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With a 6% year-to-date return (through May 23), iShares MSCI Austria ETF (NYSEARCA:EWO) is the top-performing iShares European stock ETF thus far in 2008.

But EWO, and the so-called “Alpine Tiger” economy, is no short-term story. The fund also ranks No. 1 among all continental stock ETFs over five years, with a 30.5% annualized return, and No. 2 for three-year returns, at 22.9%. The reason isn’t so much related to Austrian growth but to successful expansion by the country’s largest banks, telecom firms, and other companies into the formerly communist lands of eastern Europe.

Financial Times columnist Haig Simonian recently wrote, “no one outside Vienna’s First District may care about the Austrian domestic market but the growth potential of Czech Republic, Hungary or Slovakia, to name but three, has been a powerful draw.”

Those countries, and others from the old Warsaw Pact, helped boost many Austrian stocks in recent years. EWO’s NAV grew from $10.70 in May 2003 to $41.36 in April of 2007. And now, a three-month gain of 17.6% has EWO back above $39 per share after a weaker 2007.

Investors, it seems, see hope for a new round of major success stories, this time in central Europe. Many top Austrian companies—all key players in EWO’s top-heavy, 36-stock portfolio—are now expanding into the under-developed economies of the former Soviet bloc.

No. 1 EWO holding Erste Bank, the country’s largest bank by assets, makes up 16.8% of the fund. The firm recently reported strong first quarter earnings, citing higher home and auto loans in Romania and the Czech Republic, plus its new credit-card business and banking branches in Serbia, Ukraine and Croatia. In fact, 81% of Erste’s profit came from eastern Europe, with no signs of slowing down: Erste said profit will grow at least 20% in 2009, forecasting 25 percent earnings growth.

Banks are a big part of EWO’s stellar returns: More than 40% of the fund’s assets are in financial stocks, including Erste Bank and no. 5 holding Raiffeisen International (5.4%), the country’s biggest bank by market cap. But there’s much more to the fund’s success. The Austrians, according to a BusinessWeek headline, “are retaking the Balkans.”

Vienna-based OMV (OTCPK:OMVKY), the fund’s second-largest holding, is central Europe’s largest oil and gas supplier. It’s modern filling stations, with sit-down restaurants, are such a novelty in Bulgaria that people have staged weddings in them, according to BusinessWeek.

No. 3 holding Telekom Austria’s (OTCPK:TKAGY) investment in emerging Europe has allowed the firm to increase sales more than 20% since 2004, largely through its mobile subsidiary, Mobilkom Austria. As with other firms in other industries, Telekom Austria finds eastern and central Europe highly lucrative. For example, the company has operating margins as high as 58% in Bulgaria.

If expanding into the fledgling economies of central and eastern Europe seems like a no-brainer, BusinessWeek points out that it hasn’t been as easy for companies from other countries. Dutch telecom giant KPN sold its stake in a Czech competitor in 2003, after it struggled to work with the nation’s government, the majority owner.

“The Austrians know that region better than other people,” KPN CEO Ad Scheepbouwer told the magazine. “It’s been their backyard for hundreds of years.”

Austrian firms took risks in the Warsaw Pact nations, but were careful to limit their exposure. Erste Bank, for example, bought state-owned banks only with the proviso that it could refuse problem loans. OMV, meanwhile, probes new territory with filling stations, before spending more on say, refineries.

EWO’s recent gains indicate that some investors believe Austrian firms can do the same in former Soviet markets, such as Belarus, Kazakhstan, Albania and Romania.

EWO moved rapidly up our ETF Momentum Tracker International Momentum Table over the six weeks leading into Memorial Day, rising from No. 31 in mid-March to No. 8 last week.

Beyond its big stake in financials, EWO invests heavily in industrials, energy and materials stocks, which combine to account for more than 40% of assets.

The fund handily beat the MSCI EAFE Index Fund (NYSEARCA:EFA) (Europe, Australia, and Far East) from 2001 to 2006, four times ranking among the top 1% of European stock funds. That outperformance came to an end in 2007, but the fund holds an 8.6% edge on the index thus far in 2008.

EWO could be an unconventional play on emerging markets, avoiding Asia and South America, with the potential of big gains with less risk. The fund’s three-year standard deviation of 17.14 indicates less volatility than the iShares Brazil ETF (NYSEARCA:EWZ) (29.96), for example.

That said, potential investors should be aware that EWO carries significant risk, due to its single-stock focus, its emphasis on financial stocks and its exposure to struggling and under-developed economies. Measured by standard deviation, it remains about twice as volatile as the S&P 500.

Source: iShares Austria: Exposure to Rapid Growth in Post-Communist Europe