Wages and economic growth fuel advances in the Baltic asset management industry, Krystyna Krzyzak reports

Fund assets in the Baltic states have shown some of the fastest growth in the region.

The net assets of Latvia's second pillar funds had grown by 77% year-on-year to LVL180m (€256m) by mid-2007, according to Latvia's Financial and Capital Market Commission. In Estonia assets were up 54% to EEK10.2bn (€654m) on the year to end-September, according to Estonia's Financial Supervision Authority and over the same period, Lithuania's pension assets grew by 88% to LTL1.5bn (€427m), according to Lithuania's Securities Commission. Over the reporting period the Latvian system had around 542,000 participants (58% of the working population), Lithuania's 880,000 (55%) and Estonia's 545,000 (79%).

Estonia's higher accumulation, despite having the smallest number of participants, is due to its higher contribution rate. While employees pay only 2% of their gross salary in contributions, the state adds another 4%. In Lithuania the contribution portion has risen incrementally, to 5.5% in 2007. In Latvia the contribution doubled to 4% in 2007. "So you had a significant increase in assets, despite the fact that the overall number of members went up by 10%," says Sergey Medvedevs, president of Parex Investment Company in Riga.

The systems in Estonia and Latvia have, since their inception, been compulsory for new entrants to the labour market, which has provided a steady supply of new premiums. The first outflows in terms of retiree payments will start in Estonia in 2009 and in Latvia in 2013. In contrast, Lithuania's system is wholly voluntary.

The success of the system in each country is also partly due to the good returns on many portfolios. "The timing of the [Estonian] reform, in 2002, was also successful because that is when the bull markets started," notes Vahur Madisson, fund manager at SEB Uhispanga Fondid.

Dramatic wage growth has also contributed to higher assets. In Latvia the average monthly gross wage shot up by 90% between 2001 and 2006 to €430, and to €575 by the third quarter of 2007. Lithuania's wages over the same period were up by 52% to €433 and to €565 in 2007, while Estonia's rose by 71% to €352 in 2006 and to €687 by late 2007. At the same time unemployment has fallen to record post-independence lows, while employment is rising as economic growth creates new jobs.

However, these countries have small - and declining - populations. Between the start of 2004 and 2007, Latvia's fell by 1.6% to 2.281m, Lithuania's by 1.8% to 3.385m and Estonia's by 0.6% to 1.342m. Emigration following EU accession in May 2004 has added further pressures. "In areas such as construction, Latvian workers are getting the same level of salaries as in Germany or Ireland, which gives them less reason to leave," says Medvedevs. "Some Latvian emigrants are returning because of the lower cost of living."

As economic migrants do not register when leaving, there are no reliable statistics. However, Estonia appears to have suffered the smallest exodus, while according to some estimates around 10% of the Lithuanian population has left to work in the richer EU countries, the highest rate among the eight east European states that joined in 2004. An additional factor is that Estonia and Latvia, having seen their ethnic population cut by deportations and inward migration from other parts of the Soviet Union after World War II, are reluctant to import cheaper labour from the east.

The negative aspects of high wage growth include their contribution to inflation, which has scuppered the Baltic countries chances of adopting the euro in this decade, and eroded productivity.

The primary debate engaging Baltic analysts is whether the Baltic economies will have a hard or soft landing. Latvia, with the highest inflation in the EU and a current-account deficit that averaged 25% of GDP in the first half of 2007, is most at risk, and suffered devaluation speculation last year.

The contagion spread to Estonia, which experienced a devaluation rumour in November despite lower inflation and current-account deficit. This has inevitably affected the pension funds' investment strategies. "Devaluation [rumours] have pushed up interest rates, so we have used this chance to come back to local [Baltic] corporate and government bonds," says Fabio Filipozzi, fund manager at Hansa Investment Funds in Tallinn.

In terms of fund management, players Fhave been some notable changes. In Lithuania Finasta has incorporated the funds previously run by Medicinos Bankas Investment Management, and is set to do the same with those run by the local pensions operation of Polish insurer PZU. This has meant the number of its second pillar pension clients will increase 3.5-fold to 37,000. The Lithuanian Securities Commission has issued an operating licence to Iceland's MP Pensions Funds Baltic to run three second-pillar funds.

One of the significant developments in Latvia was the termination of the state treasury as mandatory pension fund asset manager at the start of October. The outstanding 80,000 members - with total assets of LVL11.5m - that had not choosen their own alternative were distributed among the eight asset managers with more than two year's experience of managing second-pillar assets.

A forthcoming change, effective from the start of 2008, increases the maximum equity component of dynamic funds from 30% to 50%. Those funds will also be able to invest up to 5% in riskier assets such as private equity.

In terms of asset allocation, Latvia's high inflation - the highest in the EU and predicted to reach 15% this spring - has
caused a shift from low yielding Treasury bonds into term deposits, reports Medvedevs. These were yielding more than 10% as of December 2007. In addition, state treasury issuance has been low and the market remains illiquid.

Increasing wages and disposable income have also spurred the investment fund business. Latvia's inflation presents a conundrum for investors. There has been an inevitable shift to short-term bank deposits that offer 10% per year in local currency, yet last year's devaluation rumours made investors wary of the lat. Medvedevs predicts growing interest in euro-denominated investment funds, with a shift to bond funds as clients became more risk averse in the second half of 2007.

Lithuania's investment fund market reached LTL1.3bn as of September 2007, of which equity funds accounted for two-thirds. According to Saulius Racevicius, CEO at Sindicatum Capital International and president of the Lithuanian Association of Investment Companies, the shift to equities started in 2006 as equity funds started producing high returns. However, what Racevicius describes as "the driving factors of greed and fear" have more recently made investors more appreciative of market risks and volatility. "There has been a shift from risky emerging markets into more globally diversified portfolios," he notes. "The market is still very inexperienced. People are not familiar with the realities of equity markets and should be more moderate with their expectations."

More sophisticated Lithuanian investors will have more options in 2008. Legal amendments that come into effect in March allow for the creation of specific investment vehicles. "This is very important for the investment fund industry," adds Racevicius. "It will now be possible to offer real estate, venture capital hedge and closed-end funds."

On the equity front, the poor performance of Baltic stock markets, which fell some 20% in the first 11 months of 2007, propelled a shift into other equity markets. "One of the reasons for our pensions' high returns was that a large portion of our assets was invested in the securities of fast-growing companies in the CEE region," says Andrius Barstys, CEO at Finasta Investment Management. While the majority of participants and assets have opted for balanced funds, followed by conservative fixed-income, Barstys says that in Finasta's case the most popular is its 100% equity product. "The returns have been exceptionally high," he explains. "Also, the average age of our participants is much lower than the Lithuanian average. They realise that their investment period is very long, so they tend to accept the high risk. They also tend to be some two-and-a half times wealthier in terms of salaries."

Paradoxically, Lithuania's bond pension fund managers are facing a government proposal for lowering fees because of their lower returns.

The macroeconomic imbalances have also provided opportunities for new product development. According to Filipozzi, Hansa launched a private debt fund in mid-2007, aimed at institutional clients such as pension funds, invested in the corporate debt of Baltic companies.

This year is set to be challenging for the Baltic asset management industry. In Estonia, pension funds are set to increase exposure to real estate as a result of changes in legislation. "We want to raise our exposure in real estate," says Filipozzi. "On the local market property prices have risen over the last three years, so we will be looking abroad." Overseas Hansa intends to invest via funds, while locally it will do so directly. "One of our challenges in the next two years is to build up competence in this area," Filipozzi adds.

Madisson confirms the growing interest in real estate investment. "We have had a slowdown in the residential market, but most of our exposure is in balanced and mature properties with good cash flows."