Oliver Belfitt-Nash in Ulaanbaatar, Graham Stack in Kyiv -

Emerging markets have bounced back following the global economic crisis, but while the big Bric exchanges have caught the attention of most investors, the focus is shifting rapidly towards the so-called frontier markets. Mongolia and Ukraine are two of those expected to be hot in 2011.

Russia's market saw a big rally between about 2005 and 2007, rising some 40-50% a year and making investors a fortune in the process. But by the start of 2007, interest had started to shift from the traditional "emerging markets" toward the "frontier markets" - basically the same thing, but less developed.

That story was quickly interrupted by the global financial collapse, but as we come out of the other side, attention is rapidly returning to the frontier markets as the last places where the intrepid investor can make a few thousand percent return in a matter of years.

Despite the sell-off of global emerging market (GEM) shares in January - investors pulled out a whopping $10bn at the end of the month, the third largest one-week outflow on record - most specialists think this is a temporary correction. "Outflows from developed market funds over the last four years reached a staggering $350bn against the $100bn that GEMs took in. Money follows performance and since the beginning of this bull market, GEMs are up by 100%," says Plamen Monovski, CIO of Renaissance Asset Managers.

Despite receiving little attention, both the Mongolian and Ukrainian stock markets remain amongst the strongest performing in the world over the last year.

Since the start of the year, Ukraine's UX (Ukrainian Exchange) index is up by 7.0%, but was up over 67.9% in 2010. Mongolia produced a truly impressive performance in 2010, having the world's best performing equity market (for the umpteenth year in a row), up 164%, as well as the second fastest growing economy and the second best performing currency, according to Sardor Koshnazarov of Eurasia Capital. By contrast, Russia's leading indices were up by only about 22% last year. "For the MSE-Top 20, Mongolia's main stock market index, we expect continued outperformance and target a conservative level of 20,000, or up 40% (up 60% in dollar terms), for year-end 2011. We expect the Mongolian Stock Exchange to retain its title among the top three equity markets in 2011," says Koshnazarov.

And both countries have launched major reforms to their exchanges to boost liquidity and reduce risk, which should further bolster their performance this year.

Ukraine's new market

The Ukrainian Exchange is new. Developed by the Russian exchange RTS, in partnership with local brokerages, and founded as a company in October 2008, the UX was launched at the nadir of Ukraine's mega-crisis in late March 26 at 500 points as headlines were warning og an imminent sovereign default.

Contracting by a quarter, Ukraine's economy was amongst the worst hit by the economic meltdown and is only just beginning to regain its feet. However, its stock market has recovered much faster. By the end of 2009, the UX index was trading at just under 1900, lifted by the general rally in emerging stocks, the US' $600bn injection of liquidity into global markets (QE2) and the realisation by local investors that Ukrainian stocks were cheap as chips.

Except for a spring 2010 correction, the index rallied to a new high of over 2800 at the end of January thanks to the government giving the appearance of political stability, striking a deal with the International Monetary Fund and making some real reform measures. "The [UX] index is moving rapidly towards its historical virtual peak of 2935 that was set on January 15, 2008," says Oleg Tkachenko, CEO of the Ukraine Exchange. The peak is referred to as "virtual," because the index was calculated for more than a year before the exchange was actually launched.

The launch of the UX has been a spectacular success, with about two-thirds of trading volumes moving over to the new exchange from its competitor the PFTS in the first year of operation. However, this year will see more changes after Russia's two leading exchanges, the RTS and Micex, announced on February 1 they would merge: the RTS controls UX, and Micex owns the PFTS. Dorian Foyil, owner and CEO of Foyil Securities, who was involved in setting up UX, welcomes the idea of the economies of scale that a single exchange would bring to Ukraine's stock market, and sees UX as "the last man standing."

"In my view, we may not see PFTS 12 months from now. The market has already switched to the UX platform. UX has taken most of the equities trading, with PFTS largely sidelined. It's not going to switch back," he says.

Mongolia remade

The Mongolian Stock Exchange (MSE) is doing a lot better, but largely because it is so far behind Ukraine's. And in principle, the MSE could be a lot more attractive than the UX: unlike Ukraine, most of the listed companies are in either the natural resources sector or cater to consumers; it is a leveraged China-play, which is the most popular investment story in the world today; unlike most of the Central Asian region, it has a real democratic government; and because it remains an undiscovered backwater for international investors, the valuation of Mongolian listed assets are pennies on the dollar in like-for-like comparisons with peers in other emerging markets.

That aspect is about to change. On November 8, New York-based Firebird Management made the single largest trade in Mongolia's history, buying almost 3m shares of MSE-listed Baganuur coal mine for $15m - 10 times the normal turnover on the exchange. However, it's the local investors who are driving the growth of the market, and driving it hard enough to make the MSE consistently the best performing market in the world for most of the last decade.

Yet it is also the market's very youth that also causes most of the problems. Daily turnover on UX is in the order of $5m rising to $20m in boom times, whereas that of the MSE-Top 20 is on the order of $50,000 to $100,000 (Russia's exchanges have turnover of billions of dollars a day). And the MSE is littered with shells left over from privatisation that are not functioning, reporting or even operating. Most of its financial infrastructure is missing.

With 336 companies forming a total market capitalisation of just over $1bn, it has performed exceptionally well in 2010... on paper. The exchange grew 164.7% in dollar terms and 130.7% in Mongolian tugrik (MNT) terms to reach MNT1.373 trillion at the end of 2010. The majority of this was from the top five companies: Tavan Tolgoi JSC (coal, 326.7%), Baganuur (coal, 200.0%), Shivee Ovoo (coal, 293.9%), APU (beverages, 215.9%) and Shariin Gol (coal, 519.1%).

Clearly the momentum is starting to build. Since the start of this year, the Top-20 Index has jumped 73%, while volumes are up to MNT367m ($282,000) a day - volumes seem to be doubling every year - spread over 45 brokers grasping for a slice of the market. Of these, there is one giant who controls what happens at the MSE, BDSec, which manages over 80% of all trades. When most companies have less than 5% free float, manipulation becomes the norm and the single broker can set the prices as they see fit. "The Mongolian capital market is in its infancy," says Bold Bataar, chairman of the board of the Mongolian Stock Exchange, bursting the bubble of excitement. "I wouldn't pay any attention to the MSE's Top-20 Index."

The exchange may be backward, but the government is clearly focused on fixing its shortcomings. In January, the London Stock Exchange (LSE) took on a management contract to trim the rough edges of an ex-soviet privatisation vehicle, bringing in new regulations to enable liquid and sophisticated transactions for the Mongolian capital market.

The reforms will enable a wave of IPOs in the coming years, the biggest of which will be the gigantic Tavan Tolgoi coalmine project. This is split into 12 licenses, two of which are already listed on the MSE as Tavan Tolgoi, one of which has been listed under Mongolian Mining (MMC) in Hong Kong, three of which are held by other private companies and the remaining six are owned the state-owned Erdenes MGL.

The state's share is estimated to contain 6.4bn tonnes of high quality coal, making it one of the largest deposits in the world. One in every four trucks leaving this mine will carry high-quality coking coal used for steel production in China, and the rest will be thermal coal for electricity production, only 250 kilometres from the Chinese border.

Once Tavan Tolgoi has been sold, there are plans to list the other 15 strategic deposits. "This will be a long and painful process" says Bold. "The number one priority is to earn people's trust and create complete transparency, but this will take at least 18 months."