch-up story.

Investors brave enough to get into the stock markets of Russia or China when they were first set up have made a mint. Russia continues to get a terrible press, but over the last decade the RTS Index has returned 750% and $1,000 invested into any of the blue chips when the market was founded in 1995 would have made you a millionaire in the meantime.

With several of its large companies already listed on international exchanges, Mongolia is already investable. SouthGobi Resources raised over $460m, Mongolian Mining Corporation $650m and Winsway Coking Coal Holding $472m in their respective Hong Kong IPOs last year, and Hunnu Coal and Xanadu Mines raised a total of A$66m in Australia. In all, there are currently a total of 18 Mongolian companies listed on the Australian, Hong Kong, London and Toronto stock exchanges, with at least a dozen more Mongolian resource companies expected to raise capital over the next couple of years.

But the point of the FMG Mongolia Fund is to buy locally listed shares on the MSE. "The trouble with international listings is they are don't really reflect what is happening on the ground in Mongolia. They are subject to the same fears and turbulence of all international shares," says Arild Johansen, CEO of FMG. "We are going to invest into 10-12 liquid names and stick it out to see how the market develops. The market is young and not yet integrated into the global economy so all the external problems are little more than white noise to the MSE."

That's one of the advantages of being at an early stage of development in a market that is as far from everywhere else in the world as it is possible to be - it doesn't matter what happens elsewhere. Indeed, the MSE Top-20 index was entirely unaffected by the sharp sell-off on emerging markets that started last summer.

FMG has long experience of investing in frontier markets, having set up an Iraqi fund two years ago and a Russian fund in 1995. "We bought oil shares linked to the Kurdish story [in northern Iraq] and when the turbulence came in 2008 these share were still up," says Johansen. "We also invested in Russia in 1995 and that market was very similar, but the market outperformed over the long-term. The idea is to get in front of the tidal wave to come."

FMG has seeded the fund with $250,000 and hopes to raise a total of $3m-4m from the fund's traditional clients, mostly expats working in the finance industry in places like Hong Kong. If things play out like they have done in Russia and Iraq (which was the third best performing fund in the world in 2011 according to Barclay's hedge fund ranking), then Johansen says investors can hope to quintuple their money in five years.

Next phase

Obviously, Mongolia remains an extremely risky investment with its almost total dependence on China as the wild card. However, Johansen believes that the first phase of transition of chaos and collapse is over. In the second phase of development, a country typically starts to rebuild and grow. Like Russia, Mongolia is blessed with a cornucopia of natural resources. The country has already signed several contracts to develop its copper and coal deposits, and billions of investment has already pumped up economic growth to 17% in 2011, making Mongolia one of the fastest growing countries on the planet.

Moreover, the government has already launched real reforms for the capital market: last year, the MSE signed a three-year deal with the London Stock Exchange (LSE) to reform the local exchange. "The free floats of many companies are still too small and a lot of companies listed on the MSE simply don't exist any more," says Johansen. "So the first task for the LSE is to do some house cleaning and this alone will be a bit improvement and help open the market to the rest of the world. The point is to get into the market when it is ugly and wait for it to get to just bad - that is where the big gains are."

FMG is not the only one thinking on these lines. At the start of last year, US fund Firebird Management's Jamie Passin, who set up the Firebird Mongolia Fund and Firebird New Mongolia Fund, bought 40% of the MSE's entire free float in a matter of days. The index soared from about 5,000 to over 30,000. Since then, the index has sunk back to 20,000 and has remained stuck there ever since. "The local companies will continue to sell more beer, people will want to buy more products, the banks will make more loans and the amount of money spent will continue to rise. Passin's investment is troublesome, but it will be absorbed quickly as it is still so early in the game. We are talking about a country that is expected to have GDP growth of around 20%-30% in the next few years," says Johansen.

The economics of the Mongolian story are clear: dig coal and metal out of the ground and send it over the border to meet the rapacious demand in China. But the political risk is harder to assess: Russia worked out well enough for portfolio investors, but the same is not true in Ukraine where the lack of leadership has left the local exchange an illiquid backwater. "There is more accountably in Mongolia and there is more democracy here than in most other frontier markets. I am more concerned about what sort of government corruption there is and if the government is dysfunctional but we remain confident that Mongolia is on the way up," says Johansen.