Perth Tolle is the founder of Life and Liberty Indexes.
And she allocates over 50% of her hard-earned money to emerging markets.
Why invest in emerging markets at all?
Why invest overseas if the U.S. stock market has done so well? And what are emerging markets anyways?
We are answering all this and more in today’s interview.
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How to Invest in Emerging Markets and Why Most Are Doing it Wrong with Perth Tolle
Perth Tolle: My experience having half of my childhood in China and half in the US and then going back there and seeing how different my life would have been had I grown up completely in China versus my formative years being here in a more free society. That's what made me realize that freedom makes a difference and an impact in not only my life, but in markets as well.
Taylor Schulte: Welcome to the Stay Wealthy podcast. I'm your host, Taylor Schulte, and today we are talking about freedom. My guest is Perth Tolle and Perth is the founder of Life and Liberty Indexes.
She also sponsored an exchange-traded fund that was recently launched called the Freedom 100 Emerging Markets ETF. The ticker is FRDM, like Freedom for short, if you want to look it up. With her help, today we're going to be diving deep into the world of emerging markets. Here's the deal.
In my opinion, emerging markets stocks belong in a long-term diversified investment portfolio in a traditional 60% stock, 40% bond portfolio. My firm allocates close to 10% to emerging markets, so a million dollars retirement portfolio might have around a hundred thousand dollars in this volatile, often difficult to understand asset class, which is a meaningful position, but why invest in emerging markets at all?
Why invest overseas if the US stock market has done so well and what are emerging markets? Anyways, we're going to be answering all of these questions and more in today's interview. For all the links and resources mentioned in this episode, visit youstaywealthy.com/56.
I just shared in the introduction that I recorded that my firm allocates close to 10% to emerging market stocks in a traditional 60 40 portfolio, which is I think both you and I would agree that that's a meaningful position, but in your own personal investment portfolios, you allocate over 50% to this extremely risky asset class. So I'd love to just start there. Why do you personally take such a large position in emerging markets?
Perth Tolle: I think 10% is a very reasonable approach, and I would say that's a very good standard among strategic 60 40 portfolios. I commend you for having that allocation for your clients. My own philosophy for my own personal investing is buy cheap and hold for a long time.
So this is something that I think my partners at Alpha Architect would agree with as well. I would say the kings of that even more so than me, but I am investing for the long term and I believe emerging markets have favorable valuations and growth prospects for the long-term that more so than their developed market peers.
So yes, I am a very overweight emerging market at this time. I don't recommend that for everyone, but since I'm a very long-term investor, I'm okay with the volatility in that portion of my portfolio. And actually my daughter who has even longer timeframe has very overweight emerging markets as well in her portfolio, but her 529 is more diversified. I would add here though that I am biased.
Obviously I have an emerging markets strategy and a hundred percent of my emerging markets allocation is in that strategy. So I am investing in my own strategy here and is more biased than most people. So you take that with a grain of salt.
Taylor Schulte: And yeah, we'll dive deeper into that. Maybe first we can just break down really simply, what are emerging markets? I feel like sometimes when we talk about emerging markets, people's eyes glaze over. They're like, what is that? So what is an emerging market and what makes a country an emerging market?
Perth Tolle: So an emerging market is what you would think of traditionally as third world countries. So it was actually a term coined by a world Bank economist in the eighties to replace a fund that invested in third world countries.
The reason why they call it emerging is because they're typically countries that are coming out of autocracies or more autocratic types of governments into a more market economy with more developments in their institutions, their economic freedoms, and just rising share of global output.
Taylor Schulte: And so what would be a few examples of emerging market countries that most of us would know?
Perth Tolle: So some common emerging markets that we all know about are the brick countries. So Brazil, Russia, India, China and South Africa are probably the most common. So because we're familiar with bricks, we think of those as emerging, but some of the less well-known emerging markets are countries like Chile or Poland, Malaysia and so forth.
So some of those markets may not be as well-known, especially in the more commonly used indexes, but probably the most well-known emerging markets are China, India, Brazil, and Russia.
Taylor Schulte: And you mentioned Brix, which is an acronym BRIC. So if anyone wants to look that up, you can go just type in brick into Google and learn more about that. Why do you think someone would ever want to consider even a small position, let's just say 5% of their investments, why would they even want to consider a small position in emerging markets? What do you see as the benefit or the opportunity for allocating some money to that asset class?
Perth Tolle: There's a few benefits and opportunities here. So one is diversification. You're lowering your overall risk by diversifying to these markets that are different fundamentally than the developed markets.
So some of these markets are growing their middle class, they have more of a consumer culture, and their demographics are a little bit better than you see in most emerging markets. I mean most developed markets, the exception there being China, who has the worst demographics in the world.
But in most of these countries, like Indonesia for example, and some of these other bigger frontier markets, smaller emerging markets like Vietnam, they're a favorable demographics. The other reason is they're expected to grow faster as far as projected growth in the future than developed markets.
And also right now their valuations are extremely favorable compared to developed markets and even us. So US valuations, our stock market has been going up for quite some time. We've had a nice full run here. And so our valuations, our companies are more expensive now, whereas in the emerging markets, they're much cheaper.
So if you believe in reversion to the mean, the emerging markets are much more poised for recovery here.
Taylor Schulte: So set another way. US stocks have been doing really, really well over the last 10 years or so. Emerging markets haven't been doing as well. It's like Warren Buffet always says buy when there's blood in the streets or buy things that nobody else wants to buy in. Emerging market stocks seem to fall in that camp today. Would you agree?
Perth Tolle: Yes, I would agree with that.
Taylor Schulte: I want to talk about home country bias, but first, and you've alluded to it, your home country is China. You were born in China. I'd like for you to just tell us a little bit about your experience in China growing up there and then what you've learned over the years and how that ultimately inspired you to create the life and liberty indexes, which ultimately ended up you sponsoring the Freedom 100 ETF, the ticker bean FRDM.
So talk to us a little bit about your experience with China and everything you learned and how that led to what you're doing today.
Perth Tolle: I was born in Beijing and I grew up there until I was about nine years old, at which time I moved to the US. I grew up here until after college and then went back to Hong Kong to live for about a year before returning to the US.
So my experience having half of my childhood in China and half in the US and then going back there and seeing how different my life would have been had I grown up completely in China versus my formative years being here in a more free society. That's what made me realize that freedom makes a difference and an impact in not only my life but in markets as well.
When I went back to Hong Kong after college, it was around 2003 and 2004, and I traveled extensively to the mainland, to Beijing and Shanghai and Xen and other areas. So I saw some things there that kind of shocked me as someone who grew up in a mostly free society.
And it opened my eyes to the impact of freedom. And I was born just after the one-child policy was instituted in China. So my entire generation is basically a whole generation of single children, and there are exceptions of course in the countryside, sometimes you can have more than one, or if you have a girl first, sometimes you can have more than one, or if you pay, you can have more than one.
And that policy has been now changed to the two-child policies. So now you're allowed to have two children in China. But just having a government that has so much control over each person's individual choice to the point they can tell you how many children you can have and then doing this thing with the one-child policy, it changed the entire culture of my generation.
So now even though they allow two children, very few people are having two children as they are seeing here. And the reason why they're doing that is because the demographics are so bad after having 30 years of the one-child policy that they now need people to have more children for the future productivity of the country.
But having had that policy in place for 30 years, the values of whole generation have changed. The policy itself has led to huge gender imbalance. So there's, for every 100 girls born in the country, there are about 118 boys.
So you can see the gender imbalance is a huge issue, which leads to also a more militarization as society because what does a boy do if there's no prospect of ever getting married because there's no woman? And it also leads to trafficking and drives, trafficking in surrounding regions inside China, in the Asia Pacific, and also as far as there are reports of women from Columbia being trafficked to China.
So actually changes in that one policy had a huge impact on me and made me realize that hey, governance is actually important to society and to markets.
Taylor Schulte: And I want to dive deeper into China and how that kind of translates to your typical emerging market mutual fund or ETF that you might buy today. But really quick so we can kind of set the stage for that conversation. I'd like to briefly talk about market cap weighting.
So when any of us invest in an index fund, whether it's an index mutual fund or index ETF, which we're huge fans of here in the stay wealthy community, the fund's job is to track a particular index.
So for example, you might buy a fund that tracks the S&P 500, but as you and I know you don't own an equal share of all 500 of those stocks, if you actually look at the holdings, you'll find that you own a higher percentage of some stocks like Microsoft, Apple, Google, you'll own a higher percentage of those larger companies than smaller ones like Hewlett Packard or United Airlines.
So the companies are being weighted in that index fund by their total market capitalization. Higher market cap companies like Microsoft carry a higher weighting percentage than smaller cap companies like United Airlines. So let's just start with in general. General, do you think that there's a problem weighing stocks this way and why? And then we'll get into the emerging market space?
Perth Tolle: Yeah, so market capitalization weighting has its advantages and disadvantages. Some of the advantages are it's cheap, it's easy, it's in an efficient market. It generally captures a good representation of the stocks in that market.
And that's because the more efficient the market, the more market capitalization makes sense because the more information is available and transparent and reliable, the more prices capture the actual value of the company based on all of that available and reliable information.
So in a developed market, it's generally the accepted default to use market cap waiting. And that is fine as long as the information in those markets is freely available. But that's not always the case in emerging markets where information isn't available, reliable or transparent.
So in emerging markets, sometimes you have bad data, sometimes you have data that's unavailable or is unreliable, and sometimes you have different sets of data for different people.
So in addition, in emerging markets, political risk matters as much as economic risk and market cap weighting just doesn't consider any of those risks. And I would add here that especially in the emerging markets market capitalization weighting leads to a very high allocation to China, which I think has contributed to the underperformance of emerging markets as a whole because China has been such a huge part of the market cap-weighted emerging markets indexes.
And when you're investing in a less free market like China where central planners and the state controls a lot of the market activity, investors don't efficiently capture so much of that growth. So if you look at the Shanghai composite for example, over the last 10 years, it's basically flat. Despite all that, China has obviously grown over the last 10 years.
Taylor Schulte: So market cap-weighting let's say the S&P 500 US stocks, maybe it's not perfect. There are people like Rob Arnott out there that make some arguments. So maybe it's not perfect, but it's pretty darn good. It's a pretty good representation of the US stock market.
Perth Tolle: It's a good representation of the market in an efficient market, yes.
Taylor Schulte: But moving over to emerging markets, a market cap-weighted index has some bigger problems. So maybe talk to us a little bit more about what those problems are when you look at a market cap weighted emerging market index fund, you're just stereotypical, you go to Vanguard or Fidelity and just buy your plain vanilla market cap weighted emerging market index fund.
Perth Tolle: Any plain vanilla market capitalization, weighted emerging markets index fund, which is 99% of the emerging markets index funds out there are going to be based on either MSCI, emerging markets index or FSE emerging markets index. And there's some based on S&P.
The main problem with market capitalization weighted emerging markets indexing is that you get a very heavy concentration in the biggest emerging markets, which happens to be China. So China is the biggest emerging market, and it gets a very high weight in these indexes because of that market cap weighting.
Taylor Schulte: About what percentage?
Perth Tolle: So in Vanguard, which are based on FSSE, you're going to get about 35% and growing because of the addition of AHAs. And in iShares based on MSEI, you're going to get about 32% currently in China and also growing because of the addition of AHAs.
Taylor Schulte: So if you buy your low-cost plain vanilla emerging market index fund through a Vanguard, let's just say Vanguard, if you look under the hood, about 30% of your money is being invested directly in China,
Perth Tolle: More than 30% in growing, yes. And that's just direct China exposure. You also have in emerging markets a lot of indirect China exposure. For example, a South African company, Naspers, which is in my index as well, made a huge investment in a Chinese company Tencent a while back in the very beginning of the company. And that has grown to be a huge portion of Naspers market cap.
So now that Tencent exposure has now been moved, they did a spinoff to another company called Process, which is listed in Amsterdam. So it's no longer the process shares are no longer in my index. But you can see from that example that most of these emerging markets do trade with China or they invest in China.
So there's also indirect exposure to China. In addition, most of these big broad market cap weighted emerging markets indexes have about 70% in the Asia region. So you have 30 plus percent in China, if you include Taiwan, Hong Kong, and South Korea, which are all very well correlated to the China market.
You have in all of those indexes more than 50% in the China region, if you call it the China region surrounding China. And then you have 70% in Asia. So it's a huge allocation or a huge concentration in one country and one region. And also it's becoming a more, as we can see in recent events, kind of a risky area to be investing in.
Taylor Schulte: The conclusion here is that, like you said, 99% of emerging market funds, if you just go buy one of these low cost Vanguards like emerging market funds, just know that you're making a highly concentrated bet on China and Asia in general.
Perth Tolle: Yes, China especially.
Taylor Schulte: China especially. So this kind of problem that you uncovered led you to found and create the Life and Liberty index. Just so we don't confuse people here, there are indexes and then there are funds that track that index, right? So the S&P 500 is an index that was created, and then there are mutual funds and exchange traded funds, and it's their job to track that index if they so choose.
So you created the Life in Liberty index, and then subsequently you sponsored the launch of an ETF to track that index, which is called the Freedom 100, emerging Markets ETF. Again, ticker is Freedom or FRDM if someone wants to look it up.
So talk to us about the weighting methodology that you used for this index and how it's different than the traditional market cap weight that we just bashed on there for a few minutes and kind of why you landed on that and how it helps solve some of these problems that you've uncovered.
Perth Tolle: So our index is created using freedom weighting instead of market cap weighting. So instead of using the size of the market, we use freedom metrics on the country level to determine the country's weight and inclusion in the index. So we're looking at how well a country protects the human freedoms and economic freedoms of their citizens, and if the level of protection is higher, they get a higher weight in the index.
If the level of protection is lower, then they get a lower weight in the index and the worst offenders are excluded altogether. To determine the freedom scores per country, we use 79 indicators, and these are compiled by the Cato Institute, the Frazier Institute, and the Friedrich Nauman Foundation for Freedom in their joint project called the Human Freedom Index and dataset. And these data, I categorize into three categories, the rights to life, liberty, and property.
So the rights to life are things like terrorism, trafficking, disappearances, torture and so forth. Rights to liberty are things like rule of law, due process, freedom of speech, freedom of religion, freedom of the press, freedom of assembly, freedom of movement, and internet freedoms and so forth. And then property rights to property are your economic freedoms.
So these are things like the level of government interference in private markets, legal system and property rights, sound, monetary policies, freedom to trade internationally and other regulations. So the higher a country scores in these, the higher its weight.
Taylor Schulte: What would be an example of a country that's been eliminated from the index?
Perth Tolle: Very different from what the other market cap weighted indexes we just discussed. We have actually no allocation to China currently. So there's no China, no Saudi Arabia, no Egypt, and no Russia. Saudi Arabia is another one that is notable because MSCI is currently adding Saudi Arabia to their emerging markets index, and it's not an insubstantial weight, so it's not going to be one of the smallest countries once added.
Taylor Schulte: Some might put you in the camp of socially responsible investing or SRI or ESG, that camp of investing. And a lot of times investors are willing to put their money in a socially responsible investment knowing that they may get lower returns, but they're supporting their beliefs and morals and values, and so they're okay getting a lower return by doing that.
I'm just curious, your goal for this fund, this index, is it to match the broader based emerging market returns, or do you think that by weighting it, how you're weighting it, you expect outperformance or underperformance? How do you view that?
Perth Tolle: We do expect the freer countries to perform better, more sustainably to recover faster from drawdowns and to use their human capital and economic capital or their capital and labor more efficiently.
And you see this throughout history that over time the freer markets are the ones that become tomorrow's develop markets. They're the ones that grow faster, they're more sustainable and are more efficient because you don't have the constraints of central planning or autocracies. So we do expect alpha in the long run, but we created this for investors to be able to replace their market capitalization, weighted emerging markets index products.
So we created it to be very broad, very diversified, and to highly correlate to the beta. And when I say beta, that means the market capitalization, weighted index funds. So basically it's designed to correlate well to market cap weighted indexes.
But we do yes, expect that in the long run freer countries do perform better, but that's in the long run. So emerging markets, half of them are still autocracies and coming out of autocracies, I mean it's not developed. It's still emerging situations.
So you have to be aware that if you're investing in emerging markets, that is a more long-term play. Some of the alpha is going to take time to play out. And so I wouldn't invest in it expecting that anytime in the short term, but I would expect high correlation to the other broad-based market cap weighted indexes.
Taylor Schulte: And you talked about a few of the countries that don't show up in the index because of some of the rules that you've applied. What are some of the countries that do show up in the index fund or in the index, and is there a country or two that someone might do kind of a double take and say, wait, why the heck is that country included? Or maybe it's a little controversial, and how do you address something like that?
Perth Tolle: The biggest countries in the index currently in order of size are Taiwan, South Korea, Chile and Poland. Taiwan being the biggest one there. The controversy being, oh, is it a part of China? And yeah, there are questions surrounding its sovereignty, but Taiwan is very much an independent country and they have different laws in China. They have China Cannons pointed at them every day.
So they're constantly on the front lines of the fight for freedom in the region. And you'll see that in current events, how they've always, since they won, supported the Hong Kong protestors and offered asylum to anyone fleeing Hong Kong after protesting and so forth.
So Taiwan is the biggest holding and after that South Korea, and because both of these countries are very free and therefore the highest holdings in the index, it's a happy accident. And because they're highly correlated to China, we get very high correlation to the market cap weighted benchmark indexes without having that direct exposure to China.
So that was just the way it worked out there. The next to Chile and Poland, Chile, of course there's some protests going on there as well currently, and I think their government responded to it a lot better than the way Hong Kong government has responded. So it should be resolved much faster.
So Chile also does a lot of trade with China, so about 25% of their trade is with China. So some people have used chili as kind of a China proxy as well. So if you expect China to grow, then you invest in copper and chili or lithium to grow their smart car efforts.
So we don't penalize these freer countries for doing trade with less free countries. We are all about that. So we're all four countries benefiting from free trade with the less free countries. So that's perfectly fine, and we don't penalize that in our index.
Taylor Schulte: And make sure you highlight for everybody you've created this rules-based strategy like you and your team are not deciding what country is going to go in and what country is going to go out. You've designed the methodology and the rules here and it kind of is what it is.
So maybe you can just expand a little bit on this rules-based quantitative approach that you don't have full control over all the time. You might see a country in there that maybe you personally don't really want to see in there, but it's in there because of the rules in place.
Perth Tolle: So some of the other countries included in the index are South Africa, the Philippines, Mexico, Indonesia, Thailand, and India. And some of these countries, like for example, Thailand, the Philippines has some questionable human rights practices.
And if this were an active index, I would not choose to have these allocations in there. Thailand is very small at less than 3%. In the Philippines, it is around 6%, so they're small. But one of the things that got to be aware of with an index like this is that it's a rules-based approach, and we have to follow the methodology and these country scores are given to us by a third party think tanks that we operate independently from.
So I personally don't decide what countries get to be in the index. I can't say, oh, I don't like Thailand, so you can't be in the index. Or I saw a newspaper article about what's going on in the Philippines or the drug wars, so I'm going to kick it out. So everything is based on the predetermined rules and the algorithm set in the methodology, and I can't gain the system to exclude or include any country.
Taylor Schulte: So if we've convinced somebody that they should be investing in emerging markets, even if it's just for diversification purposes, is it your opinion that they should fill that sleeve of the portfolio with a fund like freedom that has this freedom weighting approach to it?
Or do you think someone should put some in a Vanguard type solution, market cap weighted and then put some in freedom? Should there be a balanced approach? Or are you in the campus that says, no, there's a lot of problems with those market weighted indexes, you should put all your money in freedom.
Perth Tolle: So yeah, so if you're looking for what I think is the best way to allocate your emerging markets portfolio, so if I'm giving you my best idea, my best recommendation here, I would say absolutely freedom weighting makes a lot more sense then using market cap weighting emerging markets because those markets are not that efficient using the size of the market alone without considering human and economic freedoms. That doesn't make sense.
So I would say this product was designed to capture emerging markets growth using a different exposure to emerging markets, and that exposure is in the freer markets. So that to me makes the most sense. And it is well diversified across four different regions, so it can be used as a core on its own.
That said, a lot of people cannot stomach having no China at all. So there's two camps here. There's one camp that cannot stomach having no China, there's another camp that cannot stomach having China.
So I'll address both of those here. So the people that can't not have China, and so they want some China in the portfolio, I would say to the extent that you want to have direct China exposure, allocate a portion of your emerging markets to a market cap weighted approach like EEM or VWO.
So have a portion in that other market cap weighted approach and then a portion in the freedom weighted approach. And that gives you two different kind of exposures to emerging markets. And you don't lose China completely by having that combination.
So any combination whether it's 50 50, 20 80, 80 20, whatever is appropriate for however much you want to have in there. The other camp that wants no China at all in the portfolio, which is a new camp these days, but I appreciate those guys. I would say ask yourself, why do you not want China in the portfolio? Is it because it's not free? And if that's the case, then we have the solution for you with the freedom weighted approach.
Now there's also other X China indexes out there that are market cap weighted, and I would say that those indexes are kind of like a bandaid. So it's just a market cap weighted index that kills China by objective. So that's the whole point of the index is to have no China in there. I would say that's a bandaid to the problem. You're addressing the symptom and not the cause and probably doesn't make a lot of sense.
So if you don't want China in your portfolio and that's because of some of these human rights practices out of China, then I would put a hundred percent of that in the freedom weighted approach.
Taylor Schulte: You've said the word tracking error a few times, and some financial advisors or professional money managers are judged by how well their portfolio performs relative to an index such as the S&P 500.
So if their returns veer too far from these broad base index returns in let's say any really given quarter, even if it's proven to be beneficial over long periods of time, if their returns kind of veer from these big indexes that we all talk about, they run the risk of getting fired. They're not keeping pace with these indexes on a short time period.
So even if freedom, your freedom ETF is the best ETF to own in the emerging emerging markets space professionals like myself or hedge funds or professional money managers for institutions, they may not adopt it because in the short term it might not track the broader based emerging market indexes. It might veer from those indexes, which could get them fired.
So they end up just hugging the emerging markets index that's full of China and it helps them keep their jobs. But I take issue with it because it hardly sounds like the role of a fiduciary, which is something we've talked a lot about on this podcast.
So I know you don't have any answers, but I'm just curious if you have any thoughts on this, any brief thoughts and maybe how that problem can be solved or how maybe you're working to help solve that problem?
Perth Tolle: Yes, so I have talked about tracking error in the past, and I think I probably was addressing institutional investors in those instances. So I think as individual investors and advisors to individuals and families, we have an advantage over these big institutions that have a lot of constraints around tracking error.
Tracking error is not necessarily a bad thing. So you can have outperformance tracking error as well as underperformance tracking error, and if it's outperformance, then obviously that's good. So sometimes high tracking error is a very good thing over time and it just means you're capturing alpha.
So I wouldn't worry too much about tracking error. Actually, this particular index has a tracking error of about 7%. I know some people calculate it differently as well, and that's the Bloomberg calculation and it has correlation to the MSEI emerging markets index of about 88%.
Taylor Schulte: Well, I really appreciate you coming on and sharing all of your knowledge with us. It's really fascinating. I learned a ton today about the emerging market space. I really appreciate it. If people want to learn more, if they want to learn more about you, where would you send them?
Perth Tolle: So the website is lifeandlibertyindexes.com, and I'm on Twitter at Perth Tolle.
Taylor Schulte: And we'll link to all of your websites and everything in the show notes, which can be found at youstaywealthy.com/56 and Perth, again, thank you so much for coming on. I really appreciate it, and I look forward to seeing you soon.
Perth Tolle: Thank you.
Taylor Schulte: Hey, it's me again. I just wanted to say thank you one more time for listening and remind you to please, please leave a quick review if you're on an iPhone, leave a quick review on iTunes if you're enjoying the show.
I'm getting great feedback from listeners just like you, and I really want to keep the momentum going. So if you have a chance on your iPhone, leave a quick review on the Apple Podcast app. And thank you so much in advance for all of your help and support.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.