Betting Big on Eastern Europe's Emergence

The emergence of China and India on the world's economic stage may be overshadowing Eastern Europe's long-awaited coming-out party, but the owners of Eastern European mutual funds won't get too much sympathy.

Despite Wednesday's drubbing of Russia-heavy funds -- set off in part by wireless provider Vimpel Communications' (VIP) plunge following its admission it may face a hefty tax bill -- Eastern European stocks have produced mind-boggling returns over the past two years, far outpacing those in the so-called developed nations of the world.

Guenter Faschang's (VEEEX)Eastern European Equity fund, for example, is up 43% this year, after a 50% gain in 2003. Faschang says the fund's fantastic performance is a direct result of "euro-convergence" dynamics associated with eight Eastern and Central European nations joining the European Union this year.

The fund charges a hefty front-end load of 5.75%, as well as high annual expenses of 3%. It also owns a hefty chunk of VimpelCom, whose 27% drop Wednesday hammered funds across the Eastern European sector. Nevertheless, when a fund returns upwards of 40% in consecutive years, it's almost rude to complain about fees, even if they are double those of the average domestic fund.

The question is, of course, whether Eastern European stocks can maintain their stunning pace to justify those fees. TSC posed that question and a few others via email to Faschang at his office in Zurich.

Why are Eastern European funds outpacing other regional funds?

Eastern Europe benefits from euro-convergence. Several countries joined the E.U. on May 1, 2004. The euro will be introduced between 2007 and 2010, depending on the country. In this convergence phase the following effects are present: Interest rates are going down to euro-zone levels, inflation rates are declining, budget deficits are being reduced, E.U. funds for infrastructure improvements are increasing, and foreign direct investment is also increasing due to low wages. Finally, domestic consumption is growing due to rising incomes and falling interest rates.