Accessing CEE opportunities

Growth opportunities and commodity plays continue to develop in the Eastern European market, while Central Europe stands as a safe-haven in the region, as Emma Dunkley reports

Over the last 20 years the Eastern European market has burgeoned, following the collapse of the Berlin wall in 1989, reforms in the Soviet Union and the subsequent wave of privatisations of former state-owned entities. These events helped lay the foundations for the growth of local capital markets in parts of Central and Eastern Europe, which continue to become increasingly efficient and liquid. 

Investors seeking exposure to commodities have sought to tap the region, which is generally prolific in natural resources such as oil and gas. Lyxor Asset Management global head of ETFs Dan Draper says: “These are trends which, in the longer term, make the region attractive – it’s the sector story behind the region which investors want to play, such as oil, gas and other commodities.”

Draper explains that although there was a large sell-off last year and significant credit concerns in Eastern Europe, the global markets have started to recover, with natural resources and basic materials strong propagators of the cyclical recovery. “The Eastern European market has done extremely well recently, along with renewed interest in commodities,” says Draper. 

Healthy returns

The Lyxor ETF Eastern Europe, tracking the Wiener Borse CECE Overall index, has delivered the best three-month and six-month returns at 36.89% and 107.84% respectively, according to data from Morningstar. The underlying CECE index comprises equities from Poland, the Czech Republic and Hungary. Lyxor’s Eastern Europe ETF is denominated in euros and dollars, with the dollar fund achieving a slightly lower three-month return at 36.81%. 

Draper says: “We don’t hedge currency because that’s more of a structured product approach. There’s been a huge debate on currency hedging – but we’re creating the building blocks which provide the underlying economic exposure to a market.” He adds that investors can opt to hedge currency exposures by using forwards, currency futures, or through a quanto structure with the ETF as an underlying. 

When providing exposure to Eastern Europe and other emerging markets, Draper says that the synthetic model is crucial in order to mitigate settlement risk in the underlying securities, among other risks. He adds that the swap counterparty also adopts the tracking error and removes the risk of trading locally in smaller, less liquid markets. 

Crédit Agricole Structured Asset Management (CASAM) also utilises the swap-based methodology, with 52 of its 55 ETFs constructed synthetically. CASAM managing director Valérie Baudson says: “We chose this replication because most of our investors are institutional, so they’re concerned with performance and want to get as low tracking error as possible.” She adds that it is important to be aware of any counterparty risk embedded in the ETF and highlights that CASAM transacts its swap with Crédit Agricole for equity ETFs and Société Générale for fixed income ETFs. 

“As we started our range in September 2008 just after Lehman collapsed, we were very sensitive to the issue of counterparty risk,” Baudson says. Consequently, CASAM decided to work systematically with its counterparts, and ensure that the assets held in the ETF, which are typically a basket of stocks, are of a high quality. She says: “It’s very important which stocks are held in the fund, and this can differ widely between issuers. Our funds invest in large and liquid European stocks, such as the Eurostoxx 50. The question the investor has to ask is: if the counterpart defaults, what do I have in my fund?” 

However, Baudson explains that physically replicated ETFs can also entail counterparty risk, for example, through securities lending and above all, optimised notes. She says some managers returning the performance of the index sell the equity and instead buy an optimised note from a bank, which provides the performance of the equity plus optimised dividends. This then places 100% counterparty risk on the issuing bank, as the performance is no longer based on a stock, but a note. 

The CASAM ETF MSCI Eastern Europe Ex-Russia, tracking the respective MSCI index, was one of the top performing ETFs in the three-month period, returning 34.32%. The index comprises equities in Poland, Hungary and the Czech Republic. According to Cheuvreux analysts, Poland’s Gross Domestic Product (GDP) increased by 1% by the end of the first half, while the Czech Republic has been attractive due to its low debt to GDP ratio.

Nonetheless, iShares Europe head of sales strategy Nizam Hamid says that while there has been recovery in Eastern European and emerging markets, there is an underlying element of risk relating to regulatory control, political environment and currency risk among other factors. “Yes, they’ve been better performing markets, but they have also had higher risk,” he says. 

The iShares Dow Jones Stoxx EU Enlarged 15 ETF was one of the best performing funds over the six-month period, returning 90.74%. Hamid also highlights that the iShares MSCI Eastern Europe 10/40 ETF, tracking an index comprising large cap stocks, was up 81% over the last six months. He explains: “It depends how much extra risk you want to take on board. You can have specific exposure to the EU Enlarged countries – Poland, Czech Republic and Hungary – or the full emerging Eastern Europe region including Russia through the 10/40 ETF, which entails higher risk.” 

Investors who want to take less risk can alternatively opt for exposure to Turkey or Austria. Hamid says Turkey is an interesting market, straddling the border between Asia and Eastern Europe, with less political risk than other Eastern European countries. “If you want lower risk exposure with an emerging market feel, the Austrian Traded Index (ATX) banking and energy sectors largely comprise stocks from companies in Eastern Europe. The ATX is lower risk than other Eastern European markets, but still has the diversification,” says Hamid.

Although most iShares’ ETFs are fully replicated, some of the iShares funds use an optimisation process to rid of the less liquid, harder to trade stocks. Hamid says: “We use an optimisation package like MSCI Barra to minimise our risk to the benchmark in terms of selecting stocks, so we optimise against the liquidity factor.”

Alpine investment

Indeed investors seeking lower risk investments have turned to countries such as Austria or Switzerland which are generally regarded as safe environments. Credit Suisse Xmtch senior portfolio manager Thomas Merz says: “Switzerland is considered a safe-haven, so it was a logical response that the government bond indices performed well over the last year, while other segments like equities and corporates declined during the financial crisis.” The Xmtch Swiss Bond Index Domestic Government 7+ and 3-7+ delivered the best one year performances, at 29.60% and 26.02% respectively.

Merz says Credit Suisse Xmtch is the only provider offering three different ETFs tracking the domestic government bond index, based on different maturities. “All our ETFs are traditionally replicated, so the funds hold the bonds which are issued by the Swiss government.”

One of the benefits of the Swiss market is its high level of liquidity, complementing the liquidity offered by the ETF vehicle, according to Merz. “The guarantee of liquidity from ETFs is also a clear attraction for retail investors, as the market maker is obliged to quote. An ETF does not lose liquidity whereas other instruments might do so, meaning the investor doesn’t always have the possibility to go in or out of a product.” He says that institutional investors are attracted to ETFs for the ease of access for short-term tactical asset allocation. 

In terms of currency risk, Merz explains that this is only an issue when the fund is denominated in one currency and listed in another, as this leaves the net asset value exposed to currency risk. This is evident when certain stock exchanges only allow funds to be listed in certain currencies. For example, the Xmtch on SMI ETF is denominated in Swiss fancs but is also listed on the Deutsche Borse. Merz says: “There you’re facing a currency issue because you might have paid in euros but the fund net asset value is in Swiss francs.” However, he adds: “Institutional investors usually want un-hedged ETFs as their building blocks, as they usually do an overlay on their whole portfolio.” 

With the liquidity and safe-haven benefits offered by Switzerland and the growth opportunity linked to Eastern Europe, the Central  and Eastern European region remains attractive for investors to tap via ETFs. As Baudson at Casam says: “Our analysts are positive overall on the Central and Eastern European region, for the rest of the year.”

ETFs in central and eastern Europe