Eastern promise

Eastern Europe holds renewed promise for the Specialist Sector, writes Paul Burgin.

The recent addition of offshore funds has added some £30bn in assets to the hotchpotch Specialist sector. Offshore giants such as HSBC’s Indian and Chinese equities funds now dominate. They are worth £3.9bn and £2.1bn respectively. JP Morgan Global Convertibles, Baring Eastern European and Templeton BRIC account for a further £7bn.

UK domiciled funds have proved almost as popular. The biggest include the commodity-themed JP Morgan Natural Resources and BlackRock Gold and General, both around the £2bn mark.

Single market funds

These funds sit in the Specialist sector rather than Emerging Markets or other standard sectors because of their composition or focus on single markets. Comparing performance across the sector is a meaningless exercise as fund strategies vary widely. But in recent years the main beneficiaries in both inflows and performance terms have been those funds with a BRIC, Latin American or commodities slant.

Topping the list is JP Morgan New Europe, with one-year returns of 138.32% to the end of March according to Financial Express Analytics data. It is closely followed by HSBC Indian Equity which delivered 134.28%, well in excess of the sector’s average of 47%.

The laggards include a number of income and absolute return strategies which have lost money over three years, according to the Financial Express data.

Eastern lights

After a bruising few years, Eastern European portfolios are showing promise once more. They suffered as oil prices fell, hitting Russia hard, and debt worries engulfed the Baltic nations in the financial crisis. Fears have receded and the local market has jumped.

Oleg Biryulyov, manager of the JP Morgan New Europe fund, has seen his recent performance driven by relative over- and underweight positions.

He is keen on Sberbank, a Russian bank that was marked down heavily when investors ignored its fundamentals when they rushed for the exits.

“It has very little in the way of subprime, is managed well and the market is low penetration,” explains Emily Whiting, client portfolio manager on the fund. Sberbank is classified as a ‘tier 1’ bank in Russia and the Government promised that no bank of its stature would be allowed to fail. Investors overlooked the implicit guarantee, creating a big pricing anomaly.

Underweights have also played a key role in the last few years. Whiting says the fund has a long-term stance of no holdings in Gazprom or Lukoil despite the stocks representing 29% of local indices. “There is a lot of state intervention and our minority interests are not always aligned with management interests when that happens,” she says.

State-linked firms do not always see the direct benefit of increases in oil prices. Capex spending decisions can be dictated by government and firms are heavily taxed. The portfolio preference is for smaller firms such as Turkmenistan’s Dragon Oil that remain outside of governmental control. It is also listed in London and Dublin where transparency and governance requirements are far tougher than on local exchanges.

“You have to be aware of liquidity. As a fund, we need to be able to get our money in and out,” adds Whiting.

Elena Shaftan, manager of the Jupiter Emerging European Opportunities fund, says the region is beginning to recapture investor interest as oil recovers and Latvian debt issues fade. She says: “The latter sparked fears the problem would be spread to other countries in the region.

These factors encouraged investors to focus on markets such as China and India instead. But 2010 has seen a turnaround, with emerging Europe attracting an increasing share of inflows – helping markets there to outperform.”

Changing perceptions have pushed opportunities to centre stage. She too was an investor in Sberbank, which rose 128% in the second half of last year.

This year, she is optimistic as regional economies show signs of picking up. Russian retail sales picked up in February as unemployment fell. “Expectations are that the economy will grow by around 5% in 2010, underpinned by further improvement in employment and substantial pre-announced increases in pensions that will give consumers greater spending power,” says Shaftan.

Like Russia, Poland and Turkey should escape the fiscal difficulties faced by Western nations. They too should benefit from further outsourcing. Although labour costs may be higher than in Asia, Eastern Europe shares the same regulatory and legal framework as the EU, and has a skilled workforce. Its physical location makes for lower transportation costs and delivery times.

Yet Eastern Europe remains cheap. Shaftan adds: “The two largest regional markets, Russia and Turkey, still trade on discounts of close to 40% and 20% compared to the emerging market average – so the valuation gap has yet to close.”

Q&A: Sanjiv Duggal, HSBC fund manager

Few governments have been praised for their stimulus measures and growth forecasts. The Indian Government has surprised markets with both in its recent budget, says Sanjiv Duggal, manager of the HSBC GIF Indian Equities fund, the sector’s largest.

Q. What are the economic implications of the budget?
A. The Government’s medium-term plan is to reduce the deficit to 5.5% of GDP for the fiscal year ending March 2011. The market was positively surprised by the budget deficit reduction target and the Government’s GDP growth forecasts. The Government still forecasts the economy will grow by 7.2% for the fiscal year ending 31 March 2010, moving up to 8.5% in FY11 and 9% in FY12. As such, it was time to consider a calibrated exit strategy for the fiscal stimulus, in order to manage the country’s finances and reduce national debt.

Q. Was the budget in line with your expectations and the consensus view?
A. The budget was only marginally better than what we were expecting, although I suppose it was much better than what the market was expecting. The key difference was again on the budget deficit reduction target, as the market was expecting a higher budget deficit target, and thereby a higher borrowing requirement by the Government from the market.

On the other hand, the Government managed to give 60% of tax payers cuts in the income tax rate.

Q. How do you think the budget will impact equity markets in the near and medium term?
A. The market is responding to the budget positively. We saw strong foreign institutional investor inflows into the Indian market of about $2bn within eight to nine trading days. Overall, the Indian market rose about 10% following the budget announcement. Going ahead, the focus will remain on how the Government implements some of its plans for the near and medium term, including tax changes.

Following the 10% rise, the market will be in a wait-and-see mode. We would keep a core India position and then look to top slice or bottom fish depending on how the market evolves. If the market rallies another 5%-10%, the fund would look to trim holdings and take some money off the table, around the core positions.

Q. Sector wise, which sectors will benefit from the budget?
A. The sectors that will benefit are the consumption-oriented areas because of the income tax cuts, which will more than override the increase in excise duties. Other areas of consumption revolve around discretionary, auto and housing, even though the service tax will affect construction cost and housing prices. Homebuyers are set to face higher prices due to the imposition of service tax on construction and sales of real estate, as well as an increase in the cost of various inputs like cement.

We have been adding to financials and real estate, and we are looking for more consumption-oriented stories. In addition, we retain our focus on the industrial sector and are looking for opportunities to add to this area.

Adviser View: Sheridan Admans, The Share Centre

Advisers like:

• Good managers in BRIC, Latin American and commodity funds
• Strong performance and outlook for some
• Hidden gem appeal

Advisers dislike:

• Inconsistency of sector
• Performance data can be skewed
• Negative connotations of ‘Specialist’ sector tag

Sheridan Admans of The Share Centre thinks some of the criticisms directed at the Specialist sector are unfounded. He says: “Other people refer to it as a dumping ground, but that is not the real issue. The problem is there are often not enough funds of a certain type to warrant their own individual IMA categories – for Latin America or Gold for example.”

The sector is difficult for lay investors to navigate. Whilst advisers can pull out LatAm funds for comparison with Global Emerging Markets or Global Growth competitors, most ordinary investors cannot. “They need to know what it is in the sector and what they should be comparing it against,” says Admans.

It is easy to overlook some of the sector’s gems, many of which have been top performers in recent years. Admans likes SWIP’s and Threadneedle’s LatAm funds. High-risk investors with strong convictions should look at Jupiter Financial Opportunities or the Neptune Russia and Greater Russia fund.

Even funds with apparently weak performance can be good picks. First State Global Listed Infrastructure’s three year 36.69% return looks poor against the sector average. But Admans says: “Manager Peter Meany runs the fund out of Australia and it provides good returns as a defensive income producing play.”

He is a recent convert to Investec Enhanced Natural Resources which uses derivatives to reduce commodity volatility. “I was sceptical when we first looked at the fund. In the crash of 2008, the fund tracked the market down almost one for one for the first six weeks, which added to our doubts.

“But then the overlay kicked in and the fund plateaued as everyone else continued to fall,” adds Admans.