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Freedom Factor Blocks China

Lara Crigger
Perth Tolle

Last week, Bloomberg reported that the Trump administration was considering limiting American investors' access to Chinese securities, possibly by capping indexers' ability to include China stocks in their indexes or by restricting government pensions' ability to invest in China securities.

Though the likelihood of such restrictions is small, if they did come to pass, they could potentially disrupt billions of U.S. investment dollars, including those tied not just to China A-share stocks but to broader emerging market indexes and products. Investors would need methods of investing in emerging markets without exposure to China.

Several products out there do just that, including one socially responsible ETF that launched earlier this year: the $12.7 million Alpha Architect Freedom 100 Emerging Market ETF (FRDM). FRDM weights its countries based on more than 75 metrics evaluating a country's "freedom levels," such as the amount of violent conflict it experiences, the freedom of its press and judicial systems, and how freely its citizens can access capital (read: "Freedom Weighted ETF Debuts").

We recently spoke with Perth Tolle, founder of Life + Liberty Indexes and sponsor/indexer for FRDM, to get her take on ex-China emerging markets investing.

ETF.com: Setting aside the question of whether restricting investment into foreign companies is something a U.S. president can do, is it something a president should do?

Perth Tolle: In this case, I think [President Trump] may be responding to reports from the Wall Street Journal about how China interfered with MSCI and threatened their business in China to get them to include more [China-based] A-shares in their indexes. But just because another country that may not have our democratic norms interferes in private business doesn’t necessarily mean that's something we should do as well.

The good news is that we don’t have to. We already have a free-market solution for the problem they're trying to solve—which is that there's a lot of China in these emerging market indexes. That's a function of market capitalization weighting. China has more than 30% in basically all the popular emerging markets indexes that are cap-weighted.

By using freedom weighting instead, we solve the problem of overexposure to a single country. Not only does that help with concentration risk, it avoids the other risks of investing in unfree markets.

ETF.com: Such as … ?

Tolle: When you're invested in unfree markets, you're dealing with the whims of an autocratic government. So, they can shut down companies at will; they can nationalize them. They can restrict your expression, or your movement, or movement of your employees in or out of the country. They can restrict capital flows. You're also dealing with inefficiencies in the way things are run, because of central planning.

Freer countries tend to have more sustainable growth. They tend to recover faster from drawdowns, because they're freer to innovate. And they tend to be more efficient in their capital and labor.

ETF.com: You say freer countries have more sustainable growth, but what about China? It's been growing for, what, a decade and a half now. There are some signs of slowdown, but certainly not stopping.

Tolle: Yes, the growth in China has been pretty phenomenal. But investors overseas haven't been able to take part in that growth as much as they would have had China been a completely free country with the investor protections afforded by some of these freer markets.

ETF.com: There are a few emerging market index out there that don't have China in them, yours included. How does weighting countries by their freedom level compare to these other ex-China benchmarks?

Tolle: So, if you just want to cut China out of your emerging market index, there's the MSCI Emerging Markets ex-China Index. [Two ETFs track this benchmark, the $28.6 million iShares MSCI Emerging Markets ex China ETF (EMXC), and the $2.4 million KraneShares MSCI Emerging Markets ex China Index ETF (KEMX)].

There's also another one by what used to be Emerging Global Advisors, which was bought by Columbia Threadneedle. They now have an ETF based on that, too. [The index is the Beta Thematic Emerging Markets ex-China Index, tracked by the $11.5 million Columbia EM Core ex-China ETF (XCEM).]

The difference between the Life + Liberty Freedom 100 Emerging Markets Index and these other indexes is that we're not just killing China out of the index as our part of our objective. Our objective is to give freer countries a higher allocation. So we also don’t currently have Russia, Egypt, Saudi Arabia. We’re not “ex” any particular country. We hope all these countries become free enough to be in the index.

But ultimately, the correlation between these indexes [and to the vanilla benchmark] is high, because instead of China, we hold high allocations in Taiwan and South Korea, which are countries highly correlated to China. You'd expect the correlations to be pretty high.

So you don't lose anything by going ex-China, and you don't lose anything by going freedom-weighted. It's a form of expression for investors. If you want to express your values through your portfolio, this is one way to do so.

ETF.com: What’s something you see going on in emerging markets right now you think investors are overlooking?

Tolle: There are some frontier markets that are very close to becoming emerging that are under-noticed. It would be interesting to create a product off them, though it would be hard to do, because they're not as tradable and liquid. Size of market is an issue. Still, there are some very free frontier markets, and others that have made a lot of strides in increasing their freedom levels.

Some of them are post-communist countries, like Estonia. Vietnam, too.

ETF.com: Vietnam feels like it's been on the cusp of moving up to emerging for a long time.

Tolle: Yes. Also, I think maybe the some of the classifications could use an update—which countries are emerging, which are developed. That would be interesting to see an update on.

ETF.com: FRDM has been on the market since May. What’s one thing about running an ETF that you didn't see coming?

Tolle: There are a lot of things, actually. Even back when I had only the index, it was very low pressure. When you just have an index, people say to your face, "Oh, this is awesome!" but you don't know if they're actually going to invest.

Now that it’s launched, we've seen waves of grassroots interest. If you look at our trades, many of them are in 100 shares, round lots. And there are just a lot of them. That grassroots retail support we've had, I so appreciate.

I know that, over the long run, historically, freer countries do better. You see it over and over.

Contact Lara Crigger at lcrigger@etf.com

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