Avoiding Autocracy Is Sound Investing

Earlier this month, I highlighted the Freedom 100 Emerging Markets ETF (CBOE:FRDM) and it's worth revisiting that nifty take on emerging markets equity investing again today.

The initial treatment of the exchange traded fund can be viewed here and it's certainly worth noting that FRDM is down just 3.62% year-to-date. No, losses aren't anything to brag about, but that data point confirms FRDM is outperforming both the S&P 500 and the  MSCI Emerging Markets Index, the latter of which is down 14.84% year-to-date.

That's impressive, albeit in less bad fashion. Still, it's enough to stoke curiosity regarding why FRDM is  so easily outperforming the emerging markets benchmark. A lot of FRDM's out-performance and potential to continue doing so over the long-term is attributable to, well, freedom. In client conversations, however, advisors need to hang their hats on more than catchy fund names.

Much of the allure of FRDM boils down to what the fund excludes, as much as what it includes – an important characteristic against the backdrops of geopolitical tensions, equity market volatility and sagging emerging markets performance.

Why FRDM Can Be Fantastic

FRDM is a prime example of an oft-used phrase in the world of ETFs: Methodology matters.

The fund tracks the Life + Liberty Freedom 100 Emerging Markets Index, which is a “a freedom-weighted emerging markets equity strategy using personal and economic freedom metrics as primary factors in its investment selection process,” according to the index issuer.

In other words, countries not known for economic and political freedom, think China and Russia, among others, aren't among FRDM's geographic exposures. That is to say the fund dodges stocks of companies based in autocratic countries and there's something to that investment strategy.

Countries with autocratic governments are often home state-owned enterprises (SOEs), or companies largely controlled by the state, and those firms have less-than-impressive track records of creating value  for investors.

“State ownership increases risk because politicians’ agendas don’t always align with investors’ interests. Corporations typically have a narrow objective of maximizing profits for shareholders, while governments’ responsibilities include resource security, foreign policy, and social welfare, to name just a few. Higher wages are likely good for workers and the local economy, but they crimp companies’ profits,” says Morningstar analyst Daniel Sotiroff.

Russia's invasion of Ukraine is a reminder of the risks of investing in countries with an autocratic form of government and now many of its SOEs are being booted from major emerging markets indexes. FRDM avoided that problem altogether and it does the same with China – an autocratic country that's almost impossible to skirt in traditional emerging markets funds. FRDM's exclusion of China, clearly advantageous, is relevant for another reason.

“Parallels are being drawn between Vladimir Putin's designs on Ukraine and China's long-running claims on Taiwan. China has also been cracking down on freedoms in Hong Kong and has been persecuting its Uyghur population. But China doesn't have to go as far as invading Taiwan to show investors the risks that come with investing in the country,” notes Morningstar's Tom Lauricella.

Autocracy: Avoid at All Costs

China and Russia are making it easy for investors to disavow emerging markets stocks. While that strategy may have near-term merit, it could prove faulty over longer time horizons.

Point is there's a right and wrong way of embracing stocks in developing. FRDM is availing itself to be one of the right ways. Funds that don't avoid autocratic governments are in the other camp.

Autocratic rule hasn't been in the investment spotlight for sometime. China changed that last year. Russia is reinforcing it this year and FRDM is standing out for all the right reasons, including what it excludes.

Related: Let Freedom Ring with This ETF