Owning emerging market stocks could benefit your investment portfolio in two ways. First and more obvious, owning emerging market stocks would make your portfolio more diversified, thereby lowering risk. Second, emerging market economies tend to grow much more quickly than developed economies, so many people assume that emerging market stocks will outperform developed market stocks.
Unfortunately, that second assumption has not held up in recent years. The following chart shows the comparative performances of the Vanguard FTSE Emerging Markets ETF (VWO), and the SPDR S&P 500 ETF (SPY), in the 10 year period ending Oct 12, 2019.
Source: Yahoo Finance
As you can see, US stocks, as represented by SPY, have done incredibly well over the past 10 years. Emerging market stocks, on the other hand, appear to have gone almost nowhere. What gives? A look under the hood of VWO gives us a clue.
VWO tracks the FTSE Emerging Index. According to the index’s fact sheet, Chinese stocks constitute 35% of the index, far more than any other country’s allocation. So how have Chinese stocks done over these past 10 years? Not great.
The graph above shows the Shanghai Composite Index, which tracks the performance of mainland Chinese stocks. As you can see, the index has gone nowhere these past ten years, mirroring the performance of VWO.
But how can this be? The Chinese economy has grown rapidly during this time, so shouldn’t its stocks have gone up as well? Unfortunately, things are not that simple. Even if a country as a whole gets wealthier (which China undoubtedly has), there’s no guarantee that the wealth accrues to shareholders of its companies.
One factor that determines whether shareholders benefit is the strength of investor protection. If investor protection is weak, then controlling shareholders could make decisions that benefit themselves at the expense of minority holders (e.g. pay themselves an unreasonably big salary).
Another factor is the rule of law. Without it, shareholders can become victims of fraud and other crimes that siphon value from companies. Corruption also harms companies’ prospects by going against meritocracy. In other words, it prevents the best individuals from rising to the top within companies, and it prevents the best companies from rising to the top within a given country.
Even without corruption, centralized economic planning can also harm shareholder value, as companies in industries that go out of political favour can end up losing a lot of money. The Chinese electric car industry, for example, has fallen on hard times recently as China has cut back its subsidies.
Unfortunately for Chinese shareholders, the three factors stated above play a negative role in the Chinese markets. The Strength Of Investor Protection Index scores China at 4.5, well below the world median of about 5.5 (Canada is at about 7.5). China ranks highly on the Corruption Perceptions Index which by itself is not unusual for an emerging market economy, but China also has the dubious honor of having many of its rich end up dead or sent to prison. Lastly, no one can deny that China, while it has some hallmarks of a market economy, is still dominated by the Chinese Communist Party.
Now, it would be unfair to give the impression that China is alone in this situation. Other countries suffer from substantially the same types of problems too. One such example is Russia, which has also seen its stock market stagnate this past decade.
At this point, we might be tempted to disregard emerging market stocks altogether, but that might be like throwing the baby out with the bathwater. Some emerging markets suffer less from the problems just discussed. It would be great if we could invest only in those countries. This is where the Alpha Architect Freedom 100 Emerging Markets ETF (FRDM) comes in.
FRDM tracks the Life + Liberty Freedom 100 Emerging Markets Index, which scores each country by their human and economic freedom metrics and chooses to allocate higher percentages into countries with higher scores. If a country’s score is too low, the index doesn’t include the country’s stocks at all. This is very different from a traditional emerging market index, which weights each country simply by the size of their stock markets. This is why China tends to get the highest allocation in traditional emerging market indices.
FRDM’s unique index methodology would have allowed it to perform better than traditional emerging market ETFs such as VWO. If you look into FRDM’s index, you’ll notice that Taiwanese and South Korean stocks have the biggest weights in FRDM. As the chart below shows, investing in either of those stock markets would have generated decent returns - perhaps not as great as investing in US stocks, but decent nonetheless.
Source: Yahoo Finance
But apart from the monetary incentive to invest in FRDM, there’s something that just feels “right” about investing in those countries that gives protection for the less wealthy and upholds the rule of law. It is for this reason that, had I still continued to publish MoneyGeek’s portfolios, I would have included FRDM in them.
So if you’re looking for ways to diversify your investment portfolio further, it would probably be a good idea to give FRDM a look.
Disclosure: MoneyGeek doesn’t receive any compensation from Alpha Architect nor Life + Liberty Indexes for publishing this piece. MoneyGeek also doesn’t have any business relationship with Life + Liberty Indexes, past or current. It does have a past business relationship with Alpha Architect in which MoneyGeek created software for AA.