The primary focus of most investors is generating returns. And that certainly makes sense given that we all have future goals we are trying to attain, and our portfolios are the major tool we have to achieve them. In recent years, however, there has been another goal that has been rising in importance. Many investors now also want to use their portfolios to express their values. They want to use them to help produce positive change in the world. They want to use them to do good.
ESG investing has been the source of significant debate within the investing community in recent years. No one debates that giving investors a choice to invest in ways that are consistent with their values is a good thing. But some argue that this type of investing comes at the cost of reduced returns, while others believe that investors can do good while maintaining or even enhancing their returns.
In this week’s interview, we are speaking with Perth Tolle of Life and Liberty Indexes. Her research has shown that when it comes to emerging markets, investors can both do the right thing and potentially enhance their returns. She has developed a factor-based approach that ranks countries based on their level of human and economic freedom and then uses that to build investable indexes. The first index she developed, the Life and Liberty Freedom 100 Index, is the basis for an ETF that was issued by Alpha Arhitect a few weeks ago.
Jack: Thank you for taking the time to talk to us.
One of things I found very interesting about your research is that you have been able to take concepts like human and economic freedom that are typically mostly qualitative in nature and have been able to reduce them down into a quantitative system that selects the countries represented within your index. Can you talk about the factors that are most important in selecting countries that represent the principles of human and economic freedom you follow and how you were able to turn them into the quantitative factors that you use to build the index?
Perth: Thank you for having me.
Yes, the lack of quantitative freedom metrics was the biggest challenge in the beginning of the project. At first, we created our own system of quantifying the many types of qualitative freedom metrics out there, using ordinal scales. But that system would take us about 4 months each year to score all the countries. Thankfully, around the same time I officially started Life + Liberty Indexes, the Fraser Institute, Cato Institute, and Friedrich Naumann Foundation for Freedom got together for a joint project where they quantified freedom variables and combined them to derive a composite score for each of about 160 countries. I had already been using Fraser’s economic freedom data set as one of my inputs in the system we created, so I compared notes with them and found that our two systems were very similar. We now use the composite country scores from their Human Freedom Data Set, a comprehensive measure of 79 human and economic freedoms, as our country level freedom metric. They cover both personal (civil, political) and economic freedoms, or what I call the rights to life, liberty and property. Examples of rights to life variables include disappearances, internal organized conflict, homicides, and 5 proxies for women’s rights. Rights to liberty example variables include rule of law, freedom of movement, freedom of expression, and freedom of assembly and civil society. And rights to property variables include size of government, legal system and property rights, sound monetary policy, freedom to trade internationally, and business regulations. We use each country’s combined freedom score derived from all 79 variables to drive country selection and weights. Life + Liberty Indexes is completely independent from the scoring organizations and they do not endorse any investment product. Using Fraser, Cato, and Friedrich Naumann’s country scores with permission gives us quantified freedom metrics with third-party objectivity and a fully transparent scoring methodology.
Jack: The rise of ESG type strategies has led to a lot of debate within the investing community about the balance between doing good and optimizing returns. From your research, it seems that in Emerging Markets it is possible to do both simultaneously since the countries with the highest levels of freedom also tend to produce the best returns. Could you talk about the work you have done in this area and why you think increased freedom leads to better performance?
Perth: In emerging markets, there are huge discrepancies between freedom levels from one country to another. Whereas in developed markets, they are all fairly homogenous as far as protections for human and economic freedoms; and arguably, it’s these protections of individual rights and rule of law that has provided the foundations for their development over time. So it’s not optimal to weight emerging markets the same way as developed markets. Based on history, we know that countries with more reliable freedom protections have done significantly better than those that don’t. Our research shows that freer countries experience more sustainable growth, faster recoveries from drawdowns, and more efficient use of human and economic capital. Over the long term, we would expect alpha from this naturally occurring growth trajectory in the freer markets, but of course that’s not guaranteed. We are providing a differentiated exposure that is freedom-weighted, which mitigates the concentration risk present in market capitalization weighted emerging markets indexes, and in the long run has the potential for outperformance.
All that being said, there is also a behavioral element to freedom investing, where if you invest according to your values, you have better chances of sticking with that investment when things (markets) are rough. As you said in your blogpost in Feb 2018, “The most important thing about investing is often not what you invest in, but how much you believe in it. The reason is that conviction is what allows you to stick with your plan when times get bad. If you begin to question your investment approach during periods of market decline and volatility, then you won’t stick with it. If you don’t stick with it, you won’t achieve your goals.” I created this index for people who believe in freedom to have a way to express those values in their investment allocations. And for those people, I believe it will lead to better returns through this behavioral factor, and they will have better chances of achieving their investment goals.
Jack: Corey Hoffstein of Newfound Research often talks about how the most challenging aspect of building portfolios can be taking all the ingredients (the factors) and combining them all together into a recipe. Decisions like how to combine the factors you use together, how many countries and stocks to include in the final index and how to weight the positions typically play just as big a role in determining future returns as the factors that are used to build a portfolio. Can you talk about how you use the factors you follow and combine them together to form your index?
Perth: This index was constructed with the primary goal of representatively reflecting the markets in each of the included countries, in a way that maximizes tradability. One thing that’s different about the way we combine factors is the ordering of country vs. security weighting. Unlike most other EM indexes, where security weights drive country weights, our country weights drive our security weights in a top-down approach. We isolate the freedom factor on the country level, and on the security level, we use market capitalization weighting excluding SOE’s, to bring the economic freedom theme all the way through. So the security weighting happens within their respective country weights. We do it this way because freedom levels are best measured on the country level, as governments are best positioned to protect freedoms, not companies. As far as how many countries we include – the algorithm determines the number of countries included. In the two years of live history of this index, it’s been 10 countries every year, but it’s not capped that way. It can be 9 or 11 countries in any given year. The securities are capped at 10 per country.
Jack: I have found that using some real-world examples can be a good way to better illustrate how many factor-based indexes are constructed. Could you talk about one country that is currently in your index and one that is not and how the factors you utilize can be used to differentiate them?
Perth: India was barely included this year, and Brazil was barely excluded. These countries are ones to watch in coming years and make some interesting case studies.
Brazil is one I did not expect to ever not be in the index, because it’s such a bedrock of emerging markets indexes. But our data source, the Human Freedom Index and Data Set, is a very comprehensive measure of freedom, the most comprehensive that I have found. The others out there either measure only political freedoms, or only economic freedoms. As an example of the comprehensive nature of our data source, it is the only freedom data set that takes into account personal safety and security. According to the authors, if you can’t walk down the street without fear of getting killed, you’re not really free. Brazil, with some of the highest homicide rates in the world, saw a lower safety and security score due to scoring “0” out of 10 in the sub-variable of “homicides,” the worst possible outcome. This, combined with their new political climate, will probably keep them on the cusp of exclusion, or possibly continued exclusion.
India, on the other hand, was barely included in the index this year. Being the world’s largest (by population) democracy, it’s hard to imagine India not being in the index. Yet, they came very close to exclusion due to their trade barriers. One of the economic freedom variables is freedom to trade internationally, with sub-variables including tariffs, non-tariff trade barriers, and freedom of movement of people and capital. India scored very low on these, and that brought their composite score to lower than that of the somewhat surprising smaller regional markets of Indonesia and Thailand. If economic freedoms weren’t considered, India would have scored similarly to the Thailand and Indonesia. This is another feature of using a data provider that produces such a comprehensive freedom metric. One of the original authors of the economic freedom index and data set, Jim Gwartney, compared the various components of freedom to the parts of an automobile. A car cannot run without all its parts working together. A car with a steering wheel but not a transmission, does not run. That’s why it’s important when measuring freedom to take a comprehensive approach.
Jack: Once you select the ten countries that are in your index at any given time, you are including the largest stocks within each country to get to the 100 stocks it contains, which seems sensible since it gives you the most exposure to each market as a whole. I noticed that Rob Arnott is one of your investors and you are working with Alpha Architect to bring your index to market, both of whom are well known for their work on factor investing. Will you consider using factors like value and momentum and quality in the construction of your indexes in the future? Have you looked at applying these factors to emerging markets and whether it can help to enhance returns?
Perth: Originally, in the first version of the freedom-weighted EM index, I mixed the freedom factor with valuations and yield. But based on further consideration and feedback from interested investors, I stripped the strategy of everything except freedom. Now I’m working with some of the best factor quants around, and I am open to applying those factors in the construction of future indexes. For the first index, I wanted to give the freedom factor a chance to be tested in the market on its own. Freedom-weighting is the main innovation here, and I didn’t want to dilute the theme with the first one. But I agree, the possibilities are endless for additional versions of the index where freedom is mixed with other factors.
Jack: Thank you again for taking the time to talk to us today. If investors want to find out more about you and you and Life and Liberty Indexes, where are the best places to go?
Perth: The index website is lifeandlibertyindexes.com. I am on Twitter @perth_tolle. And I am on LinkedIn. Thank you for having me!
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