Jin’s Note: I had the pleasure of chatting with Perth Tolle, the founder of Life + Liberty Indexes. The following is the second of two parts of the transcription of that conversation. You can find the first part of our conversation here. I’ve edited the transcription for clarity, and occasionally made some comments in italics.
Jin: You mentioned that there are seventy-nine–do you call them factors? What do you call them?
Perth: Yes, variables.
Jin: So, seventy-nine variables. I don’t want to go through all seventy-nine of them, but are there a couple of favourites that you have out of those seventy-nine, or another question would be: of the seventy-nine are there some that are more important than others?
Perth: Yes. So, I did some testing on this. And, it’s interesting because data on these factors and the significance of their correlation to investment returns or stock market returns really falls short. There are three reasons for this.
One is sample size. It’s too small and too short-term. The vast evidence in history of freedom having positive effects on markets, even exponentially positive effects, cannot be captured with the short history of stock market returns, and the even shorter history of freedom data. Like the story of America itself, for example. America was born out of a desire for freedom and independence from a king who could control what you do versus individuals who decide what to do for themselves. So, that’s one reason for the data falling short, sample size is small and short term compared to the vast evidence of freedom on markets throughout history.
The second reason the data falls short is the variables don’t work in isolation, they interact with many other factors to drive returns. There are factors like absorption barrier risks that the data may not capture. I’m quoting Nicholas Nassim Taleb here, what he calls absorption barrier risk is any risk that would take you out completely. For example, death, that’s an absorption barrier risk. Or, in an investment situation, running out of money, bankruptcy, that’s an absorption barrier risk. So, an absorption barrier is a risk that would take you out completely. And in this case, the absorption barrier risk of investing in a less free country would be something like a company getting nationalized, or a CEO or your team getting kidnapped or disappeared, or your partners arrested for short-selling or any other arbitrary reason, etc. I’ve actually just sent a friend a book that tells the true story of this very thing happening in Russia, Red Notice by Bill Browder, which I highly recommend for anyone interested in Finance in emerging markets like Russia. There are a lot of these examples, in China as well, that in recent years have been more publicized. Like what happened with Crown Casino, the Hong Kong booksellers, or the head of the Man Group in Hong Kong after the 2015 crash.
Perth: Yep. You can read about all that. It was documented in international news outlets. So, that would be a risk that the data doesn’t always account for, absorption barrier risk.
And, the last reason that the data doesn’t forecast well is the impossibility of predicting what arises out of free will and human creativity. The data can measure the extent to which the governments stay out of the way of this creativity, but you can’t measure the surprises that come out of it. George Gilder says—“an economics of systems only, of markets and not of man, is fatally flawed; it is preoccupied with mechanical models of markets and uninterested in the willful people who inhabit them. Ignored are the surprises that arise from free will and human creativity.” So, we can create an environment where people want to come and be productive in society. Steve Jobs is an example. His biological dad was an immigrant from Syria. He was adopted. So, we can create an environment where people from Syria want to come to the United States and search for freedom, and then they can have children who can grow up in freedom and be productive citizens. And we can measure the extent to which we create that environment, but we cannot measure or predict that this guy would come here, have a kid, the kid would be adopted by a family in Mountain View, and then grow up to be Steve Jobs and create the iPhone. We cannot predict that with the data we have.
Jin: Yeah. I read his biography, and I remember Walter Isaacson saying in his book that this was a uniquely American story, that it could not really have happened anywhere else. And, I believe that, especially--
Perth: I would like to read that.
Jin: Yes, it’s a great biography. It was a great read. But, It also spoke to its surroundings--like Silicon Valley—where he grew up, in particular, because there’s just so many computers there, you know. The whole environment was perfect for someone like Steve Jobs to arise from.
Perth: Yeah. That’s awesome. And see, stuff like that is what you really can’t predict. Like, he was almost adopted by different parents. His adoptive parents originally wanted a girl, and then his birth mother was, like, “No you can’t have him because you don’t have a college degree.” So, they finally promised to get a college degree, so she let them have him. And then the upbringing in this family, and in that environment in silicon valley, was highly formative. So, this stuff—you just can’t predict what humans are going to do. Humans are unpredictable. There are surprises that are going to arise.
Now, that’s a long-winded way of saying why it’s hard to isolate certain of these variables for correlations. That being said, there are some variables that showed higher correlation relative to others, and I ran this as a very quick model, but the ones that came out on top are very interesting—and I did this only on economic freedom variables because they go back longer, i ran a 10 year test. The human freedom variables only go back 6 years. Out of the economic freedom variables, the ones that came out on top were interest rate controls, trade barriers, and capital controls. All trade variables, so evidently trade is a very important factor.
Jin: What is interest rate control?
Perth: Interest rate controls are like monetary policy.
Jin: Oh, I see. So, is it about how independent a central bank is from the government?
Perth: Yes, it looks at whether monetary policy is more government controlled or market controlled, and that would relate to the independence of the Fed (short for ‘Federal Reserve’) from the government.
Jin: Yes, perhaps the independence of the monetary policy also correlates with other factors like corruption and government controls in other aspects of civil society and—
Perth: Yes, absolutely.
Jin: Yeah, that makes sense to me, and a more market trusting country would perform better on economic metrics.
Perth: Yes. Absolutely.
Jin: So, I guess that, because there are only five or six years’ worth of history for these more human freedom factors, does that make it really hard for you to draw any statistical conclusions about whether those variables influence the stock market returns of a country?
Perth: Yes, it does make it a little harder, but we can do imperfect testing.
Jin: So, in aggregate then. I imagine trying to discern how important one factor is would be really hard because the variables are all correlated somehow?
Perth: Yes. they are all interconnected. Jim Gwartney, one of the first original thinkers on this, he’s the one who came up with a definition for economic freedom that we use now. He compares the freedom variables to a car. He says, what’s more important to the running of the automobile: is it the engine, the wheels, or the transmission? It’s all of them, they’re all interconnected. If anything breaks down, the car ceases to run. So, it’s very difficult to isolate factors when they all work in conjunction with each other, which is why I use the final composite score.
Jin: I see. So, if you were to take the aggregate scores and compare that to stock market returns, what sort of statistical evidence do you see?
Perth: We are still testing for statistical significance, because there are still a lot of limits to the data we have. As data sets grow, maybe we’ll be able to draw more conclusions statically speaking.
Jin: Oh. Okay.
Perth: Yeah. So, the history on the data set is still very short, and a lot of this data is measuring the extent to which a country provides the foundation or the environment for freedom, protecting individual rights and getting out of the way of human creativity and all the surprises that arise from it. And the stock market has so many other dynamic interacting factors at play. Also governance shifts happen very slowly, and some policy effects are not seen til years after they are enacted. It’s very difficult to statistically draw a link to market returns for those reasons.
Jin: Yeah. It just seems like the time horizon is just so short so far. Like, there might very well be evidence in about — I don’t know exactly how long it would take—twenty, thirty years’ time.
Perth: Yeah, obviously there’s evidence in history. There’s evidence in the movement of people within countries, the movement of capital within countries. But if you are looking for a statistically significant correlation between freedom and stock market returns—I have not found it. This is a concept that kind of transcends what the data can currently show.
Jin: I bet there is some correlation, there’s just not enough data to prove it. Yet.
Perth: I think so too. But, with the data I currently have, I could not prove correlation. Also, you know, what are you looking at? Are you looking at one year? Or, are you looking at three year, five year, ten year, fifteen year?
Jin: Putting my stat. hat on—it’s just impossible. I did my PhD in Financial Mathematics, so statistics—
Jin: Yeah, I did. So, I do some stats, and, I know that, especially if you look at annual returns, that’s nothing. You need way more data than that to draw any conclusions.
Perth: I would agree with that from what I’ve seen.
Jin: So, yes, it doesn’t mean that there’s nothing there–just that for the numbers to show it you need multiple decades. Even twenty, thirty years is, some would argue, way too short.
Perth: Maybe I need to become a client of yours as well, because I could use your statistical skills here as i’m obviously not finding the connections.
Jin: You know a lot of people with statistical skills. Anytime you need someone to do stats, you won’t be short of any people for that. My next question is sort of related to that though. Some of these variables that you measure are fairly qualitative, right? Or, they could be quantitative, but they could be hard to measure. For example, how do you measure corruption because, obviously, no government statistic would show, “Oh yeah, this is how many bribes people accepted this year”?
Perth: For corruption we would use the Transparency International Corruption Perception Index Reports. We do not currently incorporate this data source because our freedom data already has a lot of factors that correlate very strongly to corruption.
Jin: Do you know how they do it?
Perth: No. I’d have to look at their methodology.
Jin: Send in some investigative journalists?
Perth: Yeah, so, some of these are survey based. So, it could be that they ask people on the ground in each country. Yeah. I don’t know. But, I’ll have to get back to you on that. So, let me look up their methodology, and see what they do to actually measure it. (Third-party quantitative sources like World Bank, EIU, and V-Dem)
Jin: I see. How often do these variables change, and do they ever change very quickly? Because, I’m thinking about events like what Turkey went through--was it a year or two ago?
Perth: Yes. Turkey is a really good example of a country where freedom is in unusually fast decline. Usually, freedom scores change very slowly over time. But right now, we are seeing a quicker change than usual, even globally, and even in the United States. So, Turkey is actually a reason why we added a new rule in our methodology to capture these very drastic declines.
Another example is Poland. Poland used to be a shining star for freedom in Europe. They are the top performer among ex-soviet bloc countries, due to their protections for human and economic freedoms. And they’re still enjoying the benefits of that freedom tradition. But a few years ago, our Poland delegate told me, “Okay, if this government, the PiS government, gets into power, things are going to get a little crazy, but, you won’t see that reflected in the stock market for two or three, maybe even four years.” And, it happened just like he said. Kaczyński got into power. They got an almost constitutional majority, and freedoms started going downhill. They started attacking press freedoms, judicial independence, etc, and the Polish people were and still are rising up against it, but it was not reflected at all in the stock market for the first few years. In fact, last year, Poland was one of the best performing emerging markets. In fact, largely because Poland was our top holding last year due to their overall freedom score. Our index ended up out-performing MSCI EM by six hundred basis points (i.e. 6%). Now, this year, after our annual rebalance, Poland went from top holding to the fourth holding, so, they went down quite a bit, and that’s unusual. Most of that was due to declines in their scores in the areas of judicial independence, trade and press freedom. So, what’s happened in Turkey and Poland recently are unusually quick moves in freedom levels, but we have a methodology that can capture these fast moves, if they do happen.
Jin: I once read a book on more frontier markets. I forget by whom, I mean the name of the book, but it was written by some World Bank economist, and they really emphasized the freedom of the press as one of the factors that really helps a country get out from the bottom basement of economic growth into a more high growth situation. So, yes, it’s troubling to see the freedom of the press get crushed like that.
Perth: Yes, and that’s been happening globally too. That’s a very interesting book, by the way. If you find the name, please send that to me—I’d be interested in that.
Jin: Yeah, yeah. I’ll see if I can try to find it (It’s The Bottom Billion). I read this, like, ten years ago, so I only remember bits and pieces of it, but, yeah, it did strike an impression on me.
Perth: How did you get interested in that book, or is it this issue?
Jin: Well, I’ve been interested in finance for at least that long.
Jin: I started my PhD in Financial Math in 2007, and I was interested in markets for at least a couple of years before that. During that time, it was just one of those books that I came across and thought would be interesting to read. It’s a great book. So I’m just going to ask one last question. This sounds like a very interesting index, and I was wondering when we can see an ETF based on it?
Perth: So, that’s under consideration, and that’s all I can say. [laughter].
Jin: So, no timeline on it yet?
Perth: No, no timeline. I will say that i am excited about bringing this to market in the form of an investable product, and that the index was created to be the basis of an ETF. We use metrics that haven’t previously been used as factors, factors that make a huge difference in outcomes in markets from the foundational level. Things like press freedoms, property rights, and other rule of law, so i hope to see something out soon that investors who believe in freedom can use.
Jin: Yes, that’s very reminiscent of what Alan Greenspan said in his book. I think it was in The Age of Turbulence that he wrote that property law was one of the most important things—necessary conditions for an economy to prosper.
Perth: Yes. Property rights and rule of law are very important metrics in the index.
Jin: Great. Thank you so much for taking the time to chat with me.
Perth: It’s my pleasure. Thank you.
I would like to thank Perth for taking the time to chat with me. If you’re interested in learning more about Life + Liberty Indexes, please visit http://www.lifeandlibertyindexes.com/.