Eastern Europe: Hedge Funds’ New Playground?

A look at hedge fund activity in Eastern Europe

Dan Axmer, Asset Alliance
Originally published in the May 2006 issue

Investor interest has increased in Eastern Europe over the last couple years. In Russia, interest started to pick-up after the YUKOS affair, and then accelerated because of the recent surge in commodity prices. Elsewhere, much of the interest started with the accession, and subsequent entry into the European Union (EU) in 2004, of Poland, Czech Republic, Hungary, Slovakia, Estonia, Lithuania, Latvia, and Slovenia. These countries are now looking to continue the convergence process with the final objective of adopting the Euro. Currently, there are another five Eastern European candidate countries negotiating with the EU about entry: Bulgaria, Croatia, Macedonia, Romania and Turkey are all at different stages of this process.

Interest from hedge funds has also increased. The markets in Eastern Europe tend to be less efficient than developed markets, which create opportunities for active managers willing to exploit these inefficiencies. As the regional markets have grown and liquidity has increased, absolute return strategies have become easier to implement. The current aggregate market capitalization of the regional equity markets is roughly $1 trillion, of which Russia makes up around 60%.

So what are the attractions of Eastern Europe that have drawn international and domestic investors alike to increase their investments in the region? And what are the developments in the Eastern Europe hedge fund universe and the principal strategies that are utilized by the managers?

Eastern Europe investment case

One of the most compelling reasons for investing in Eastern Europe is to benefit from economic growth arising from the transformation from planned to market-based economies. Significant improvements in productivity, industrial production, labour policies, and access to new markets have driven corporate earnings to a growth rate which substantially exceeds those of companies in Western Europe. As a consequence, the population has seen an increase in disposable income, which in turn has led to increases in domestic consumption and spending.

Convergence is driving performance in Eastern Europe. The possibility of EU-membership has transformed those states seeking membership to converge to European standards. Fiscal and monetary policies in these countries are being reformed in the line of developed Europe policies. The resulting falling interest rates and lower inflation has created economic stability in most countries, leading to higher consumer and corporate confidence, credit growth and a decrease in the cost of capital.

In tandem with EU convergence, capital markets are changing in the region. Investor interest, international listing requirements, M&A and takeover activities, are all creating an increasing demand for transparency and reporting standards. Improvements in corporate governance and decreasing political interference in the financial market have contributed to decreases in equity risk premiums. The result is that the capital markets are becoming more liquid.

The dramatic rise in commodity prices has also transformed the investment universe in the region. It is not only increased investor interest in Russia, but also in smaller countries like Kazakhstan. Russia is one of the world's largest oil and gas producers with 11% of oil production and 23% of gas production. Clearly, the current high prices benefit these economies.


Current hedge fund universe

There are 60-70 absolute return funds dedicated to Eastern Europe. The universe is quite young since many of the equity markets were only established over the last decade or so. The first funds were launched in the 1990s and were predominately focused on Russia. The 1998 crash scared many investors away from Russia and only recently have they begun to invest in the region again. Russia and Turkey are the largest and most liquid markets in the region and tend to be the most popular to trade. Most funds have a broad mandate and can invest across all countries in the region and sometimes in the Middle East and Africa as well. Country specific funds dedicated to countries other than Russia are starting to appear. Reflecting the opportunity set, equity strategies are by far the most popular. Funds tend to have a bias towards natural resources and banking stocks, which are the largest sectors in the region.

The hedge fund market has grown exponentially in the last couple of years and the diversity of the managers in terms of strategy and styles has increased with it. The last two years have seen 8-12 launches a year with the larger fund management institutions launching funds in the last year or so. This year has already seen a couple of new launches with others planned for later this year.

Hedge fund strategies pursued in Eastern Europe

There are currently four broad strategies that funds pursue in Eastern Europe; equity long/ short, event driven, fixed income/currency and multi-strategy. The long/short equity strategy is fairly new to the market and the catalyst has been the increase in ability to borrow equities. Since the local equities markets are quite young, both the legal framework and local parties have not been used to shorting. The prime brokerage arms of international investment banks have played an importantrole in the development of a functioning market. Having seen the demand from hedge funds, many of them have built-up knowledge and inventory in the region. However, the market is still far from being as efficient as developed markets. Usually, borrowing is only readily available in the largest company's stocks. There are ways to gain exposure to the region without investing in the local markets, large ADR/GDR programs are already in existence where there is ample liquidity to go both long and short. In the pursuit of capital, many Eastern European companies have decided to raise money abroad, often listing in London and/or New York. Most of the Eastern European stock exchanges have also launched domestic derivative markets during the last couple of years though the number of contracts and liquidity tends to be limited. Many prime brokers provide a range of derivatives OTC.

The long/short strategy is similar to that employed in developed markets, but is more concentrated to large cap stocks. One of the most popular trades to hold long has been Gazprom, which has been perceived as cheap by many managers, and the subsequent re-rating that has taken place the last couple of months has proved them right. On the short-side, some hedge funds made money on shorting YUKOS in 2004 when the Russian government charged the company for tax evasion. YUKOS, being a large stock at the time, was readily available to borrow, enabling hedge funds to get short. Many funds also use relative valuations within the region to decide which stocks to long and short, especially in the banking sector. Spread trades of stock in the same company are also actively used either between domestic and international stocks or between common and preferred shares. Pair trades are still not that frequently used as the market has not reached enough depth to make it viable. Overall portfolio exposure is usually managed by either index derivatives or baskets of stocks.

The long/short funds are almost always longbiased, but they can differ in the way they manage the net exposure. Managers with strategies with low net exposure have more capacity constraints due to availability to short, so the universe of long/short managers has an average net long exposure of between 30% and 70%.

Event-driven strategies are becoming increasingly popular. Mergers and acquisition activity in the region is high with international companies looking to expand by acquiring inexpensive assets. Last year, Unicredito bought HVB, the justification of which was in part motivated by HVB's Eastern European business. Some other large deals saw Mittal Steel acquire Kryvorizhstal in the Ukraine, the Czech government selling its 51% holding of Cesky Telecom to Telefonica, Fortis buying Turkish bank Disbank, and Gazprom acquiring Sibneft. Hedge fund managers focusing on events were able to generate good returns from this strategy.

Pie chart of assets under management across strategies

Shareholder activism is also employed to affect events. William Browder of Hermitage Capital is perhaps the best-known activist in the region. Browder is known for his activism in Gazprom, Sberbank and UES. There are a number of other activists that have a lower profile. Most of them buy significant stakes in companies, with or without management and/or majority owners' approval, with the objective of unlocking shareholder value, often by improving the transparency and openness of the company. Sometimes they are invited on the board of directors, other times they form proxies with other investors to make changes. Most activists appear to have experienced their best success when giving advice to smaller companies and aligning themselves with existing stakeholders.

Another event driven strategy, restructuring, is becoming quite common. For example, in Russia, the electricity sector and the fixed telephone line industry are going through large restructurings. Hedge funds have played a significant role in providing financing for these changes. There are a few dedicated Eastern European funds in the fixed income/currency space. The oldest fixed income funds are long-only convergence funds, where opportunities are becoming more limited. However, the convergence countries have seen increasing volatility due to political instability and current account deficits. Few will be able to join the EMU on schedule so a more active approach to investing in fixed income/currencies has been employed by some funds. Many hedge funds have been short the Hungarian Forint and bonds during the last couple of months as the current account deficit has worsened. The carry trade in Turkey has been a long standing favorite for many funds, as the Turkish Lira is one of the highest yielding currencies in emerging markets. There has also been an increase in corporate bond issuance by many companies, which has increased the universe of fixed income investments significantly. Currently, many traders specializing in Eastern Europe trade for global emerging market funds. As interest in the region continues to increase more dedicated vehicles are likely to be launched.

There are now a few multi-strategy funds in Eastern Europe and they have fairly different investment styles. These managers benefit by playing a situation from the cheapest possible asset class. Also, in some situations where one asset class may be too illiquid they can have the flexibility to implement the trade by using some other asset or a combination. Overall, many multi-strategy managers tend to have quite attractive risk-adjusted returns as a result.

Outlook and opportunity for hedge funds

The Eastern European markets have gone through massive change during the last couple of years. The local markets have grown in size and the liquidity has improved tremendously. The markets are still inefficient and underresearched compared to developed markets, which provides opportunities to active managers. The current levels and volatility of most local markets should benefit managers with flexible mandates. The future is bright for hedge funds in Eastern Europe. The universe of managers is far from crowded and as the underlying markets expand the expectation is that more vehicles will be launched in the future.