Freedom Factor Blocks China

October 03, 2019

Perth TolleLast 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. 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. 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. 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.

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