Investing

How the investment world is trying to promote 'freedom' in emerging markets

Key Points
  • China accounts for almost 32% of the MSCI Emerging Markets Index, but is excluded entirely from the Alpha Architect Freedom 100 Emerging Markets ETF (FRDM), which is sponsored by "freedom-weighted" portfolio provider Life + Liberty Indexes.
  • A recent study conducted by Marshall Stocker, vice president and head of country research at investment firm Eaton Vance, concluded that countries with a low level of economic freedom outperform their freer counterparts over a five-to-10 year period.

Investors are increasingly concerned about the impact of their money on the world, and the emergence of portfolios geared toward investing in freedom and democracy are one example.

As well as determining which factors contribute to varying levels of civil, political or economic freedom in emerging market countries, a key issue for fund managers and economists has been whether to allocate capital to countries with current quantifiably high levels of freedom, or those in the early stages of transition to open market economies and democracy.

China accounts for almost 32% of the MSCI Emerging Markets Index, but is excluded entirely from the Alpha Architect Freedom 100 Emerging Markets ETF (FRDM), which is sponsored by "freedom-weighted" portfolio provider Life + Liberty Indexes.

Russia and Saudi Arabia also miss out. The fund directs the highest proportions of its capital to Taiwan, South Korea, Chile and Poland.

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Life + Liberty Founder Perth Tolle told CNBC that the fund still permits indirect exposure to China. For example, it holds Naspers, which has a stake in Tencent, while Chile has significant trade ties to China.

"The happy accident here is that South Korea and Taiwan are the freest emerging markets in our universe so they have a very high weight in our index and those are highly correlated with China, so we get a lot of correlation without actually having direct China exposure," Tolle told CNBC via telephone.

"We do have indirect China exposure through trade and investments that other countries do with China, and we don't penalize those countries for that free trade."

Ed Smith, head of asset allocation research at Rathbones, contended that the development of South Korean and Taiwanese economies owed some thanks to state intervention policies, and suggested that the academia had moved toward a focus on the direction of travel as the key driver of returns.

"The mechanism that led to South Korea's huge success, and also Taiwan, was quite frankly an authoritarian use of the state to raise the investible surplus, but directing it to the industries and firms important to the economy's ability to sustain higher wages in the future," Smith told CNBC.

"That led to much more rapid, intensive cycles of investment than perhaps a free market would have allowed for."

Predicting policy change

A recent study conducted by Marshall Stocker, vice president and head of country research at investment firm Eaton Vance, concluded that countries with a low level of economic freedom outperform their freer counterparts over a five-to-10 year period.

This is primarily due to the risk premium of investing in countries with low rule of law, large governments which impose high taxes and inconsistently applied regulations. Beyond the 10-year investment horizon, however, returns even out.

Stocker's team focuses on trying to anticipate policy change in specific countries during an investment horizon which will affect various asset class returns.

"What happens over a longer period than 10 years? They come along and steal your stuff, so all that profit you accrued gets stolen," Stocker told CNBC.

"It could be from outright theft, like what might be going on in Zambia today, it could be from monetization through hyperinflation — the Zimbabwe story — and lo and behold, those returns go back to being equal across the levels of economic freedom."

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With investors becoming more concerned with ESG (environmental, social and governance) factors, Stocker suggested that ESG is moving from version 1.0, which centered around negatively screening out countries with low levels of ESG, to version 2.0, which involves engagement.

"Here's what's encouraging — when countries increase economic freedom they have the salutary benefit of ESG gains," he said, adding that by investing in countries where economic freedom is increasing, investors become "missionaries" for ESG improvements.

The long run

Over a longer period, there is a broad correlation between equity markets and GDP (gross domestic product) per capita, according to Jon Harrison, managing director of EM macro strategy at TS Lombard.

"We find that there is a high correlation between GDP/capita and a small number of indicators, categorized as: Human capital, institutional & regulatory environment, trade liberalization and financial system development," Harrison told CNBC via email.

"We find that these are roughly weighted 40%/30%/20%/10% — so Human Capital is the most important."

In richer economies with a GDP per capita greater than 30% that of the U.S., this correlation breaks down, but for emerging markets it holds firm.

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"Undemocratic countries are able to make substantial progress on human capital without necessarily becoming 'free', but may come up against limitations as the level of wealth increases — for example, it may be more difficult to eradicate corruption in a non-democratic country," Harrison added.

The firm also found a high correlation between ESG factors and economic growth, with undemocratic countries able to make greater progress before reaching a ceiling.

"The important point about both our structural change analysis and our ESG analysis is that EM economies offer 'low hanging fruit' both in terms of economic growth and ethical improvement — which would seem to be a reason to invest in them," Harrison concluded.