Investing in Central Europe

The merits of local management

Originally published in the July 2007 issue

The last few years have seen a surge in demand for emerging market assets as investors scramble for superior risk-adjusted returns in the face of increasingly efficient developed markets where too many ‘players’ continue to chase a dwindling set of opportunities.

Many of the leading emerging markets now appear to be in danger of going the same way as their developed market cousins, as the world’s leading investment houses compete to get a piece of the action.

The search for alpha has moved away from traditional, developed markets. Existing emerging market hedge fund products are growing strongly and a number of new emerging market hedge fund launches are trying to take advantage of local market inefficiencies.

Most new emerging market hedge funds are generalist and global in structure and have tended to focus on the larger emerging markets by capitalisation. Those products that are not global are often either regional (Latin America, Central/Eastern Europe) or market specific (Russia, Ukraine). However in this latter case, the product is often long-only with performance fees.

In the UK, identifying hedge fund talent within a large traditional long-only investor is a challenging task. Nonetheless the model of managing long-only assets next to hedge fund assets (with close compliance supervision) has worked well in a number of organisations, for example Gartmore, Hendersons, Old Mutual and Morley.

Focus on Poland

But recent history suggests there are still plenty of attractive opportunities to be had for the purposeful investor, not least if one is willing to contemplate investments outside the universe typically inhabited by the average international manager.

In July 2005 Morley launched its Central European Equity Long/Short fund in order to offer investors a chance to take advantage of just such an opportunity. The fund invests mostly in Poland, the perfect proxy for the central and eastern European region due to the size of its economy and stock market.

Somewhat unusually Morley uses its overseas subsidiary, Commercial Union Investment Managers (CUIM) Polska, based in Warsaw to manage the fund, largely based on the fact that its equity team had produced spectacular relative returns in managing local funds.

With just over 38 million inhabitants and Gross Domestic Product of around £189 billion (€278 billion) in 2006, Poland has long been viewed as the powerhouse of Eastern/Central Europe. Output is as large as that of the nine other countries which joined the EU in May 2004 combined.

Having last year delivered impressive growth of 6.1 per cent while simultaneously boasting low inflation and manageable fiscal and current account deficits, the Polish economy has helped spawn a vibrant stock market, albeit one with plenty of inefficiencies to be exploited and thus ample opportunities to generate superior returns.

In recent years the Polish equity market has become a de facto regional stock exchange with a strong base of large institutional investors (pension, mutual and life funds) and a high degree of foreign participation. Furthermore, the market has begun to attract a growing number of Initial Public Offerings. While the majority naturally remain Polish, a growing number are from the regions, with Czech, Slovak, Hungarian and Austrian companies all now listed in Warsaw.

Combining the product development and hedge fund distribution capability of Morley in London with a well established team of six Warsaw-based Polish equity specialists covering a large chunk of all listed securities has proved highly beneficial.

Utilisation of this local presence is in marked contrast to the strategy adopted by the vast majority of hedge funds investing in emerging markets which tend to be managed out of the major financial centres.

The importance of a local presence

While running money from London or New York makes sense to the extent that the products are largely global and these locations are centres of information flow, there are some clear disadvantages. A local presence firstly gives a manager a superior feel for the capital inflows and outflows by foreign institutions, which have a particularly important bearing on the large-cap stocks.

But perhaps even more importantly, it provides detailed specialist knowledge of the market at the mid- and small-cap level.

Much of the WIG 20 Blue Chip index is made up of former state-owned monopolies which tend to offer lacklustre returns and are closely followed by leading international investors in any case. It is the mid- and small-cap stocks where the real action tends to be found, shares which have in recent years offered returns not dissimilar to those found within the stock markets of Asia’s so-called Tiger Economies. But to gain access to these stocks is near impossible without a local presence. Local stock analysis digs deeper down the capitalisation spectrum, where inefficiencies are the greatest and alpha generation capabilities most significant. Only with this local presence provided by local fund managers can investment opportunities be effectively identified.

Polish reports and accounts are, after all, published in the local language – only larger companies’ reports tend to be published in English. The staff in Morley’s Warsaw office are Polish. How many non-local hedge fund managers would employ local people to undertake local research?

One of the original ideas behind many hedge funds is to focus resources and time on what the managers are good at. Morley’s fund does exactly this, despite a number of investors suggesting to us that we should invest directly in other Central European stock exchanges.

One of the less well known features/dynamics of the Polish equity market is the support it receives from its local ‘funded’ pension scheme. In simple terms, there is a compulsory funded pension scheme for all employees in Poland (in the same way that Chile has ‘funded’ pensions provision), and by law a large percentage is compelled to be directed to the local equity and bond markets.

One of the problems in developing hedge funds focused on one or more of the smaller emerging markets is the ability to short stocks. For example in Poland, while shorting individual stocks is technically legal, there are taxation and accounting uncertainties. However the problem is partially solved by shorting index futures.

The result is that Morley has produced an asset largely uncorrelated to the local stock market, the European equity market, the S&P 500 and the Lehman’s Bond Index and what is more it has performed rather well despite having a low net market exposure of on average of approximately a few percent long.

The future for Poland looks bright. After the EU entry, fundamentals for long-term (10 years plus) strong economic growth have become even more solid. In this positive environment for equity investing, with market volatility remaining high, the concept of an equity-oriented hedge fund is one of the best ways to exploit opportunities in the local market.

Charles Hoblyn is Head of Hedge Fund Sales at Morley Fund Management