Avoiding Corruption in Investing

While avoiding direct military engagement with Russian military forces, governments around the world have enacted a variety of sanctions that have significantly harmed Russia’s economic circumstances. Russia’s stock market has been closed since February 25, 2022. Russia has generally been included in emerging markets indices. If you wished to invest in U.S. dollars, then you can also find ETFs that focus on Russia specifically. Firms that provide funds that invest in these indices have essentially written off their positions in Russian equities as there is simply no way to trade them.

 

While it is generally good advice to diversify your investments broadly around the world, both as a risk reduction measure and to capture gains wherever they occur, sometimes investments in certain areas just need to be avoided. That’s part of the argument put forward by ESG investing, although the tendency is to focus more on the corporate level when assessing the Environmental, Social, and Governance criteria. Should one invest in a company that is domiciled in a country known for violent conflict, political corruption, and/or lack of freedom?

 

A year or two ago, I came across a podcast interview with Perth Tolle. Ms. Tolle is the founder of Life + Liberty Indexes, an index provider and sponsor of the Freedom 100 Emerging Markets ETF. Born in China, she was raised in the United States after age 9. Part of her career was spent in both Hong Kong and Beijing. Thanks to this exposure, she developed new understandings of the connection between freedom and the performance of the securities markets. Eventually, she developed her index and the associated ETF, with the ticker FRDM.

 

Focusing on a single ETF is not the way I usually write a blog post. Nevertheless, I think there is a certain value in appreciating what Ms. Tolle has done here in developing an index that weights investments in the Emerging Markets by certain freedom metrics.

 

Freedom Index Criteria

Investment Philosophy

Freedom-weighting

Quantitative personal and economic freedom metrics are primary allocation drivers in their investment process.

Top-down approach

Because governments are best positioned to protect freedom, freedom metrics are most effectively captured on the country level.

Comprehensive freedom metrics

Freedoms are interconnected. Civil, political, and economic freedoms work together and should be measured as a composite.

Ex-SOE (State-Owned Enterprises)

State-owned enterprises are less efficient than private companies, even in freer markets.

Freedom makes better markets

Freer markets grow more sustainably, experience faster recovery, and use their labour and capital more efficiently.

 

Quantitative Freedom Metrics

Instead of the Environmental, Social, and Governance (ESG) criteria that we have become increasingly aware of in recent years, Ms. Tolle’s index focuses on criteria concerning Civil, Political and Economic freedoms.

Civil

• Violent conflict
• Internal organized crime
• Terrorism
• Trafficking
• Disappearances
• Detainments
• Torture
• Women’s freedoms

Political

• Rule of law
• Due process
• Judicial independence
• Plurality of political parties
• Corruption and transparency
• Freedom of movement
• Freedom of expression
• Freedom of religion
• Freedom of the press
• Freedom of assembly
• Freedom of association
• Internet freedom

Economic

• Legal system and property rights
• Sound monetary policy
• Freedom to trade internationally
• Business, credit, and labor regulations
• Level of government interference in private markets

 

Cautions?

I must admit that it gave me some pause to read that the data this index uses comes from the Fraser Institute and the Cato Institute, Canadian and U.S. think tanks, respectively, with decidedly libertarian streaks to their philosophies.

 

None of the research used by the index, however, seems to be advocating for the elimination of public healthcare, public schools, or laws regulating the ownership and use of firearms.

 

Holdings

The clearest way to see the difference between FRDM and any other emerging markets fund is to compare the holdings. IEMG, which is one of the largest U.S.-domiciled ETFs in the Emerging Markets Equity category, has significant holdings in China (including Hong Kong), Russia, and Saudi Arabia, three countries that are unfortunately rather well-known for their disregard for the lives of those who get in the way of their rulers.

 

Other countries that do not find their way into FRDM’s holdings but are in IEMG include Colombia, the Czech Republic, Egypt, Greece, Hungary, India, Kuwait, Peru, Qatar, Russia, Saudi Arabia, Turkey, and the United Arab Emirates. I will admit to not being fully aware of why they are excluded from FRDM’s holdings. Remembering their investment process, they appear to follow the same number of emerging market countries at 26, but they next apply a country-level market capitalization screen. A country with a relatively small stock market may be excluded for that reason alone. Only then do the unique screens of FRDM get applied.

 

Below is a table of the top ten holdings of FRDM compared with IEMG. In addition, I added the holdings of EMXF, the iShares ESG Advanced MSCI Emerging Markets ETF to see how it compares.

 

Notable exclusions from the Top Ten in FRDM are China and India, the two largest countries in the world by population, both of which are prominent in IEMG and EMXF. Notable inclusions in FRDM that are not in the Top Ten in the other ETFs are Chile and Indonesia.

 

Below is a YTD (Year-To-Date) chart of FRDM compared to IEMG and EMXF. While I would not want to make too much of less than three months of data (this is being written on 2022-03-14), FRDM is doing relatively better than either the core or ESG-oriented ETFs. Perhaps the most valuable thing to observe in this regard is that there is a meaningful difference in the way FRDM is constituted.

But it’s a U.S.-domiciled ETF

I have written elsewhere that, for simplicity’s sake, you might wish to avoid investing in U.S.-domiciled ETFs. Still, there may be sound reasons for investing in FRDM or other securities that trade in U.S. dollars despite the complications of currency conversion, tax inefficiencies depending on the account type, or estate tax filing obligations. Right now, when Russia is pummeling Ukraine, you might feel one small way to express your solidarity with the Ukrainians and other countries around the world that are being subjected to violence and threats of violence is to invest in funds that do not and will not invest within belligerent countries.

 

Investing in a well-diversified portfolio is almost always the advice I would give to someone whose personal financial circumstances indicate that investing is the right thing to do for them. Sometimes, however, it may be better to narrow the scope of that diversification.

 

 

This is the 139th blog post for Russ Writes, first published on 2022-03-14.

 

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.

 

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