FUND SURVEY 2013: End of an unsustainable run

By bne IntelliNews August 28, 2013

Nicholas Watson in Vienna -

The run had to end eventually, and it did in spectacular fashion when the last week in June saw around $5.5bn sucked out of emerging market bond funds, their worst week on record.

That was the fifth weekly withdrawal on the trot for emerging market bond funds, a trend that began in May when the head of the US Federal Reserve, Ben Bernanke, gave the first signal the US central bank would begin reducing its asset purchases later this year. "We saw significant outflows, probably the strongest since [the crisis in] 2008 and this was a re-pricing of risky assets - in emerging markets a kind of cleaning out of the investor base and this 'crossover' money," describes Peter Svoboda, manager of Erste Asset Management's "ESPA Bond Danubia" fund, which returned 4.0% over the bne survey period from June 30, 2012 to June 30, 2013.

Certainly bonds from emerging market issuers like those from Central and Eastern Europe and the Commonwealth of Independent States (CEE/CIS) have enjoyed a remarkable couple of years. Last year's bne fund survey saw Erste's "ESPA Bond Emerging Markets Corporate" fund take top spot in the fixed-income category with a huge return of 8.0% on the back of the robust fundamentals in much of CEE in terms of higher growth, better fiscal positions and lower debt. These solid economic fundamentals, together with the tame inflation, higher interest rates, rising local currencies, and tightening spreads on the hard currency side as central banks continued their quantitative easing, attracted a huge amount of bond investment over the past two years.

Even with the $12.5bn outflow seen in the last five weeks to the end of June, Daniel Vernazza, an economist at UniCredit Group, pointed out at the time that it only undid a little more than half of the $22.8bn inflows seen in the first half of 2013, leaving a net inflow of $10.3bn. "Looking at longer time horizons, in the last 52 weeks there has been a net inflow of $35.0bn and, since the data was first collected back in late 2006, net inflows total $91.2bn," Vernazza said.

This year, the winner of the "bne Best Fixed-Income Fund 2013" is Raiffeisen Capital Management's "Raiffeisen Eastern European Bonds" fund with a return over the survey period of 5.4%. "The good performance of [the fund] was mainly due to the exposures in Hungary (smaller exposure but high returns) and Poland (smaller returns but high exposure)," says Ronald Schneider, head of Global Emerging Markets and Eastern Europe (Fixed Income) at Raiffeisen Capital Management.

This was closely followed ELANA Fund Management's "ELANA Eurofund" (5.3%), Citadele Asset Management's "Citadele Eastern Europe Bond Fund" (5.2%), the "ELANA Cash Fund" (4.9%) and Pioneer Investments' "Austria - Central & Eastern Europe Bond" (4.7%).

The first five months of this year continued that tremendous 2012, which saw a 12-13% performance in emerging market and corporates bonds, high yield bonds at 20%-plus, and triple-C rated bonds around 30% as investors, flush with money to invest, searched for better yielding instruments than those found closer to home. "This was something not sustainable," says Svoboda.

And so it came to pass, when from the start of May the US yield curve began to steepen dramatically as investors switched out of emerging market bonds that were trading at ridiculously low yields. Investors say hard currency emerging market bonds were trading at an average spread of 230 basis points (bp) before the May sell-off began; now these bonds are trading 100bp higher.

Looking ahead, fund managers say the recent shakeout that has left mostly dedicated bond investors is perhaps no bad thing. Given a medium-term investment horizon of three to five years, they say investors should realistically look for an annual yield of 3.5% to 4.0%, which will be driven by the ongoing - albeit slowing - convergence process of the region to Western European standards. There will be no repeat of the impossibly high yields of the past two years. The average yield of the bonds in the "ESPA Bond Danubia" fund portfolio, for example, is about 3.7%.

Local currency bonds, in particular, are expected to do well. According to Thomson Reuters' "European Fund Market Mid-Year Review 2013", published in August, the 7th best-selling fund asset class in the January-June period was "Bonds Emerging Markets - Local Currency" with €8.63bn. "It's a good moment to be entering the local currency bond market," says Erste's Svoboda.

Taking stock

On the equity side, funds had a much better year than last year. In the last survey, the winner was Erste's "ESPA Stock Istanbul" with a performance of minus 0.2%.

Even so, the environment remains fragile, with the Fed's suggestion of a "tapering" of its quantitative easing causing a sharp reversal in sentiment, which hit emerging market equities, as well as bonds and currencies. "It's a difficult market," admits Alexandre Dimitrov, head of CEE equity fund management at Erste Asset Management. "It's not really only about the asset, but also about the pricing of the asset. Even if you see interesting assets, the whole question is about timing. It's not about the asset per se - if we do like the asset, it's more about the timing, when we take a position and how to execute that position."

"The last year was actually timing," Dimitrov says, "and if you ask me about the next six to twelve months, it will also be about timing."

If that's the case, then it was surely a good time to invest in the Balkans and Turkey, but still not so much for the frontier markets of the Caucasus and Central Asia.

This year's winner of the "bne Best Equity Fund 2013" is East Capital Asset Management's "East Capital Balkan Fund" with a return of 19.5% over the period. (The "ELANA High Yield Fund" actually returned slightly more, 20.9%, but it's small size of less than €2m precluded it from being a contender in our ranking.) This East Capital fund mainly invests in shares in companies in Romania, Bulgaria, Croatia, Serbia, Turkey and Slovenia. As market conditions change, the fund manager says it might also invest in other countries in the region such as Bosnia-Herzegovina and Macedonia. The fund's strategy is to enter the market at an early stage, and to buy inexpensive shares in companies in sectors benefiting from long-term development trends, such as EU convergence and growth in domestic consumption and investment.

Within the Southeast European region, Turkey is still, like last year, the investor darling - though clearly the violent ant-government protests earlier this year have taken the shine off that. East Capital cut its exposure to Turkey in its Balkan fund to just over 30% in June. The "HSBC GIF Turkey Equity Fund" returned 17.7% during the survey period, while the "East Capital Turkish Fund" returned 12.7%. "Turkey was really the one market which made us happy in 2012," says Dimitrov. "The political issues did not really surprise us - with every big country you have these problems. What was surprising was the magnitude of the protests."

The Baltics too looked a good place to invest money over the past year, a result perhaps of the markets having been oversold for so long. The "East Capital Baltic Fund" returned 17.7% and the "Citadele Baltic Sea Equity Fund" returned 11.4%. Kristiana Janvare, senior portfolio manager at Citadele Asset Management, puts the success of the "Citadele Baltic Sea Equity Fund" down its flexibility to focus on the markets and segments with the best growth prospects at any given point in time. "Thus, in the surveyed year when investors demonstrated selective risk appetite and Eastern European equity markets overall showed weak performance, the fund managed to achieve a return of 11.4%, thanks to its exposure to the Baltic equities, which outperformed due to the relatively strong economic recovery in the region, and due to its investments in German and Scandinavian equity markets."

However, the frontier markets in the CIS remained unforgiving, with Ukraine a particular concern. The "Citadele Caspian Sea Equity Fund" was down 11.3% and the "Citadele Ukrainian Equity Fund" down 22.2%. The "Sturgeon Central Asia Equities Fund" was down 17.5%, and the "Swedbank Central Asia Equity Fund" down 3.5%.

However, the "East Capital Bering Central Asia", winner of the "bne Best Alternative Fund 2013" with a huge 22.0% return, shows that the tide maybe turning in the region. Clemente Cappello, founder and CEO of Sturgeon Capital, notes that after the exodus from frontier markets during the economic crisis, there are signs now that investor interest is at last returning. "We are starting to see some green shoots," says Cappello. "In the short term Central Asia is under-performing, but I see it as like steering a ship - these things take a lot of time to play out."

In general, the outlook for equity funds is on the up. According to the Thomson Reuters mid-year review of European funds, lying just below the local currency bonds in 8th position was the fund segment "Equities Emerging Markets", which pulled in €7.385bn during the January-June period.

Ivaylo Penev, portfolio manager of the "ELANA Balanced EUR Fund", which is the winner of the "bne Best Balanced Fund 2013" with a return of 18.5%, says after a couple of hard years around the time of the global financial crisis, he started to clear out the portfolio of companies that were too leveraged and to look for safer growth stories or those that were immune to the macroeconomic problems of Europe. "As risk appetite is increasing, it is time to add some beta by rotating out of investments that depleted their potential to second-tier names, which are starting to improve their numbers," Penev says. "This will be the strategy for the next 12-18 months and we hope that if we do our homework, the results will be no less stellar."

Mark Mobius, the emerging markets investment guru at Franklin Templeton Investments, says the recent sell-off in reaction to suggestions of a "tapering" off of US quantitative easing ignores the fact that the reason a reduction is under consideration at all is because the Fed perceives a strengthening of the US economy, which is positive for global emerging markets. In addition, and most important in the long term, "we believe that many Central and Eastern European markets, notably Turkey, retain the potential for strong growth as technological catch-up, urbanisation and demographic effects play out."

"Eastern European markets are not immune to changes in global equity market sentiment, but over the longer term we believe that economic growth could feed into rising corporate profitability," Mobius told investors at the end of June. "Our research suggests that a considerable number of Central and Eastern European stocks trade at valuations that do not reflect their attractive longer-term prospects."

Bricks and mortar

Finally, the performance of our survey's real estate funds would appear to bear out the findings of a July report from Colliers International Eastern Europe, which found that increasing asset allocation to property looks set to continue as investors shift out of equities and bonds in search of lower volatility. This increase in the weight of money relative to a fairly illiquid supply of prime assets, it believes, will harden real estate prices and ultimately shift money into secondary property assets and locations. "With no dramatic changes in rents anticipated on the downside, prime office property continues to look a good bet and warrants the shifts in allocations being reported and realised," Colliers says.

The winner of the "bne Best Real Estate Fund 2013" is Renaissance Real Estate Company's "Renaissance - Nedvizhimost" fund with a huge return of 25.97%, followed not so far behind by its "Renaissance - Business - Nedvizhimost" fund with 19.56%. The "East Capital Baltic Property Fund II" returned 11.23%.

To see full table of funds in the pdf of the survey, go here.

And the winners are....

bne Best Fixed-Income Fund 2013: Raiffeisen Eastern European Bonds

"The good performance of Raiffeisen-Eastern-European-Bonds (July 2012 to June 2013) was mainly due to the exposures in Hungary (smaller exposure but high returns) and Poland (smaller returns but high exposure).

Following the ECB's announcement that it would buy EUR government bonds, the strains in the Eurozone debt crisis eased and risk premia have been priced out of the markets. Disappointing economic dynamics paired with falling rates of inflation and strong risk appetite supported local bonds. Further reinforcement was provided by rate cuts in Poland, Hungary and Turkey. CEE Eurobonds also made a positive contribution to the fund's performance," says Ronald Schneider, Head of Global Emerging Markets and Eastern Europe (Fixed Income) at Raiffeisen Capital Management.

bne Best Balanced Fund 2013: ELANA Balanced EUR Fund

"ELANA Balanced EUR Fund is one of the first funds in Bulgaria, begun in the years of glamour for our local capital markets. Its strategy is to balance income from debt instruments with growth from the riskier half of the portfolio and look for opportunities mainly on domestic ground, as well as throughout Europe. After a couple of hard years around the global financial crisis, we started to clear the portfolio out of too leveraged companies and to look for secular growth stories or solid immune to macro-issues businesses. By the end of 2011, we were positioned to profit from a long expected recovery in our own market, which lagged it's Eastern European peers big time. Eventually the catch-up started, but the market was very selective and quality outperformed. Our portfolio structure was well fit for that and the results followed. As risk appetite is increasing, it is time to add some beta by rotating out of investments that depleted their potential to second-tier names, which are starting to improve their numbers. This will be the strategy for the next 12-18 months and we hope that if we do our homework, the results will be no less stellar:" Ivaylo Penev, portfolio manager of ELANA Balanced EUR Fund and Head of Asset Management, ELANA Fund Management.

bne Best Real Estate Fund 2013: Renaissance - Nedvizhimost

"In 2013 the fund has successfully divested its major real estate asset (a regional retail centre) with a big premium to the latest valuation of the property, despite the limited institutional investors' demand for commercial property outside Moscow and St Petersburg. This has effectively proved our investment approach that is based on in-depth market knowledge, conservative investment strategy, thorough selection of unique investment opportunities and pro-active, value-added asset management. We are honoured to receive a new bne recognition as testament to the dedication, expertise and commitment of the Renaissance Real Estate team that was able to demonstrate superior results throughout the fund's six years entire investment cycle," says Ekaterina Konstantinova, Head of Renaissance Real Estate.

bne Best Equity Fund 2013: East Capital Balkan Fund

"Our long-term view that the Balkan markets offer significant investment opportunities finally started to materialize over the last period. Negative sentiment towards smaller markets due to the slow economic recovery, partially exacerbated by the crisis in Greece, pushed valuations to very low levels, but at the same time there are plenty of companies that were doing well throughout the difficult times. Being on the ground and constantly monitoring the situation, we actually increased our exposure to some of the excessively beaten down markets like Slovenia and Greece after summer last year. We have done this through selective stock picking and that has paid off in very solid returns that outpaced most of emerging market world. At the same time, we were very active in some of our key holdings, pushing for better corporate governance and higher dividends."

bne Best Alternative Fund 2013: East Capital Bering Central Asia

"The good performance result of the Bering Central Asia fund is mainly attributed to a very positive development in the share price of our top holdings - namely, Bank of Georgia, the largest bank in Georgia listed on the LSE, and one of the largest Kazakh telecom operators, KCell, majority owned by TeliaSonera. The fund invested in KCell shares at its IPO in December last year and over the period the stock gained more than 50% in dollar terms. This return was even exceeded by the Bank of Georgia stock, that withstood the external pressures of political tumult in the country and returned 56% to its investors over the same period. In KCell we like the quality of its operational performance, corporate governance standards and one the highest dividend yields in our investment universe, while Bank of Georgia, equally singled out by investor community for the high professionalism of its management team and consistent performance, was discovered by us as early as 2006 and has been the largest holding in the BCA fund since its inception. Sizeable positive contribution came also from Teliani Valley, a Georgian winemaker, Halyk Bank, Kazakhstan's top lender, and Dragon Oil, an oil and gas E&P company located offshore Turkmenistan. The only bet among top five holdings with a negative return, was ENRC, one of the largest London-traded Kazakh mining companies, which is about to be taken private by its founders at a low valuation."

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