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“The future ain’t what it used to be”

….This expression by the American baseball coach, Yogi Berra, who was famous for his silly sayings, expresses rather accurately my feelings about the future of Estonian investors and fund managers.

“Sub-contracting jobs” for Scandinavian investors in the field of portfolio investment in Central and Eastern Europe (CEE) as well as the successful launch in 2002 of the mandatory funded pension scheme, or the 2nd Pension Pillar, have redoubled the volume of assets managed in Estonia.

What part of great stock-market returns seen in the region was just luck and what was not is impossible to tell. At the moment CEE markets have lost some of the appeal for global growth investors who are hoping for better prospects in Asia. Jump-start phase of the CEE closing some of the gap with Western Europe is behind us. Now the convergence in the form of a sudden rapid rise in wages and salaries has begun to show its darker side to local entrepreneurs and at the same time increased consumer purchasing power has attracted competitors into local markets. While the flow of foreign investments to the CEE, in comparison to relatively thin layer of local savings, has had the effect of increasing overall investment and created jobs, it has led to a surge in borrowing and increased the value of real estate and local enterprises in the region. These processes are continuing but with the problems in the US mortgage loan market and clear decline in the risk-appetite the sense of caution on the part of investors concerning investing in the abovementioned region has increased.

It is possible that part of the money lent from here has gone to those local “sub prime” borrowers who have not been able to make rational borrowing decisions in the recent euphoria brought about by increased availability of financial products.

As always, this kind of “subcontracting job” includes the risk that if the region becomes less attractive to the client, investments are taken elsewhere. Local pension savings, however, are definitely growing but are, at the same time, demanding more and more global competence when invested in different asset classes.

New risks are welcome

One of the possibilities local fund managers actively offer is to invest in the so-called ‘new wave’ countries. Being among the first in these markets gives an open-ended chance to get good returns if the model that has generally worked well in the CEE is still functioning. Naturally this assumes that attitude in the investment world towards the new potential risks stays more-less sanguine and availability of international funds needed for jump-starting economies is still there.

I remember too well how in 1998, right before the crisis in Russia, investors who had got super returns with Russian shares started to ask for something “more exciting”. Why not try the Ukrainian or even Byelorussian markets? To tell the truth a small position in Ukrainian shares was really taken. But later on there was nothing we could do with these shares for years as the bid for these shares had simply disappeared – willingness to take such risks had vanished because of the evolving financial crisis in Asia and Russia. This warning example has inevitably made me cautious about investments in totally new markets. At the beginning of the last century European investors’ list of emerging markets bonds included the USA, Australia and Argentina. Time has passed but bonds of the latter are still surrounded by a certain feeling associated with that of developing countries. Opinion of some local ‘time traveller’ is that growth in several interesting new investment locations lags behind Estonia by 5 to 15 years and story there will eventually be similar to those experienced by Estonia. Certainly some of those countries will achieve that, even perhaps without such overheating we currently see in Baltics. However there could be certain more fundamental reasons for the present situation that make future path of the country totally different. But there is no point speculating over this. Such “limited losses (100%) and, in case of success, open-ended growth” possibilities have certainly a place in a large investment portfolio. Provided there are enough of them and that such investments have low correlation.

In the developed markets investors have been more and more attracted by over-performance and low costs of investing directly into market indices compared to fund managers. Current market valuations of the older CEE markets are already comparable with developed markets. Therefore cost factor connected with investments in funds will probably increasingly influence investors toward investing in indexes here as expected returns most probably decline. Cheaper (cost for investors around 0.5% p.a.) index instruments will compete specially with funds investing in the shares of large companies.

For some time extra returns could be still achieved in the region by investing in well-managed small-cap funds, as it is more likely that some hidden value could be found there. But in the case of such investment style the liquidity risk will probably be greater than could be assumed based on the low volatility and exceptionally high turnovers of recent years. It should be emphasised that talks about the necessity of a long-term investment-horizon must be taken seriously.

Future trends

It is likely that in the coming years some of the local managers will be offering also the 1X0/X0 (usually 130%/30%) type funds that have become popular in developed markets, where the larger portion of portfolios is generally made up of long positions (waiting for a rise in prices) and the rest is in short positions (waiting for a fall in prices). This enables the fund manager in more mature markets to add value for the investor compared to the index and to manage market risks better. The best ‘salesman’ for such products would be a prolonged volatile market; and the continuation of the present higher volatility in markets seems quite possible.

In the future, investing will become cheaper

Together with the growth of assets under management the pressure by governments to reduce service fees has increased. For example, pension funds’ fees are likely to decrease in Estonia at the coming years. In recent years the proportion of investments in CEE markets has decreased in most of the pension funds’ portfolios. In addition to locally managed funds many of the financial products on retail offer have now a global dimension – it has been accepted that local investors’ money needs to be invested outside the region. The principle (paraphrasing one of the leaders of the Estonian national awakening in the 19th century, Jakob Hurt) that “if we are never going to be great in mind, we will become great in the proportion of pension savings kept in one region” is gradually becoming history.

This article was written by Kristjan Hänni to Estonian Air inflight magazine “IN TIME” winter 2007/2008.