Clare Nuttall in Astana -

With Central Asia under-performing other frontier markets and several asset management groups shutting up shop, it's becoming increasingly hard to make a case for staying in the region. But Sturgeon Capital, which launched a regional equities fund in October, expects to see its commitment pay off over the longer term.

The investment firm launched the Sturgeon Central Asia Equities Fund, the first Central Asia and Caucasus-focused UCITS hedge fund, on the back on demand for an equity-only strategy. Sturgeon's original fund is split between listed equities and fixed income, while the new fund invests into companies listed internationally that have substantial assets or operations in the region.

Despite outperforming its benchmark since the launch, the "Sturgeon Central Asia Equities Fund" has lost money, as valuations in the region have continued to lag behind other frontier markets. However, Sturgeon's founder and CEO Clemente Cappello says that the firm is confident about the longer-term prospects: "We are not doing this with a short-term horizon. The story will play out in two or three or five years' time. Markets tend to be efficient in the medium term, and we expect Central Asia to re-couple with global markets."

Globally, there are signs that investors are returning to frontier markets after the exodus at the start of the financial crisis back in 2008. "Encouraged by central banks, we expect the search for yield to start again. People are scared, but they can't afford not to invest into frontier markets for much longer. Pensions funds and insurance companies need returns," says Sturgeon associate Paul Henderson.

Cappello points out that investors are heading to Asian countries such as Mongolia and Myanmar, there are large inflows to Africa, and generally positive sentiment about Latin America - although the stories coming out of Central Asia and the Caucasus tend to be more negative and the region has not yet seen a similar inflow of capital. This is reflected by the performance of regional indices such as Renaissance Capital's Rencasia, which are substantially under-performing other global emerging market indices. Equities valuations in the region are among the cheapest globally, a discount that Cappello says is not justified.

The low valuations continue despite the region as a whole enjoying sustained GDP growth in recent years, and a good performance from a number of companies with large market capitalisations on exchanges including London, Hong Kong and Toronto. "The companies have delivered, but the investors have not," Henderson tells bne.

Sturgeon believes that there remains a solid case for investing in the resource-rich and relatively low-cost region. Its proximity to three of the four BRICs - China, India and Russia - is a huge advantage, as is the high level of education and relatively good infrastructure. Both Cappello and Henderson also reference the region's Silk Road history, which left a legacy of a trading mentality that has persisted to this day. "People give up, but we are in this market for the longer term. I think the region is at a turning point in terms of local companies and local capital markets," says Henderson. "If you believe in emerging assets, you have to believe in Central Asia. The region provides the raw materials for most of the goods that are produced in Asia and exported to the world."

Sore points

Risks for investors include rising resource nationalism in countries from Kyrgyzstan to Mongolia, and a range of political risks. "Central Asia is heavily biased towards natural resources, which is a highly politicised sector. Probably the biggest issue for us is political risk in the wider sense - the risk of the rules of the games being changed - and corporate governance issues. These are the same across the globe," says Cappello.

There are also wide variations in the maturity and ease of access in countries across the region, with Kazakhstan, Central Asia's largest economy, the destination for over 40% of Sturgeon's investments. Not only does Kazakhstan have substantial natural resources, it also has more companies listed internationally than its neighbours, and, unlike for example Mongolia, it has been through a boom-and-bust cycle, leaving the market more mature.

Kazakhstan also has the region's most developed stock market, although the Kazakhstan Stock Exchange (KASE) lacks liquidity and issues such as the use of T+0 settlement need to be resolved. It is not yet clear what the impact of the consolidation of Kazakhstan's 11 pension funds into a single state-controlled fund will be, but it is likely to be negative for the exchange to some extent.

Elsewhere in the region, Sturgeon is eyeing the high potential but less accessible markets of Turkmenistan and Uzbekistan; the latter has a vibrant stock exchange though investment is hampered by issues relating to the rule of law and currency convertibility. Countries such as Azerbaijan and Georgia have also made efforts to develop their stock exchanges and encourage investment, giving hope for investors that there will be more opportunities in future.