Dear Investors!

Balkan Emerging Frontiers Fund generated more than 4% net return in first quarter of the year! Total return in 44 months from the start of investment is almost 90%.

Supplementary Offering Memorandum of the fund was slightly amended and updated in February. Please find detailed information in the attachment.

Main stock indices in BEF Fund investment region ranged quite differently in the first quarter of 2014. Highest increase with a bit over 9% growth was marked by Slovenian SBITOP while Montenegrin MONEX20 grew a bit more than 5%. Serbian BELEX15 grew modestly for a bit more than 1%. Other indices dropped in the past quarter. Value of Macedonian MBI10 decreased for almost 1 percent, while Croatian CROBEX dropped 2%. Worst performance was marked by Sarajevo SASX10 and Banja Luka BIRS that both lost more than 6% of their value.

Though some stocks on Ljubljana Stock Exchange have indeed increased noticeably in the rise lasting since last autumn this is not reflected on BEF Fund return, as the fund has the vast majority of the portfolio invested in countries south of Croatia. We do believe that value of certain shares in Slovenia will grow further, however we are certain that in the countries south of Croatia the growth potential is much greater. Readers of our past newsletters might remember our frequent statement based on our past experience: We expect that in BEF Fund investment region the growth of stock prices will first begin in Slovenia and Croatia and then follow into southern countries. Due to the low liquidity of those markets, capital inflows will have far stronger impact on share prices than in Slovenia or Croatia. Therefore one might ask why BEF Fund has not initially invested majority of its capital in Slovenia and Croatia, and later it would move it to southern countries of its investment region. There are several reasons for this. The first, however not the most important reason, is that at the time it was not possible to predict with certainty how the issue of Slovenian banks will be resolved (in case Slovenia would apply for foreign financial assistance, there would be another sharp drop before growth period). The main reason lies in the fact that the selected stocks in the southern countries of BEF Fund Investment region are significantly more undervalued and thus have a significantly greater growth potential than those in Slovenia and Croatia. Constant shifting of investments from one country to another sounds nice in theory, however there are considerable restrictions that seriously diminish reasonability of such behaviour on the markets like BEF fund investment region is. Besides obvious trading costs there are opportunity costs of lost investment opportunities that are most important.

In real life it usually does not happen that after one market or investment would grow for some time while alternative one would be idle, that the first one would then stop at high level and only after a brief pause the alternative one would began its growth from initially low level (this would be a prerequisite for the most efficient transfer of assets). Usually the alternative investment starts growing, when the first one still grows and with sticking with the first investment one misses the initial returns of alternative investment. Besides that, our experience show that due to relatively low stock market liquidity it is nearly impossible to buy substantial volume of shares in southern countries of BEF Fund investment region, without significantly increasing their price (and thus already lowering one’s final return) once markets start to evidently move up. In the past two monitored cycles before 2007 in investments the Balkans grew by an average of at least 100%, before major investors even managed to buy significant amounts of shares. This could present a very, very large opportunity loss. Even more so if we consider compound return point of view. In order to visualise this better, please bear in mind that some of the stock exchange indices in the region are still on only about 15% of their 2007 peak values. Once they will rise just up to half of their former maximum values that will present 230% growth (0.5/0.15). However, for the investors that will wait with the investment until they first see 100% growth (up to 30% of their former maximums) this growth to half the peak values of 2007, will present only 66% return (0.5/0.3). There is quite a difference between 230% and 60% return, right? With our active investment approach BEF Fund already achieves great returns for you. Once the general stock indices growth in the region comes, the fund will generate much higher returns!

We firmly believe that very strong growth in stock share prices in Western Balkans is approaching. General belief in the region is quite the opposite. Situation is in a way similar to the one five years ago: majority was very loud about the end of the world and the collapse of the financial system, when actually a strong growth of U.S. and other Western stock markets began and is, though with minor corrections, still continuing. In spite of all Greek, Spanish, Irish, U.S. (e.g. budget lock) and other crises that still hit the headlines and were (and actually still are) trying to convince us that the end of the world and the collapse of stock markets is just outside the door. These were just triggering minor corrections, after which the stock shares prices again and again rose even higher. Even though the prevailing belief in the U.S. financial press in spring of 2009 claimed that stock shares are too expensive in respect of their operational results! Whereas dominant consensus in Japan in early 2013 was strongly negative, Japanese equities then averaged exceptional growth! And last, but not least is example of Slovenia within BEF Fund investment region: Contrary to negative forecasts and perceptions that were prevalent in both domestic and foreign media less than half a year ago, Slovenian SBITOP increased substantially!

For most of investors and advisors might be more comfortable and safer to keep to general consensus, but we should be aware that on the long term only a minority of investors that are able to think independently profit on stock markets (there are excellent books on this topic by legendary investor André Kostolany, or Le Bon’s: The Crowd: A Study of the Popular Mind).

Quite a lot of stock shares on markets of former Yugoslavia are now quoted at prices similar or even below (!) their value at the beginning of privatization. Now there is a total sale off at initial or even lower prices, but once again only a handful are investing. And after we will gain great returns, many will be complaining that they have missed their chance again. But by then it will be too late!

One of the key factors of the expected growth is a global context. Major world stock exchanges are growing for already 5 years now, since March 2009, despite all the panic and pessimism and minor intermediate corrections. We are now at the stage when due to extreme and long growth of large markets, more and more investors are seeking other alternative investments based on “what has not yet grown” and “is not yet expensive” and markets in BEF Fund investment region are one of the few in the world that still fulfil both conditions. Despite the fact that these markets globally suffered the largest drops since 2007, they have still not see any greater recovery since. So while an increasing number of global stock indices have grown over their former maximums, there are still some stock indices in former Yugoslavia at only about 15% of their 2007 peaks. Frontier markets, which also includes BEF Fund investment region, have long lagged behind major stock exchanges of both developed and emerging markets. However, in 2013 frontiers markets have on average recorded very good returns, despite the poor conditions in major emerging markets. This reflects the fact that the capital began to flow into frontier markets. It is expected that 2014 will also be good for these markets, as more global capital will flow into them. Within the entire group of these markets, region of former Yugoslavia offers the greatest opportunities, as shares in the Western Balkans the most undervalued within the entire group of frontier markets. Bulgarian Stock Exchange index has already grew 128% from its bottom, while common index of Baltic Exchanges by as much as 240%!

Recapitalisation process of Slovenian banks is of great importance as it has already significantly reduced uncertainty and has strengthen the financial stability of Slovenian banking sector. This is already reflected in lower deposit interest rates in banks. Due to immense influence of interest rates on liquidity, as already explained in our previous newsletters, this will have a strong positive effects on regional capital markets. First in Slovenia and then followed on all stock exchanges in BEF Fund investment region.

With low returns on bank savings, more and more money will move to stock shares, either directly or through investment funds. Values of shares in Slovenia are already growing, and eventually investors will once again begin looking for alternative investment opportunities in the neighbourhood, based on “what has not yet increased?” principle. As already mentioned above, growth in southern countries will be much higher than in Slovenia and Croatia. Croatia constantly holds the highest valuation of stock shares comparing to other countries in the region (not meaning that it will not grow higher, of course), thanks to Croatian pension system that, as the only one in the area of former Yugoslavia, ensures small but constant flow of pension savings on Zagreb Stock Exchange.

It is essential that the whole BEF Fund investment region is imperceptibly but surely approaching full membership in EU. The recent victory of Serbian Progressive Party (SNS) in Serbia, will certainly facilitate and accelerate this process. The fact that a strongly pro-European SNS won with an absolute majority, will certainly accelerate the adoption and implementation of the necessary reforms and privatization. This will be also be a powerful motivation and an example for other countries in the region: Bosnia and Herzegovina, Montenegro and Macedonia.

At this point we would like to present our view on protests that we have recently witnessed in Bosnia and Herzegovina and have caused some concerns to some of our investors. These concerns are needless! Let us emphasize that 2014 is election year in Bosnia and Herzegovina, as in October there will be elections on both national and regional level. As usual, political rhetoric exacerbates every four years in pre-election period. From our past experience we expect that even tougher tensions are still to come, probably in summer and/or early autumn. By that we primarily think on strengthening of nationalist rhetoric. Last protests do however not come from interethnic conflicts, but from a political confrontation within the Bosnian (Muslim) nation. If anybody thought that it was a spontaneous reaction of the street, we again recommend reading Le Bon’s The Crowd: A Study of the Popular Mind (“the masses are always guided or directed”). Similar situation were the protest in Slovenia a year ago. Once the government changed, the protests were over… We therefore expect a national outbreak of tensions with possible secession forecasts of Republika Srpska, the requirements of Croats to form a Croatian entity or Bosnian counter tendency for greater centralization of the country. But strictly on verbal level! The recipe is already known and applied every four years, as this kind of rhetoric is still attracting voters and was even repeatedly advised to Bosnian politicians by U.S. political campaign advisers. Similar concerns were actual four and even eight years ago. Alike than discussions will again remain only on verbal level and all the worries are excessive! Bosnia and Herzegovina is actually an international protectorate, led by the international community, with the assistance of international security forces.

Local politics are very well aware of who has the last word and what and to what extent they can afford, to maintain their positions and privileges (and are even paying large sums to lobbyists to retain enough positive image in Washington and EU). It is expected that the West will continue to pay more commitment to Bosnia and Herzegovina to achieve the implementation of key political and economic reforms necessary for accession to EU. EU accessing of all countries of former Yugoslavia is certain and it is irreversible process. Tensions between West and Russia due to Ukraine crisis will only accelerate this process as EU and U.S. will be even more motivated to increase their influence in “peripheral” European countries (for illustrative purposes we can remember how fast Romania and Bulgaria were accepted to EU few years ago, due to similar reasons, although they were far from fulfilling all EU acceptance conditions that were required from other countries). However we can still expect Russia to sweeten the relations with the region, which can only benefit from that.

With EU accession there will be a lot of European funds and other foreign capital inflows into the region. Besides encourage number of infrastructural investments this will also raise economic growth, number of acquisitions and mergers and further domestic and foreign investments in the securities in the region. Due to harmonization with EU legislation legal certainty and institutional framework for business and investment will constantly improve. All this will contribute to significantly higher value of companies and consequently a higher market valuation of securities.

As conclusion to all above stated facts we believe that there is a major Western Balkan markets growth ahead. Undervaluation of stock indices and shares from Western Balkan is obvious and huge! As past experiences show, it might soon be too late to participate in most excellent returns. Due to presently still low liquidity in the region, market will perform with at least 50% – 100 % return before majority of investors will get aware of that and probable even more before they react to it. The longer decay, the stronger will be the growth. History of stock exchange markets undoubtedly showed with numerous cases that the longer the market persists downwards, the stronger is than the growth, once the turnaround happens (eloquent the case Athens Stock Exchange)

Time to invest is now! Once Western Balkans will be on front pages it will be too late! By then you will reap superior returns!

Kind regards,

Your Balkan Emerging Frontiers Fund

Phone/fax +41 22 518 02 39

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