Rachel Oliver finds investors' interest increasing

Pension fund money appears to be dribbling rather than flowing into the markets of Central and Eastern Europe. A lack of substantial track records coupled with the questionable expertise offered by some of the investment managers in the area is compounded by the inherent distrust of the region grounded in most pension fund managers.

Even for those who feel slightly more confident with the political climates in Russia and the Czech Republic in particular, only a small fraction of Europe's pension fund money is available for allocation to this region. So most of the money now being ploughed into Central and Eastern Europe derives from insurance companies and banks. Pension funds are dipping their toes in the water, investing, more often than not, a maximum of 0.5-1% of their total portfolio.

By comparison, continental insurance and bank investment is booming. According to most fund managers operating in the region, the vast amount of their business comes from this sector, with pension interest remaining minimal. Active countries in particular include Switzerland, Germany, the Netherlands and Scandinavia with a surprising interest from Spanish institutions in the Invesco East Europe Development Fund. This of course contradicts a common-ly held view in the marketplace: that cultural affinity plays a predominant part in emerging market asset allocation. The assumption is that Spain will automatically overlook Central and Eastern Europe to favour Latin America as the main investment choice.

So if a traditionally conservative state such as Spain can venture east, are European pension funds likely to take a bigger slice of the market as well? Perhaps not just yet. The 1996 survey of UK pension funds, carried out by the WM Company, found that out of the £400bn ($655bn) assets monitored, only £150m was invested in European emerging markets and those were dominated by investments in Portugal, Turkey and Greece. And in light of the fact that the average UK pension equity allocation is around 70-80% of the portfolio, it is not likely that their continental counterparts will be contributing much more.

Pension funds across Europe are certainly not battering down their investment managers' doors with demands to invest vast sums in Bulgarian eq-uity, but there are rumblings that a pick-up in investment may not be so far in the future. Many pension funds are simply sitting back and watching the situation for a while, waiting for that opportune moment to either expand their portfolios or make a first investment once the initial furore has passed.

Nick Pettinatti, managing director of Shell Pension Fund's investment arm, Shell Pensions Management Services (see box) is certain other funds are including the region in their asset allocation decisions: There's no doubt in my mind that other funds are broadening the base of their emerging markets portfolio," he says. "Central and Eastern Europe fits in nicely, driven I think because you are looking for high growth and also the stimulus of their association with Western Europe, the EU as prospective member candidates and much enhanced if NATO agrees to them becoming members of the NATO alliance."

Shell chose the direct investment route, partly due to distrust of what fund managers actually do with the cash. The overriding impression formed by the fund was that most of the time they simply sat on it. But Shell, as the 10th largest pension fund in the UK with £8bn under management, is in a privileged position. Most pension funds throughout Europe will have to take the funds route because of a lack of in-house resources and expertise. Indeed, one consultant even doubted if the largest of pension funds would be able to compete with the creme de la creme of the investment management world: "It's certainly one of the options you have," says Robin Amacker from Frank Russell in Zurich, "But you have to realise that it may be an expensive way to handle it, because if you want to compete in terms of skills with the very best investment houses who have economies of scale, then it's a challenge."

One pension fund, because of its total size of under £550m under management, invests a very small proportion in Central and Eastern Europe through two emerging markets funds run by Newton and PDFM. And according to David Sheppard, head of Benelux region for Flemings in Luxembourg, a Belgian pension fund is actively considering investing via a pooled route, which Sheppard points out is often the only real option for medium-sized pension funds. "You would find that very few investment managers want to take on anything less than $15m on a dedicated basis."

Steve Cohen, head of international funds at Mercury Asset Management, whose ST Eastern Europe Fund was ranked highest by Micropal in performance over a year, agrees with this limited choice facing pension funds but puts it down more to the knowledge available rather than asset allocation issues. "An institution of whatever kind who wanted to have a segregated portfolio for Eastern Europe would need to be willing to commit a significant amount of money before a manager is willing to say they will offer a segregated outside the pooled fund," says Cohen. "It's just because it is still an area where resources are constrained and particularly the number of people who have demonstrable track records."

He adds: "The number of people out there who have a proper Eastern European investment capability is not that big and a lot of the managers would tend to be saying 'there is a limit to the amount of segregated portfolios we can take'."

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However, a segregated mandate is often more favourable to an investor who wants to maintain an active role in asset allocation and management conditions, whilst in a pooled fund, they will have to renounce an element of control. But with the actual proportion being invested in the region, pension funds really do not seem to be perturbed enough to warrant beauty parades. More often than not, those taking the fund route will incorporate the region in a global equity fund or emerging markets fund, hand-in-hand with the likes of Latin America.

"There is an extent to which pension_funds have got balanced managers already with a wide investment brief, and those managers may have already put some money into Central and Eastern Europe," says Cohen, adding: "If they already have some kind of global emerging markets allocation in their portfolio, then they will already have invested in Central and Eastern Europe. Pension funds are really looking at this as part of the global emerging markets asset class."

The Glaxo Wellcome pension fund appears to have followed this pattern. All its investments are made through external managers, who are given briefs covering Europe and all investment decisions are made at their discretion. Whether they invest in the Czech Republic as opposed to Germany is neither here nor there for the trustees, as long as the investments are safe and they keep within the terms of the mandate.

But a direct investment route seems to be a real alternative for the larger pension funds who are not entirely confident of the knowledge of the market currently held by most fund managers and is not an option to be dismissed lightly by fund managers.

The RTZ Pension Fund is not of an equal size to Shell and is also not against the idea of pursuing the direct investment route, though not just yet. "It may come - I think we're not against it in principle," says Steven Burley, investment manager. "I think it will probably be Central Europe, Hungary that we might make a direct investment and that will be managed as part of our European portfolio. Our preference at the moment is certainly to do it through funds because of all the problems that there are, particularly in Russia obviously of registration and custody." RTZ currently invests in the region through pooled funds, though the total amount is "less than 1%" which is not unusual and within that, the risk is suitably spread. "We've got an emerging market unit trust but we also have an emerging market investment trust so it would be spread around a bit."

An area wherea specialist fund might be necessary would be single country investment, though this does not appear to be of huge interest for pension funds, which might acknowledge the appeal of the likes of Russia, and the up and coming Romania, but are still cautious of ploughing a dedicated sum into the regions.

Pettinati admits the performance in Russia has been "spectacular", but maintains that single country funds would be the domain of the smaller pension fund and only as a temporary stop-gap: "I think you need to understand the risks that you are engaged in and the due diligence process is important. It would also explain why smaller funds really cannot resource that effort, so the quicker route is via funds and you pay the management fee that goes with that. But it is quite a burden to carry in total performance with 1.5% you've given away. Once you've been through that learning process and are regularly following events you might as well do it yourself and be fairly selective in the stocks you pick."

The consensus seems to be that most pension fund investment is emanating from the UK, with stirrings in Belgium, Germany and the Netherlands. Notably, most of the institutional client base of ABN-Amro's AAF Eastern European Equity Fund is Dutch pension funds, but again this route appears to be a temporary one while they gain sufficient knowledge of the market.

"I think that many of them have bought the fund because they liked the former communist story and the turnaround potential it has for the medium term," says Henk Feaandrager, portfolio manager at ABN-Amro in Amsterdam, but adds that he thinks they have bought the fund to get an initial exposure and "use that as a stepping stone for maybe eventual direct investment in the region".

Credit Suisse is "in a couple of finals" for segregated accounts for continental pension funds, which points to an awareness of the region. But simple awareness is obviously not enough. "In so far as they exist, they tend to be more conservative and mistakingly may perceive this kind of emerging market as too risky for them," says Glenn Wellman, European fund manager at Credit Suisse.

While it is difficult to say exactly how much European pensions interest there is in Central and Eastern Europe, there is a definite flow into the region which looks set to increase over the 12-18 months. With previous emerging markets such as Asia having "arrived", there will be a gap in the emerging market asset allocation of pension funds with Central and Eastern Europe looking like a prime candidate to fill it. The initial beneficiary of the decrease in Asian weightings will be Latin America, according to Wellman, but Eastern Europe will not be far behind. Pension funds might not be sitting on the sidelines for much longer.