Assets under management are experiencing massive growth in central and eastern Europe as the local economies converge with ‘old' Europe. The regional mutual fund industry is still small by global standards. The Czech Republic, Hungary, Poland and Slovakia (or the Visegrad four) accounted for a combined 0.2% of the €7.6trn net assets at the end of 2006, according to European Fund & Asset Management Association (EFAMA) figures, with the largest, Poland, still trailing Greece, the smallest fund market in western Europe.

The fundamental factor driving asset growth across the region is economic growth, generating rising employment, wages and disposable income. Nowhere is this more evident than in Estonia. Last year Estonian real GDP grew by 11.4%, unemployment fell to a 12-year low of 5.9%, while average wages soared 16% on the year.

The fund market totalled EEK30.7bn (€2bn) in net assets at the end of March, of which investment funds accounted for €1.4bn, second pillar funds €543m and third pillar funds the remainder. "There has been an explosion of domestic investment funds in Estonia," says Robert Kitt, fund manager of Hansa Pension Funds in Tallinn. Hansa's 17 investment funds grew by 66% year-on-year to more than €1bn in assets under management. The company - majority owned by Sweden's Swedbank - is also a major player in the Latvian and Lithuanian pensions and investment sectors, and for the last 18 months has also distributed its mutual funds in Finland, where it now has more clients than in Estonia.

"There have been structural changes in Estonia because people are saving more," says Kitt."The local press is also very supportive and encouraging local savings. We are seeing similar developments in Latvia and Lithuania, although Estonia is some way ahead, despite having the smallest population, with around twice the assets of the other two combined."

Equity products, for both investment funds and equity-weighted pension funds, predominate - equity products account for more than 75% of mutual funds - with the investment bias strongest in eastern Europe and Russia. According to Kitt, these have generated twice the return of western European equity funds. "Although there is no obvious trigger for a reversal of this trend, the problem is that central European equities are becoming expensive. Russian small cap stocks are trading at par and eastern Europe at a premium to western Europe and the US."

New Estonian legislation that came into effect in January allowed for the creation of venture capital and real estate funds - previously only property or land qualified as real estate investment - although none has been registered as yet. There is an outstanding issue hindering investment by pension funds into private equity as they cannot invest into partnerships.

In the Polish mutual fund sector, a drive into domestic equities currently appears unstoppable. Net mutual fund assets totalled PLN122.9bn (€32.5bn) at the end of April, a 59% rise year-on-year in Polish currency terms. Of these, mixed funds with a Polish equity portion of anything up to 100% accounted for 28%, 100% Polish equity funds 23%, and balanced funds with up to 50% Polish equity 22%. By contrast overseas equity funds accounted for less than 3%.

The Polish bull market that began in 2003 started the flow into equity-related funds, which in turn has supported growth on the Warsaw Stock Exchange. "The economic climate remains very good," says Zbigniew Jagiello, CEO at Pioneer Pekao Investment Fund Company in Warsaw. "Enterprises produced good financial results in 2006 and the first quarter of 2007, well above expectations."

In addition to a strengthening economy, which has generated disposable income for fund investment, money is also flowing out of bank deposits into these products. Jagiello foresees the potential for a further PLN50bn moving out of the PLN200bn of money now on deposit.

Given the high returns - small to mid cap Polish equity funds produced a 12-month return of 70-80% as of this May, compared with 4-5% for bonds - investors continue to pile in.

Jagiello remains optimistic about 2007-08 but expresses concern about the tendency to forget about inherent risks. "If people start redeeming units, we have to sell equities, and the market is not liquid enough, especially for small and mid cap stocks. This is the nightmare scenario for portfolio managers."


The equity boom also concerns the Polish second pillar, the region's largest pool of assets under management. At the end of March they totalled PLN127.3bn, up 34% on the year. Polish second pillar funds have little choice but to invest locally - the overseas limit is 5% - and equity portfolio allocations averaged 37%, uncomfortably close to the 40% legal equity limit.

Michal Szymanski, chief investment officer and member of the management board of Commercial Union Pension Fund, part of the Aviva Group, does not foresee any relaxation of the limits in the near future. The current regulatory priority is to set up a legal basis for annuities by 2009, when the first second pillar pensions payments are due.

"Some of these limits are a constraint on prudent investment," he says. However, he is optimistic about the new pan-financial Polish regulator set up last year, the Polish Financial Supervision Authority (KNF), and its interest in developing the Polish capital markets.

One topic under discussion is securities lending. "The situation for pension funds is unclear, so the legal risk is high," Szymanski says. "Securities lending would provide extra income for pension funds and an additional source of liquidity for the capital market." Szymanski also looks forward to further development of the corporate bond market, which would provide pension funds with an alternative to equities. "GDP growth provides opportunities for enterprises which require capital," he says. "The banking sector's liquidity is decreasing, which provides opportunities for corporate bonds. We are observing increasing issuing activity, but there is currently a lack of advisers and a secondary market."

Jagiello also sees the KNF as a supportive body. A new investment act, expected to be implemented by next year, promises to make the Polish mutual fund industry more competitive with Luxembourg-domiciled funds.

Other legal changes in the offing include transferring some fund information from the fund's bye-law to its prospectus, making changes more easy to adopt; reducing the time for KNF approval for new funds to one month from two; providing the ability to differentiate unit types within umbrella sub-funds; reducing the time to transform funds into umbrella sub-funds; and the possibility of transferring individual items of real estate into closed-end real estate funds.

Asset growth in the Polish pensions industry faces a more profound challenge. Since EU accession in 2004, the country has experienced the region's highest level of emigration; estimates vary between 1m and 2m people. According to Szymanski, Poland's client base is relatively young and emigration flows may well change the client structure in five to 10 years.

Slovakia's second pillar system, which started operating in 2005, has grown impressively, with net assets of SKK36.2bn (€1.1bn) in early May, a 147% year-on-year increase in Slovak currency terms. Following some legal changes at the start of 2007, the asset management fee was cut to 6.5bps from 7bps, and agency commission fees were regulated.

The commission regulation has reduced expenses for asset management companies, notes Richard Kolarik, vice-president of Allianz-Slovenska dss, the largest of the country's six funds. In addition, fund switching, which members could do every six months, has been restricted to every two years, stabilising the assets of individual funds.

In Slovakia, as in Estonia and shortly in Hungary, fund managers have to offer three types of fund - conservative, balanced and dynamic - to match risk profiles, with most clients opting for the equity-weighted dynamic funds. Slovak legislation regarding overseas investment, with a 70% ceiling, looks generous compared with Poland's 5%, but is still restrictive in the Slovak context. "There is a lack of shares and corporate bonds, so we have to keep the assets in bank deposits and government bonds, except that the government isn't issuing any," complains Kolarik.

Kolarik would also like to see pension funds be able to hedge their interest rate and price risk - currently they can do so only for currency exposure.

The government's plans for reducing the social security fund's deficit pose the biggest worry. There has been discussion about reducing the portion of social security tax funding the second pillar to 6 percentage points from 9, which Kolarik believes unlikely.

A more likely option is that the government will reduce the element of compulsion - the system is currently mandatory for new entrants to the labour market - and provide an opt-out for those members aged over 50 who have already joined the second pillar.


fter an indifferent performance in 2006, this year looks more promising for the Slovak investment fund industry. Net inflows into Slovak mutual funds in 2006 totalled only SKK3.5bn, compared with SKK47.5bn a year earlier."Last year was not very successful," says Martin Duriancik, board member at Tatra Asset Management (TAM) in Bratislava. "Because of rising interest rates, conservative investors were not happy with the performance of bond and money market funds, and there was a huge outflow into term deposits and structured products. But it's a different story in 2007."

During the first quarter of 2007 the net asset value of Slovak funds rose 5% to SKK137bn. Money market funds, which account for some 40% of the market, have revived in popularity, but the biggest growth has been in structured products such as capital protected funds, with record inflows since they launched.

In addition to performance, the appreciation of the Slovak crown has been an important driver. "Because of Slovakia's strong economic growth, there has been an inflow of foreign capital into the real and speculative economy," notes Duriancik. Equity funds are also gaining appeal in a generally risk-averse market, although in Slovakia's case, with its moribund domestic exchange, these are based on global markets.

Following legal clarification in May, real estate funds could start a new trend. Currently there are only three, with a total asset value of SKK1bn, although Duriancik thinks that their success will depend on how successful the funds are in acquiring the property itself. Slovak property price rises have been high even by regional standards because of the lack of other investment opportunities. Despite the foreign ownership of Slovakia's major financial institutions, foreign-domiciled funds account for a small percentage of the market, in contrast, for example, to the Czech Republic. According to Duriancik, less than 1% of TAM's mutual fund sales are originated by its parent group, Raiffeisen.

However, foreign-domiciled funds did gain one legislative advantage at the start of this year when the government levied withholding tax on domestic funds. But the biggest impact for foreign fund distribution will come when Slovakia adopts the euro.

The target date is 2009, and if Slovakia meets the criteria it will become the second CEE state of the 2004 EU intake to join the Euro-zone. "There will be very strong competition from foreign products and a clear consolidation of asset managers," predicts Duriancik. "They will have to get their costs right otherwise they will have no chance of survival."

In Hungary, unlike many of the other countries in the region, wages are not currently rising because of a tight austerity package in place to slash fiscal and current account deficits. Nevertheless, money is flowing steadily into mutual funds.

Assets of publicly offered open-ended Hungarian funds grew by 20% in the year to March to €6.8bn, according to data from the Association of Investment Fund and Asset Management Companies in Hungary (Bamosz), and those of other funds rose 75% to €3.8bn. Investors have generally piled out of bond funds and into funds of funds structures, which more than doubled in size and now account for nearly a quarter of the market.

According to Peter Heim, regional investment director at Aegon in Budapest, this is being structurally driven as a result of investors moving out of bank deposits. "Wages will pick up again in 2009-10 after the next election, when Hungary relaxes its macroeconomic policy."

For Hungary the biggest preoccupation in the mandatory pensions industry is the disaggregation of the funds into conservative, balanced and equity-weighted offerings. The idea is that only members with a few years left until retirement should opt for the bond-based conservative products. This will mark a sea-change for the industry, which although sizeable, has focused largely on bonds.

Of the HUF1,494bn (€5.9bn) of mandatory pension assets at the end of 2006, 70% were debt securities and less than 10% equities.

With the new fund range due by 2009, asset managers have been building up their equity portfolios. Heim notes that the current equity portion has risen to around 25%, and will be around 35-40% by 2009, of which two thirds will be domestic.

The move towards more sophisticated asset management will test the local industry. "Assets could grow by 25-30% over the next five years, but the big problem is the lack of a skilled labour force," Heim says. "Human resources is our most critical issue."