Why Mongolia and Sri Lanka are top of the stock markets

One exchange is the world's smallest, the other is in a country recovering from war, but they're both thriving

If you had invested in a tracker fund at the start of the year, which of the world's stock markets would have done the most for your pound? China, or somewhere nearby? How about one of the resource-rich economies of Latin America, growing fat on the commodities boom? The answer is none of the above (and you would have lost money in China, where the rather overheated stock market went into a sharp reverse). No, the winner of this year's stock-market crown is the Mongolian Stock Exchange in Ulan Bator, although resources are largely the reason for its victory. Opened in 1991, the world's smallest stock exchange by market capitalisation has gained a stunning 187 per cent so far this year (in sterling terms), and a still impressive 136 per cent when measured in the local currency, the tugrik.

However, actually investing a pound there is something of a challenge. According to data from Bloomberg, this year's best-performing stock market, to which you could more easily gain some exposure, has been that of Sri Lanka. Had you invested a pound in the Colombo market at the start of the year, your money would have turned into £2.07 at the close of last week. Investors in the local currency, the Sri Lankan rupee, saw their money increase by 92.3 per cent.

How has the island nation pulled it off? Well, an end to years of strife between the country's government and the independence-seeking Tamils in the north and east has helped. In May 2009 government forces crushed separatist rebels, bringing to a close four decades of ethnic tensions that the United Nations says may have cost up to 100,000 lives.

Although the aftermath of the war was messy, and the island still has many issues to deal with, the stock exchange in Colombo immediately benefited, rising 128 per cent in 2009 as investors poured in. And this year it put in a repeat performance. A booming IT sector – the London Stock Exchange (LSE) is a prominent investor, having bought the Sri Lankan technology company MilleniumIT in September last year – and its proximity to booming South-east Asian economies such as India and China, have provided a lot of the impetus, as have government privatisations and a rash of other flotations.

"We have between 60 and 75 initial public offerings lined up for next year. That includes five state entities and 35 finance companies," said Malik Cader, director-general of the Sri Lankan Securities and Exchange Commission, earlier this month. Xavier Rolet, the chief executive of the LSE, also talks enthusiastically about what he has bought. War is supposed to be good for business. Peace is much better, but a bit of democracy wouldn't go amiss; just think how high the country could fly then.

Other than Sri Lanka, the resource-rich economies of Latin America came heavily into play among this year's top-performing markets. Peru and Chile were stars, Argentina, one of the continent's two heavyweights alongside Brazil, also did well, as did Colombia. That has to be put in context: there is an element of bounce-back after the dark years of the recession. All the same, putting a pound into tracking these markets at the start of the year would have produced a more-than-healthy return.

Bill Dinning, head of strategy at Aegon Asset Management, says: "These markets are very much resource plays. We've seen a boom in the prices of industrial metals, and precious metals have also done very well. And there is some support for it still. The outlook for economic growth in 2011 has improved, in the US, in Germany and even here.

"I think we are still playing that game and that will sustain parts of the commodity complex that fuels the markets of these countries. The one thing to watch for is whether the energy complex joins in the bull market. Gasoline is up 10 per cent this year and crude oil has averaged the second-highest price since 2008. That would actually be a worry and a break on growth."

Two other stellar performers, the Thai and Indonesian stock markets, both play into the Asian economic boom, which has continued despite the weakness of Europe and the US, driven by China.

Thailand has not been without its challenges, not least the continuing political instability which led to protests earlier this year. But concerns that this could derail the economy's recovery have proved unfounded. Consumer spending has been on the rise, export growth is strong, and one of the factors that could hamper this – inflation – has remained relatively low.

Elections are expected to be held towards the end of next year, and a repeat of the recent unrest cannot be ruled out, but fund managers say Thailand's equity markets remain cheap and should continue to perform strongly throughout 2011. A word to the wise: peace is good for business. Just look at Sri Lanka.

Robert Quinn, the chief European equity strategist at S&P Equity Research, explains the attraction of the emerging markets, whose stock exchanges have done so well. He said: "We've seen a real acceleration of the global industrial cycle in the latter parts of this year. A lot of money has come out of equities in developed countries and towards emerging markets, which offer a better risk-return profile than other assets at the moment."

One of the important factors to consider when looking at markets is currency – if you look at how markets performed in terms of local currency, as opposed to how they would have performed if you had invested a pound, you get different results. The euro-denominated market in Estonia, for example, has performed exceptionally strongly: it is up 72 per cent in local currency terms. However, in sterling, it has produced a slightly less impressive 65 per cent rise. This is because of the euro's weakness against the pound (and just about every other currency). Elsewhere, sterling's weakness helps inflate returns.

Mr Quinn says: "As for the Baltic states such as Lithuania and Estonia, they took a lot of the adjustment in wages and public spending early, when compared to their counterparts in some of the other weaker Eurozone states on the periphery. Of course, Ireland took an early hit, too. The problem there was that it didn't sort out its banks."

Jerome Booth, head of research and co-founder of fund manager Ashmore Investment Management, says of the markets: "Emerging markets generally should be trading at a premium to the developed world. Inflation, not deflationary pressures, is the main risk, but it is controllable. You have very strongly growing economies without the downside risk of the developed world.

"South-south trade and investment has taken off," Mr Booth continues. "Central banks have started to buy each other's reserves so they are weaning themselves off the old system. There is vibrant growth in investing and demand. This is where you find the bulk of land, people, energy consumption and production. Not to invest in these places is bizarre, particularly when the big risks are at home."