Ben Aris in Berlin -

Funds are booming in Ukraine, fuelled by a $10bn tide of foreign capital flowing into the country and the soaring personal incomes of the population.

Kyiv's leading PFTS index had a bumper year in 2007 and became one of the best performing markets in the world after it soared by 135% over the year. The total trading volume on the Ukrainian stock market was $2bn coming from 248 stocks traded during the year. The volume leaders of the year were the bank Ukrsotsbank ($145.8m), the machine-building company Motor Sich ($109.8m) and the electricity generator Zakhidenergo (99.8m). The most liquid equities of 2007 were the steel companies Enakiyevo Steel and Azovstal (3,128 and 2,897 trades respectively).

With money in the pocket for the first time thanks to rising personal incomes, the average Ukrainian is turning to the stock market as he or she starts to think about the long term. The funds set up to cater to this demand are now starting to motor.

Leading local investment bank Dragon Capital put the icing on the cake when it raised $208m with an IPO of Ukraine's first-ever international-listed fund - the Dragon-Ukrainian Properties and Development (DUPD) fund that targets the sizzling real estate sector. But most of the action is still found amongst the domestic funds targeting the domestic investor; over the last year most of the local banks have targeted the expanding wealth of the domestic population and set up a string of mutual and pension funds.

Based on data compiled by the Ukrainian Association for Investment Business (UAIB), funds under management by domestic mutual funds had reached $386m by September 30, and the gross equity/fixed income allocation was 64/36. The equity allocation has, therefore, grown significantly from the 50% allocation registered at the beginning of the year.

"The growing domestic investor base has been a major contributor to market strength in 2007. The latest open access opinion poll conducted by the PFTS exchange revealed that about one-third of respondents believe that the weight of domestic investors in total trading is 10-15%. Another third say the domestic share is between 15-20%, and the remaining respondents think domestic investors contribute 20-25%. In our view, domestic investors still represent up to 15% of the total base," Renaissance Capital said in its end-of-year strategy note.

Kinto

The local funds initially marketed themselves to Ukraine's high-net-worth individuals, but in the last six months they have turned their attention to the expanding pool of cash that belongs to the man in the street.

Kinto Asset management is the biggest with about $150m under management. Set up in 1992, it is both the oldest and leading financial group on the Ukrainian market with about a 55% market share. Dragon Asset Management is in second place with UAH200m ($40m), and all the other funds have another UAH100m under management between them. "Local asset management firms are small, but they are growing fast," says Tomas Fiala, managing director of Dragon Capital.

Like elsewhere in Eastern Europe, the fund business was born out of the start of the mass privatisation process and the state's decision to issue privatisation vouchers in 1994, which were eventually traded for shares in most of the country's leading enterprises. But the fund business was formalised in 2003 with the passage of the law on collective investment vehicles, which forms the legal basis for funds. In 2005, the government introduced more legislation, this time to create a legal basis for non-governmental pension funds, and will follow up with a mandatory accumulating pension system in 2009, which should fuel the growth of a pension fund sector.

Kinto continues to roll out new funds, including the Synergy funds series that gives non-residents exposure to Ukraine's equity markets and were the first funds to be listed on the local exchange, the PFTS. Since its inception in 2004, the first Synergy fund has returned a whopping 700%, while the firm's biggest fund, the Classical, has returned a remarkable 61% a year on average over the last three years.

However, investing into the domestically-registered funds is not simple for foreigners. Under the current rules, they have to first open an investment and securities account with one of the banks authorised by the National Bank of Ukraine, and various currency controls have meant only specialist investors have gone down this road. It's still extremely early days for domestic retail investment, with an estimated 1.5% of the population, or one person in 70, owning shares.

Parex

It seems that new funds are being launched every month. Local investment bank Sokrat Capital launched the Metallurgy-Engineering Premium Fund and a pre-IPO fund just before the end of 2007. Dragon Capital has consolidated all its funds.

One of the most recent funds to target Ukraine is the Parex Fund Ukrainian Shares, which invests into Ukrainian equity, but is a Latvian-registered entity. Parex is Lativa's leading bank and has been aggressively expanding into CIS countries.

The bank has been active in Ukraine for a while with two funds: a bond fund launched in December 2005 and a balanced fund in January 2006. "Both these funds were registered in Ukraine and they are pioneers in their class - open-end funds denominated in hryvna," says Denis Moschenko, director of Parex's asset management business in Ukraine. "It has been a slow start, but the funds have been performing very well and we have about UAH200m under management now. That's equivalent to about half the open-end fund market in Ukraine."

The balance fund returned 77.5% over the first 11 months of 2007 and the bond fund a little less. Although both funds were targeting domestic investors, about half of the assets under management belong to foreigners, those that have gone to the effort of setting up special investment accounts with authorized banks in Ukraine.

Ukraine's archaic legal structure is causing real headaches for fund managers. For example, under Ukrainian law, an open-end fund has to be diversified, so it can't have more than 40% of its assets invested into any one asset class. "You can't do a pure equity fund in Ukraine because of the laws," says Moschenko.

At the same time, equity funds suffer from the immaturity of the market. For example, while daily trading volumes have gone from $8m a day to $30m between the start and end of 2007, these are still tiny volumes, even by regional standards. "The free float remains small and there are still too few listed companies. However, the market will grow and the choice will widen. The investment banks have a huge pipeline of IPOs which will be coming to market over the next one or two years. We expect the [stock market] index to double in the next two years," says Moschenko.

However, given the rising interest amongst foreign investors in the Ukrainian market, recently the group went on to found Parex Asset Management Ukraine (PAMU) in December 2007, which is specifically designed to make it easier for foreign investors to get exposure to the Ukrainian market, without the hassle of opening bank accounts in the country. The new fund will allow non-resident investors to tap into Ukraine's red-hot equity market via a legal entity registered in Riga that targets shares in companies registered in Ukraine or companies for which Ukraine is a major market.

The fund is an open-end fund denominated in euros and, as such, currency controls make it difficult for Ukrainians to buy into the fund. However, a domestic equivalent fund will be launched later this year, says the bank. "Demand was high, so we decided to set up a Latvian-registered entity and collected $200m in the first month after the launch," says Moschenko. "It is easier to sell and customers are more comfortable, as they can by a product that is registered in Latvia, an EU country."

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