July 2008

EASTERN EUROPE: Potential for Greatness

Following the market correction in CEE, many investors switched out of  funds. However, the region is beginning to recover, says Fiona Rintoul  Nowhere was the impact of the recent correction to the Central and Eastern Europe (CEE) stock markets more keenly felt than in the markets themselves.

“At the beginning of the year, due to the correction, we could observe huge outflows not only from international funds and local equity funds, but from funds overall,” says Andrea McEwan, country head for CCE at Raiffeisen Capital Management (RCM).

In particular, local funds that had developed well last year, for example in Poland and the Balkans, suffered from the corrections at the beginning of this year. In many cases, investors didn’t just switch between funds, they switched out of funds altogether. “In some countries, due to increasing local interest rates, investors switched to local term deposits,” says McEwan. “They also looked to invest in structured products, certificates and guaranteed funds in some areas.”

Poland is an example of a market where investors have been switching out of funds and into bank accounts. Polish banks have been competing for savers with attractive rates because they need liquidity as an indirect consequence of the credit crunch.
“Because of the credit crunch in the developed countries, the banks can't rely on their parent banks to help them,” says Grzegorz Swietlik, a director at Fortis Investments, Poland. “They have to find cash themselves.”

Increased consumption is also taking money away from investment funds – and other savings products. “People are spending more now,” says Swietlik. “It’s one of the main drivers of economic growth. And people are borrowing more money to invest in real estate, but not like in the US. Most people are buying their first place.”

Wipe out
The net result is that the huge growth seen in 2007, particularly in Poland, has been wiped out. Figures from Lipper Feri clearly illustrate this development. At €77.3bn, assets under management in the CEE region were almost exactly the same in April 2008 as they were in April 2007, when they stood at €77.8bn.

So what now for the local fund markets in these countries? Erwin Schoeters, a managing director at KBC Asset Management, which is one of the largest players in the region, says there is now a strong appetite for capital guaranteed products – interestingly with a more international bent than has been seen previously.

In the first instance, CEE investors showed a very strong home bias and a very defensive stance in terms of investor preferences. A large portion of assets under management was in bond and money market funds, with the exception of Poland where there was a high level of equity investment, all in the (at the time) booming local market.

“With the capital guaranteed products, the underlying doesn’t have to be the home market,” says Schoeters. “A lot of themes are being played out. There are Chinese baskets and Asian baskets.”

Schoeters now expects a two-pronged development. First, there will be more savings and money market funds’ share of the market will increase considerably. Then as interest rates converge with the euro rate and come down, there will be further diversification out of the local market.

“There will be more and more international investment and not necessarily through capital guaranteed products,” says Schoeters. “I expect investors to be come more dynamic.”

This expectation is borne out by research conducted by RCM among its client base, which showed that Raiffeisen clients were turning back to stocks. However, they were no longer focusing on the home market, but rather on risky market segments such as emerging markets, alternative energy and raw materials.

“That was the clear picture we got,” says McEwan, “which was­ surprising.”

Of course, the CEE markets do not behave as a bloc and there is considerable variation from market to market. “Poland is a lot more open,” says Paul Carr, head of sales for CEE at East Capital. “You have a much more closed structure in the Czech and Slovak Republics and much more conservative investors.”

East Capital has just started selling its products in the CEE region. The firm made this move partly for philosophical reasons – “the company decided that we should sell products in the markets where we invest,” says Carr – who also identifies an appetite for regional equity.

That’s partly because of the classic evolution in investor behaviour that starts with bank accounts before moving to money market and bond funds, and then domestic equity denominated in local currency, to  regional equity. But there is perhaps also a desire by local investors to support the region by that has historical and cultural roots.

Regional equity
“A lot of asset managers have already moved part of their portfolio into regional equity,” Carr says. “A fund might be called Polish equity, but actually it invests in other parts of the region too. Western European might consider CEE risky, but Eastern Europeans see it as their region.”

These expanding appetites create opportunities for international players. Many of them are in these markets already – almost all the region’s key players are subsidiaries of  international banks – but for those that aren’t, such as East Capital, there are a number of hurdles to overcome.

The first is getting your funds into the market. Although many of the target countries are now in the EU, in practical terms it isn’t always so easy.

KBC approaches each market differently. In the Czech and Slovak Republics it has relied on getting Ucits passported, whereas that has proved more difficult in Hungary, so the firm has launched local funds there.

“We notified a number of Luxembourg bond funds in Hungary without hassle,” says Schoeters, “but when we wanted to register some capital guaranteed funds, they didn't want to accept the passport, although the fund was Ucits III compliant.”

In Poland the problem is different. The regulator accepts Ucits III, but doesn’t accept the concept of a nominee. Thus, if a Luxembourg fund is launched in Poland, the Luxembourg transfer agent has to keep a register of all the Polish names rather than getting one single order from the distributor.

“You can get approval, but then it's tough from an operational point of view,” says Schoeters.

On the plus side, the Polish regulator accepts local feeder vehicles that feed into a Luxembourg fund. There is draft legislation on the table in Poland that should sort out the nominee issue.

“It’s a matter of time,” says Schoeters. “We’ll watch how it continues. The regulators are all gathering at the CESR level. They will get more comfortable with each other over time and more comfortable about the Ucits III quality label.”

But for the time being these are real problems. It was because it’s easier to register funds in the Czech and Slovak Republics that East Capital started there rather than Poland, even though there is probably greater potential in the Polish market.

Once the hurdle of registration is overcome, there remains the hurdle of distribution. The likes of KBC and RCM can distribute through the local banking networks of the groups to which they belong. For firms without that option, things look more complicated.

Open architecture is in its early stages in the region and in some countries barely exists at all. “The large Polish institutions have developed open architecture, but in the Czech Republic you don’t see it,” says Carr.

The greater openness in Poland is partly because of developments in the local market, where niche players are starting to develop. Fortis’s Swietlik points to four niche firms that have set up in Poland – Opera TFI, Investors TFI, Quercus TFI and Caspian Capital.

“You get boutique players now,” says Swietlik. “They worked for big firms for five to ten years and now they are setting up their own company. There are over ten applications with the Polish regulator to set up small shops.”

Other markets are not yet at this stage of development and that means open architecture is less developed. “In the Czech market, there are local players connected to local financial groups,” says Swietlik. “If distribution is closed it’s easier for them. In Hungary it’s different again because OTP has dominated the market.”

There’s another issue too, says McEwan, which is that investors in the CEE countries prefer big names. “Either the distributor must have a big name or the asset manager must have a big name,” she says.

In many ways, it’s all a matter of time. For example, East Capital’s Carr considers that it’s not so much the case that Czech investors are conservative by nature as that the banks think they are conservative and therefore offer them conservative products. The more new blood comes into the market, the more likely this is to change.

His own firm is helping to break the hegemony on the distribution side. The two Luxembourg funds that East Capital has registered in the Czech and Slovak Republics will be sold by the Czech National Bank and the Slovak National Bank. East Capital was recently invited to make a presentation to the Czech National Bank's investment specialists.

“It’s the first time one of the big four Czech banks has done this,” says Carr.

Even if investors in the CEE markets have been burnt by the recent correction, things are changing in the region and it holds enormous potential for foreign asset managers. “It’s a questions of timing,” says McEwan. “All of these markets are on a path to convergence. Some of them will get there sooner, some later.” ©  funds europe 2008

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