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.

How are Eastern European companies faring against Western or "old" European firms?

Eastern European companies are usually growing much faster due to the high economic growth in Eastern Europe. Valuations, however, are still lower in Eastern Europe. The P/E 2005 for our fund is 12; the P/E for Western Europe is probably above 16.

Eastern European companies are using

International Financial Reporting Standards or U.S.-GAAP style accounting. Many have Western strategic partners, and management is on Western level. As Western companies want to invest in Eastern Europe, many stocks in Eastern Europe are takeover targets with good price upside.

Are many U.S. and Western European companies outsourcing to Eastern Europe? Will this become a problem like it is in the U.S.?

Many companies are outsourcing to Eastern Europe, but not only for low-cost production. Education in Eastern Europe is very good, and finished products like cars are now produced in the East instead of the West. Companies like

VW

,

Audi

,

Toyota

(TM) - Get Report

and

Hyundai

all have plants scattered across Eastern and Central Europe.

Also, taxes are low, and so is state bureaucracy. The countries are competing for foreign direct investment, and this leads to good conditions for investors. For example, Slovakia introduced a flat tax of 19%. In Estonia there is a 0% tax for foreign direct investment if the profits stay in the country.

The strong foreign direct investment is not a problem for the stocks in our fund. We are investing in sectors where foreign investors are coming in by taking over existing companies like banks, oil, telecom, pharma, utilities. We frequently get nice takeover premiums.

How are the political and economic problems in Russia and the Ukraine affecting other Eastern European companies?

It's very limited. Central Europe -- the focus of our fund, we have invested only 20% in Russia -- has cut most of its export links to Russia after the Russian crisis in 1998.

The companies are mostly exporting to the E.U. If the U.S. dollar and the oil prices are falling, and I expect this to continue, it is bad for Russia, which is a raw material exporter, but good for Central Europe, which imports raw materials in U.S. dollars and exports to the E.U. in euros.

What sectors are outperforming? Underperforming?

In recent months, oil and metals have been performing well. We have reduced our holdings in these sectors, because they are approaching a cyclical peak. Defensive sectors like utilities and pharma have been underperforming. We are now overweight these sectors. The most attractive sector for the coming years should be the banking sector because of the convergence process, which means falling inflation and high growth in loans. Banking services are hugely underpenetrated.

What are the risks associated with investing in Eastern Europe?

Our fund focuses on Central Europe -- meaning Poland, Czech Republic, Hungary, Baltic States and the Balkans -- and this region has very strong attractions. The main risk is external. If there is a slowdown in the U.S. and in the E.U., these countries would be negatively affected as well.

However, during the last years we have seen that in times of slow global growth these countries can still grow 4% to 10% per year. Therefore, I am convinced that the bourses of Central Europe should outperform the U.S. and Western European markets by 10% to 20% per year for the next four to five years until the introduction of the euro. Previous examples like Greece, Spain, Portugal, Italy and Ireland have shown clearly that the E.U./euro convergence is a very powerful, positive factor influencing the bond and stock markets.

Any other insights you can provide on the region?

One more relevant point would be liquidity. The stock markets of Eastern Europe are relatively small. That means if money is flowing in during the convergence phase of the coming years, the stock markets can be moved up strongly. We have seen this phenomenon in other convergence countries before. With declining interest rates, more money will go from the bond to the stock markets of these countries, and foreigners will discover the "convergence" story. This could potentially lead to high returns on the equity markets of Eastern Europe for the next four to five years.