Eastern Europe

The Eastern Europe vision

Originally published in the June 2007 issue

China might capture the headlines, but we believe investors should not be too quick to overlook the attractions of emerging Europe. Good exposure to commodities demand and ongoing convergence with developed Europe underpin the case for a structural long bias in these markets. Add in the rich opportunities to be found in the Middle East and Africa on an opportunistic basis, and the possibilities opened by a fast-developing derivatives market, and we believe EMEA equities offer the potential for superior risk adjusted returns for hedge fund investors.

At the heart of the case for emerging Europe is exposure to the global cycle of demand for commodities, particularly in Russia. As well as oil and gas, Russia is a world-class supplier of industrial commodities such as nickel, copper and iron ore to many countries, including China. Over and above that, as the Russian economy has developed, it has started to diversify away from just energy and commodities. As a result, a new professional service-based middle class has emerged. They too have seen their wealth improve, and this has enabled many to buy the latest mobile phone or home computer at shopping centres and shopping malls around the country.

Rising wealth levels and convergence with the developed countries in Europe are also at the heart of the investment case for the other countries in emerging Europe. The deployment of structural funds from the European Union to improve the transportation links is very positive for local economies, and helping to encourage other forms of investment including the establishment of new businesses in these countries. Competitive tax regimes and a welcome focus on shareholder returns makes for an attractive investment backdrop for investment in emerging Europe.

Turkey might not be a member of the European Union yet, but it is firmly on the path to political and economic convergence, with benefits for financial discipline and for companies operating in Turkey. The extent of the progress made by Turkey was clear in recent days when initial weakness in the currency was recovered very rapidly as confidence started to return. Elsewhere in the Middle East, oil revenues are gradually being recycled into local economies, often through infrastructure projects, again providing some very interesting investment opportunities both on the long and on the short side.

South Africa might be a relatively small part of our investment universe but is somewhere where we are starting to see some very interesting opportunities arising. From a top-down perspective, there remain a number of concerns, including the potential for weakness in the Rand, but our analysis of the investment potential of companies there uncovered a number of names we have recently brought into the investment portfolio of the EMEA Absolute Return Fund.

The investment approach we follow in the Baring EMEA Absolute Return Fund is very much an extension of that used in our successful long only funds invested in the region. As one of the oldest and longest established investment management companies investing in emerging Europe, with close to US$4 billion under management in EMEA equity funds at the end of December last year, we are in the fortunate position of being able to build on existing very good relationships with company management when conducting fundamental research.

As such, investing in the EMEA equity markets is very much part of our core investment business at Barings. The size of our investment team reflects this, with five experienced professionals looking exclusively at the EMEA markets, led by Dr. Ghadir Abu Leil-Cooper, Head of the team and back-up manager on the EMEA Absolute Return Fund. One of the features of Barings is a belief in the importance of local expertise backed by global insight, and we have certainly taken that to heart in the EMEA team. Not only do we specialise in complementary areas of expertise, but all five team members are nationals of countries in our investment universe, with the ability to bring local perspective to their analysis.

Given the very positive structural factors in play in the region, we believe an approach which has a structural long bias is the correct one to take. We manage this actively, and may even go net short, but over the long term we strongly believe that markets will appreciate and that it is appropriate to participate in the beta available in the region. At the same time, we believe that the level of volatility of regional markets is likely to be more than many investors are prepared to tolerate, and have structured our approach around a volatility target of no more than 15% each year, with the aim of delivering investment returns in excess of 20% each year. We work closely with our dedicated risk team both to monitor risk levels on an ante and ex post basis, and to consider the potential impact on the portfolio of making any changes.

We firmly believe in the importance of a total return strategy, and seek to deliver positive returns from both the long and the short side of the book. Before I started my career in investment management, my background was as a market maker and proprietary trader at Raiffeisen Zentralbank Austria in Central and Eastern European equities and derivatives, and this total return investment approach has stayed with me now that I am running the hedge fund.

We run a relatively focused investment portfolio, typically having in the region of 25 stocks on the long side and up to 10 on the short side, as well as exposure to a number of derivatives if we believe it is appropriate at any given time. As the EMEA markets continue to develop and open up, the derivative options available to investors have also expanded at a rapid pace. We are actively encouraging and pursuing these developments, and have already utilised a number of these in the EMEA Absolute Return Fund, both to hedge risks andto take market exposure more efficiently.

We are bottom-up investors rather than asset allocators, although to an extent these approaches meet in our work to seek to identify themes and trends in the market early, and stocks which reflect these themes and which we can bring into the portfolio. At the moment, we see particular opportunities in the banking and insurance sectors in Central Europe, where banks are aggressively expanding their personal banking services into a relatively untapped market, in companies across the EMEA region. We believe these are well positioned to benefit from increased spending on infrastructure, and on a number of specialist local steelmakers and oil and gas service companies, experiencing increased pricing power and with the potential to deliver better than expected corporate profits growth, in our view. Although we are net long on the banking and real estate sectors we look at companies on a case by case basis and have introduced a number of short positions into the portfolio, where we believe prices have moved too aggressively in recent months.

It is pleasing to be able to say that since I took over responsibility for management of the Baring EMEA Absolute Return Fund in October 2006, we have been able to deliver attractive returns to investors without breaching our risk limits; in the region of 28% in US dollar terms over these seven months to the end of April, with approximately 50% markets exposure and accompanied by ex post standard deviation of less than 10%. At a time when the EMEA markets have seen some intermittent weakness, we believe this indicates both that an alternative investment approach can be successful in these markets, and that the investment approach and strategy we have adopted for the fund are working. We look forward to being able to sustain this balance between risk and return for investors in the months to come.

Matthias Siller is Investment Manager, Baring EMEA Absolute Return Fund, Baring Asset Management.