The emerging market next door

Old certainties are being turned on their head. This week, countries in southern Europe saw their borrowing costs soar again, while the US faces a cut in its AAA debt rating. The days when all western European and US sovereign bonds were regarded as virtually risk free are gone. Instead, it is emerging nations that are increasing perceived as paragons of fiscal and monetary virtue.

"We are on the cusp of a major realignment of global asset allocation which, more likely than not, will further accelerate movement of yield, growth and, increasingly, safety-seeking money to emerging markets," says Plamen Monovski, chief investment officer at Renaissance Asset Managers.

But you don't have to go east to Asia, or south to Latin America, to benefit from this shift in investor perceptions, or the changes in asset allocation that will surely follow. Mr Monovski's favourite emerging market is right on our doorstep - and there's an attractive vehicle to play it right here.

Eastern European stock markets are the cheapest of all the emerging markets on a price-to-earnings basis, trading at a considerable valuation discount to both global emerging markets and average world markets. Yet the region has been the best emerging-market performer so far this year, thanks to strong underlying earnings growth from its highly competitive companies.

The Eastern European Trust is well positioned to tap into this growth story. It currently trades on a discount of more than 9 per cent, but its performance has been strong since BlackRock took over the management in May 2009. According to figures from Winterflood Securities, net asset value (NAV) is up 101 per cent since then, compared with 93 per cent for the MSCI EM Europe 10/40, the fund's benchmark.

The fund is managed by Sam Vecht, BlackRock's head of emerging Europe and co-manager of three other emerging markets funds. Mr Vecht's decision to reduce exposure to the materials sector, on the basis that Chinese economic growth would slow and that valuations have run ahead of themselves, has seen the fund's performance suffer slightly this year. But he remains positive on prospects for the region.

He is particularly bullish on Russia, and more than half of the fund's assets are invested here. The country has been supported by high oil prices this year and Mr Vecht is positive that state spending will increase, while a better-than-expected grain harvest could ease inflationary pressures. Other positives include President Medvedev's plans to remove politicians from the boards of all state companies and increasing privatisations.

On a sector basis, the fund is overweight financials. Banks in eastern Europe are well capitalised and offer value, and hence feature prominently in the fund's top 10 holdings. Eastern Europe's industrial competitiveness is high and rising thanks to low labour costs, a highly educated workforce and low corporate tax rates. "Countries like Turkey and Poland are set to benefit in particular from China's rising wage inflation, and we will soon see more products being manufactured there," says Mr Vecht.

The downsides include a performance fee of 10 per cent of any outperformance of the NAV per share over the MSCI 10/40 Emerging Markets Europe Index, although the performance fee payable in any one year is capped at 0.95 per cent.

There's also political risk, particularly in Russia. It is likely that the equity market will suffer volatility ahead of that country's presidential elections, and that could affect the fund given its high exposure to the region. But as we've seen lately, political risk isn't confined to emerging markets, while credit metrics are becoming increasingly important. The economies of eastern Europe are much better placed than their western counterparts and with countries such as Latvia, Serbia, Hungary and Romania enjoying upgrades from rating agencies this year, it is likely the region will see increased investor inflows. Buy

Key fund data:

Source: Thomson Reuters Datastream & *Morningstar

Notes: Performance figures as at 2 August 2011

Top 10 holdings as at 30 June 2011

Geographic Allocation