Nicholas Watson in Prague -

2008 promises to be a more volatile year for investors, but the clouds on the horizon - Kosovo, the US sub-prime mortgage crisis, inflation, stretched valuations - aren't expected to put the brakes on the freight train that is the growing mutual fund industry in Central and Eastern Europe.

The rise of the fund industry in the region is the result of an inexorable process that began almost 20 years ago, when many CEE countries began reforming their economies after the collapse of communism. The pace of this has picked up considerably over the past few years as the first of the region's countries aimed for and eventually joined the EU in April 2003.

Strong growth (over 6% on average compared with the anaemic 2.4% of Western Europe in 2006), increasing household wealth, the reform of pension systems, higher wages, better education, increased financial competition, improving governance - the causes are many but all of them have contributed to a surge in the amount of money that has flowed, and is flowing, into funds investing in the region.

The best available figures come from the fund market information vendor Lipper Feri, which puts the total amount of assets under management in 13 CEE fund markets at €68bn at the end of June 2007. That's average growth per annum of 49% since 2001.

And that's just the start. The growth looks big, but it began from an extremely low base. In terms of European assets, that €68bn figure still represents just 1% of the total asset base. Analysis from another big regional player, Pioneer Investments, shows that 62% of financial assets of households in the region are still held as bank deposits, twice the percentage held by Western European households. Much of that money should eventually find its way into far higher-returning funds.

With reform of the various pension systems just starting in many countries and household wealth continuing to grow strongly, mutual fund inflows are expected to continue expanding at 20-30% per year, perhaps more in some markets. "The rise of the middle class and reform of the pension systems will undoubtedly continue to be of huge importance," says Robert Kitt, CEO of Hansa Investment Funds. "In Estonia, from 2002 financial assets have grown 100% per annum, albeit from a low base. And in the next five years it will grow at 50% per annum. People are saving now."

Safe havens

Not all these fundamentals are certain to remain intact this year. Fund managers acknowledge that a growing risk to the performance of the region's financial markets will come from rising inflation and worsening external balances in many of the countries. The Baltic states, Romania and Bulgaria all have widening current-account deficits in double digits, while inflation has been picking up everywhere, largely on the back of rising food and energy prices. "It's difficult to say if the price of food will come down again, but given the increase in biofuels and the prospect of more drought, this is certainly not helping," says Sebastian Kahlfeld, senior fund manager for emerging Europe equities at DWS Investment.

With more people starting to compare Bulgaria and Romania with Thailand 10 years ago, which was the domino that began the toppling of the Southeast Asian economies in the late 1990s, nerves are definitely jangling. However, fund managers still believe companies in the region will enjoy good profits this year. "The top-line growth of companies in Eastern Europe is generally very high, the companies are boasting very good profit growth and the median for the universe in Eastern Europe and Russia in 2007 is expected to be 40%. In Kazakhstan the figure is higher," says Hansa's Kitt.

While many fund managers remain optimistic on the prospects this year for the region's heavyweights, Russia and Turkey, they are more cautious elsewhere, particularly with regard to valuations in places like in Poland. Christian Schick, head of portfolio management asset allocation at Fortis Investments, warns that the sharp appreciation in valuations on some markets (the Warsaw Stock Exchange index that measures the construction industry rose 142% in the year to June 30) could lead to a sharp correction in the short term - though he remains bullish about emerging market securities' long-term prospects.

The fallout from the US housing slump and the mess in the sub-prime market has yet to be fully played out, but judging from recent data it looks as though emerging Europe could come out stronger let alone damaged by the problem.

Looking at data from Lipper, since August when the crisis exploded and the word "sub-prime" became part of the everyday lexicon, CEE countries have figured strongly in the top-five list of sales of funds to investors in Europe. In November, Hungary, the Czech Republic, Slovenia and Romania all featured on the list, with the only non-CEE country being Lichtenstein. This indicates, as many are now saying, that emerging Europe is actually becoming a safe haven from the credit crunch roiling the US and other developed markets.

On the most basic level, it's not hard to see why: the percentage of mortgage loans to GDP in the region is less than 20% whereas in developed markets it's more like 50-60% - a different scale altogether. Therefore, any connections between the crisis and the CEE region are more tenuous, argue analysts,

Countries like Kazakhstan that have borrowed heavily on international markets at very tight spreads have undoubtedly seen those borrowing rates rise as the credit markets froze up. "When the credit markets stirred, nobody looked at fundamentals but decided not to lend any more money - it's not a credit issue, it's a liquidity issue," argues Kitt.

Another problem stems from those banks and hedge funds in the US that are having to raise vast amounts of cash to meet margin calls and cover losses from their exposure to the sub-prime mortgage market. Citigroup and Merrill Lynch, whose bosses have already fallen on their swords over the problem, are set to announce in January further massive write-downs, speaking fears that the credit crunch is far from over.

"The big questions for 2008 are whether the US and global investors are going to withdraw money and where are they going to withdraw it from? Will the money come from Russia, which is still cheap and attractive, or will it be pulled from more fully-valued economies like China? Also, how will the US slowdown affect Russia, Turkey or other emerging European economies?" says DWS Investment's Kahlfeld.

To the last questions, not much, argue some fund managers. "We are positive that an increasing number of foreign investors will realise how attractive Eastern Europe can be in a bearish global mood triggered by US slowdown threat," says Karine Hirn, a partner at East Capital.

Homeboys

With emerging Europe's fund industry maturing and deepening, a definite trend that's developing is funds increasingly no longer look at the region as one large beast, but as distinct markets with their own characteristics. Allied with this is the growing power of local funds, which are building their business entirely centred on the countries in the region. This has been a feature of Russia for some time with players like Renaissance Investment Management and Troika Dialog, but it's now spreading to places like Ukraine, Kazakhstan and the Balkans.

"One can see an increasing number of country specific funds being launched by asset managers, even though some of the markets are not deep and liquid enough for daily-traded retail funds - Ukraine for instance," says East Capital's Hirn.

For now though, the bulk of assets will remain with pan-CEE funds that follow regional indices, focusing on four or five major markets. "Venturing outside the index demands, in our view, a very specific and resource-demanding active stock-picking approach," says Hirn.

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