Nicholas Watson in Prague -

What has gone wrong with Polish mutual funds? Part of the answer lies in that one of the main pillars on which the fund industry's success over the last few years was built, contained the seeds of its own destruction.

The Polish government controversially requires that Polish funds invest 95% of their assets in domestic stock and bonds. While the stock market was rising, this policy helped drive prices ever higher as Poles ploughed money into mutual funds - they have invested much more than anyone else in Central and Eastern Europe into mutual funds, putting some 35-40% of their savings in mutual funds, compared with just 10% in Hungary and the Czech Republic - and funds chased too few available assets. "Three years ago, nearly 8% of society had any savings; now one-third declare they save every month," says Tomasz Korab, board member of Opera Investment Fund.

However, the global credit crisis and slowing growth at home turned the tide. The Polish stock market is down by over a quarter since the start of the year and in June hit its lowest level since November 2005. This has had a devastating effect on domestic funds, which saw massive withdrawals of money by investors. This has perpetuated a downward spiral in the stock market: the more the stock market fell, the more money was pulled out of funds, so causing the stock market to fall further. With 95% of their assets invested in domestic securities, Polish funds were simply taking too heavy a country risk, say experts.

According to data published by the Financial Supervision Commission, assets managed by Polish investment fund firms fell by 3.3% in monthly terms to PLN93.31bn in July, meaning assets have fallen for the ninth time in a row. During the last year, the value of money accumulated in funds is down by one-third, Analizy Online, which monitors the investment and pension fund market, announced in its latest report.

The flow of money out of the funds has inevitably hit the country's banks hard. The rise of the fund industry proved a goldmine for Polish banks, boosting profits for those most active in the business - the margin on mutual fund products reached 3-4%, twice as much as on deposits - and propelling valuations for the sector upwards. Wood & Co reckons that, "as a rule of thumb, each 3% reduction in mutual fund assets will reduce Polish bank profits by approximately 1%." Given the more than 20% decline in mutual fund assets this year, the Prague-based brokerage calculates an almost 13% fall in BZ-WBK's profit and 10% for Millennium's, both of which are the most exposed Polish banks to the business. In July, Millennium said the value of funds in its investment products fell by nearly half in the first half of the year.

While few are brave enough to predict an end to the global turmoil that was set off by the slump in the US housing market, analysts say barring a further crisis in the world economy, the Polish market could have already hit or at least be near the bottom.

Top and bottom

The WIG-20 fell 45% from its peak in July 2007 to its low in July this year. This has brought valuations down to a point where the index is trading at a price/earnings multiple of 10.32x, compared with the average and maximum P/E for the period of 16x and 34x respectively. "Although the WIG Index is trading at a slight premium to its historical lows, it's both below its average and median P/E multiples during the period," said one Baltic-based fund manager who declined to be named.

This 45% fall in the market almost equals the 49% drop in Polish stock prices in 2000-01. However, the fund manager says it's important to note that the current fall in Poland's stock market hasn't been accompanied by the same dire economic environment as in 2000-01. "GDP is expected to increase by 5% in 2008 and 9% in 2009, while corporate earnings are expected to increase by 7% in 2008 and 11% in 2009," he says. "Although there are significant problems facing Poland in the near future, the current and forecasted economic situation does not warrant the low valuations levels assigned to Polish companies." With the WIG-20's subsequent rise to 2,647 points in mid-August, he adds it "may be an indication that the bottom had been reached."

Certainly other fund managers are beginning to take another look at Poland since the fall in stock prices. "For some time in Poland the market has had high valuations. Now we've seen significant outflows from Poland funds and a correction in the stock market that has clearly brought valuations to more reasonable levels," says Angelika Millendorfer, head of equities emerging markets at Raiffeisen Capital Management.

PZU Asset Management's investment advisor Adam Drozdowski reckons that the equity market should have a better second half of the year, predicting the WIG-20 will rise by 15% to end the year at 3,000-3,100 points.

If fund managers are prepared to start investing again in the stock market, they also should have more assets to choose from. Despite the sharp fall in share prices, the Warsaw Stock Exchange expects a record number of companies to IPO this year. The head of the WSE, Ludwik Sobolewski, predicted in July that some 50 companies would debut on Warsaw's main market in 2008 and the number of stocks on its one-year-old NewConnect market, for firms valued at less than PLN20m ($9.8m), might climb to 100 from 24 last year. A total of 57 companies listed in the first half of this year, compared with 105 in 2007.

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