Finding the way in
More routes to investing in Europe's emerging markets are opening, with over 50 regional funds and more managers providing segregated accounts, writes Paul Forsyth.
Five years ago, only the bravest investors would have contemplated committing money to eastern Europe. But since the early 1990s investor interest has increased significantly and emerging Europe as a whole now vies with Latin America and South-East Asia as investment professionals construct their global emerging markets exposure.
In the early 1990s only institutional players sought access to the market. There were only a few emerging European regional funds and these were closed-ended. Liquidity was poor both in the underlying markets and in the funds themselves. Commitments had to be long term and typical exposures were modest compared with those to Latin America and South-East Asia.
Gradually more eastern European funds sought to provide access to the opportunities available. Privatisations took place, either directly or through voucher schemes. Today there are around 50 regional funds, most of them open-ended. Not just institutional players now use these vehicles. Interest in the region has extended to a retail level as several of the newer funds haveUCITS status and can be freely marketed in the EU. With emerging Europe forming a larger component of global emerging market benchmarks, particularly since the massive reduction in stockmarket capitalisation in Asia, the region cannot be ignored by investment professionals building a global emerging markets portfolio. These days emerging Europe represents a major part of the recognised global benchmark indices. The weighting in the IFC benchmark is 31.5%; the figure in the MSCI Emerging World Index is very similar. Two years ago both weightings were 22%.
As well as the regional funds, specialised country funds, both closed- and open-ended, have been set up. There are now over 40 publicly accessible country funds for Russia and the CIS countries. Alongside equity products, a number of specialist debt funds have been set up. Five years ago there were only a limited number of global emerging market debt funds. These now exist to cover all emerging regions. Initially, product providers where cautious, preferring to introduce hard currency-denominated debt funds. More recently local currency-denominated funds have been established. In eastern Europe, these are available on a regional basis but also on a country/currency basis.
With a variety of means of entering the market, the institutional manager is faced with two critical issues: which product provider should he use and how should he measure the performance of his selected entry route? First, the investor should be aware that some investment houses have devoted substantial resources to developing their emerging Europe capability. In many cases large teams of researchers and analysts have been put in place in the major financial centres. Several firms have built presences on the ground, arguing that it is crucial to have local intelligence and to understand the local investment culture and stockmarket mechanics. As well as the large houses, a number of boutique managers have been set up. These tend to offer very specialist, niche products, often focused to-wards individual countries or sub-regions. They may also emphasise certain asset classes or types of company. There are also specialists offering the private equity route still favoured by a number of long-term investing institutions.
The plain vanilla" eastern Europe funds take a variety of approaches and the institutional player may not always fully appreciate what he is buying. Some invest in southern as well as eastern Europe, for example. Others exclude Russia. Others again may have a very strong focus on Russia, perhaps to an extent not expected by the investor. From a technical standpoint a number of the funds in the universe will have pre-established benchmarks but, because the industry is young, these benchmarks are still evolving and until recently have been riddled with imperfections - not in terms of the methodology adopted but more in terms of how representative they are of the investment strategies the fund managers wish to pursue (see box below).
Institutional investors often feel uncomfortable with mutual funds. Many feel that being in the same bed as the retail investor is not what they are looking for. The alternative, of course, is the segregated mandate. These have been developed extensively for developed markets and also for Asia and Latin America. The segregated mandate can be structured in a number of ways - in its basic sense simply to ring-fence institutional money. More sophisticated mandates are established where an institution may seek specialist exposure to a market or region.
The most important factor in looking at the development of segregated mandates is the relative size of any commitment to the region and, of course, the importance of the region itself. Several eastern European institutions have set up operations in London of late. They are in the market to win mandates but may finance the development of their operation by broking securities. Many are unfamiliar to the London investment community but may be well known in continental Europe, particularly in centres such as Zurich, Frankfurt, Vienna and Geneva. Because of their unfamiliarity, it may take time before UK-based institutions become comfortable in delegating segregated mandates to them.
The big global players are also actively seeking institutional mandates. Although based in London, such mandates are being won on a global basis as UK investors still fight shy of committing money to eastern Europe. Schroder, for example, is winning mandates with a global brief of which eastern Europe forms part. The strategies followed are not independent of those being used on retail or intermediary funds; frequently, exposure to eastern Europe in a global mandate will be through existing mutual funds. There are exceptions. US clients in particular may demand their own specialist portfolios, the core content of which may be similar to that of the mutual funds in the Schroder stable. Schroder also comments that new emerging Europe portfolios are not necessarily new money but may involve switches of funds from other managers. On the other hand, Barings will run defined mandates for emerging Europe and does so for a variety of clients in the US, continental Europe and Scandinavia and the UK. The typical UK client will be a large pension fund. Around 50% of Barings' segregated mandates for emerging Europe come from the UK and a $40m minimum is required for these segregated ac-counts. In practice, the figure can be lower but the charging structure dictates that the use of mutual funds will then be more beneficial for clients.
These mandates appear to be fairly few in number as yet but the competition is sure to increase. Interestingly, however, none of the potential mandate managers have seen shifts away from the other emerging regions. Asian mandates are not being abandoned in favour of eastern Europe. The way in which the segregated industry is developing suggests that the institutional investor with substantial assets will actually come into the market after the retail investor. This indicates that there is no firm pattern in the behaviour pattern of bigger investors. Some will come in early using the only entry route such as the closed-ended fund but then come in again with more substantial amounts when they have seen markets develop, trends emerge and managers show their true colours and capability in managing portfolios.
Paul Forsyth is managing director of Forsyth Partners in Croydon"