Global Markets: Eastern Europe - Young and Volatile

Investing in this region is fine for people with strong constitutions and nerves of steel, writes Abigail Montrose

The former Soviet bloc has become one of the most exciting areas to invest in for those with nerves of steel. Many parts of the region are less developed than other emerging markets in South America and Asia so the potential rewards are higher.

It is common to see share valuation surge by 50 per cent over six months, but slides are just as frequent, making this a region for the experienced investor with a strong constitution and a balanced portfolio.

Eastern and Central Europe are different from other emerging markets. Unlike China or Asia they do not have the problem of turning peasants into industrial workers; levels of literacy are often much higher. Better infrastructure also makes progress much easier, says Martin Taylor, director of emerging Eastern European markets at Baring Asset Management. "All this region needs is an inflow of foreign capital, management and technology. These former Communist countries will make the leap from being Second World countries into First World countries very quickly, whereas it will take decades in China and India," he says.

Since the fall of the Berlin Wall, several countries in this region have experienced impressive rates of growth and others are now on the road to economic reform. Of the most economically advanced countries in the region, Poland has averaged a growth rate of 6 per cent in the past four years and inflation is falling. This compares with the UK's average growth rate of around 2 per cent. But this is not to suggest the region is homogeneous. The pace of development varies enormously. At the forefront are Poland, Hungary, the Czech Republic and Slovakia. Russia is still lagging behind but has improved significantly in the past 18 months. Progress is also well on the way in the Baltic states.

Privatisation has been slower elsewhere and so there has been little investment in countries such as Romania and Bulgaria. Even less development has taken place in the Central Asian republics - countries such as Kazakhstan, Kyrgystan, Uzbekistan and Turkmenistan.

Most equity investment by UK fund managers has been in the advanced economies. But the volatility of these stock markets is legendary and the rates of growth and stability vary between these countries enormously.

In the five months to the end of May, in dollar terms, the Hungarian stock market rose around 27 per cent and the Polish around 4 per cent, while the Czech fell 15 per cent as a result of a devaluation. Investment houses such as Baring and Abtrust have kept weightings low in the Czech Republic because of concerns over the poor quality of corporate information, a view that many companies are still not sufficiently competitive, and a belief that reforms of the commercial and industrial environment have been largely superficial.

Increasingly Russia is being seen as offering the most opportunity for investors. Not only is it the largest market in the area, but it now is experiencing good growth and is going through the same phase of reform that the more advanced economies in the region already have experienced. Interest rates have fallen, the political scene looks to be settling down, economically the country is improving and the IMF has extended its loan programme from one to three years. While the stock market remains small, in the first five months of this year share prices rose by an impressive 83 per cent.

This has made several fund managers bullish about the market, particularly as more than 70 per cent of the country's GDP now comes from the private sector. But there is still concern about the level of information available from companies, and just as a small market can rise sharply when a few companies do well, so it can fall sharply if a few companies perform badly. But the general feeling is that Russia is a good investment for the long term.

Investment in the former Soviet Union has shown that huge returns are possible but it is a risky area to invest in. Before venturing down this path an investor must be prepared to stay in for the long term. Ken Nicholson, marketing manager for Europe at Templeton, believes inexperienced investors should be wary of this market and not lured by the potential large rewards: "The experts may be able to make money on a quick trade, but for most people, it's essential to take a five-year view," he says.

Jittery investors should steer clear. A number of investors have lost out because they pulled out when things looked rough. For example, earlier this year when President Yeltsin had pneumonia, a number of investors sold out, and missed out on the enormous growth in the market that followed his recovery.

A number of unit trust and investment trusts invest in Eastern Europe. The lowest-risk way to invest is through an emerging market fund which invests across all emerging markets including those in Asia, Africa, Europe, the Middle East and South America.

The Abtrust Frontier Markets unit trust has 37 per cent of its funds invested in Central and Eastern Europe. In the year to end-May the value of units has risen 41 per cent, making this the top performing fund of its type.

Radhika Ajmera, head of emerging markets at Abtrust, says: "Rather than focusing on one region where the factors are pretty similar, we wanted to diversify the risk and cover all markets at a similar stage of development."

A number of fund managers, such as Templeton, Barings, Credit Suisse and Pictet, run region-specific funds which invest in the emerging markets of Central and Eastern Europe. Templeton plans to launch two Eastern European funds in the next two months. By investing in the whole region they believe this offers diversity but allows investors to benefit from the potential high rewards offered in this region.

In the past such funds have attracted money from institutional investors. But for those with an established portfolio of shares looking to invest in a more speculative market, Eastern Europe offers plenty of opportunities.