EMXC - FRDM ETF: Freedom As An Alternative EM Investing Strategy

2023-10-12 20:51:23 ET

Summary

• The Freedom 100 Emerging Markets ETF focuses on investing in countries that protect civil liberties and economic freedoms.
• The fund's exclusion of China highlights its relatively unique strategy that has impressively outperformed in recent years.
• We believe the fund can work in the context of a broader diversified portfolio for exposure to this important market segment.

The Freedom 100 Emerging Markets ETF ( FRDM ) takes a thematic approach to ((EM)) investing by systematically targeting companies in countries that are recognized for protecting civil liberties and economic freedoms.

The idea here follows the principles of classical liberalism suggesting free markets should generate greater sustainable growth and innovation through more efficient use of capital and labor. In practice, FRDM can be described as an EM fund that excludes certain countries like China and Saudi Arabia, which at least have a controversial record on some of these "freedom" points.

Favorably, the strategy has paid off with FRDM outperforming not only EM equity benchmarks but also alternative ex-China EM ETFs. In our view, FRDM does a good job of presenting a relatively unique approach. EM investors that already have exposure to China may even benefit from an allocation into the fund for diversification benefits with foreign stocks not widely help.

What is the FRDM ETF?

FRDM technically tracks the "Life + Liberty Freedom 100 Emerging Markets Index". Starting with a universe of 24 emerging markets and developing countries, the methodology uses a scoring system across 83 quantitative variables measuring each country's level of protection of personal and economic freedom.

These are incorporated from the independent third party think-tanks with the "Cato Institute" and the "Fraser Institute" recognized for publishing the Human Freedom Index covering metrics like the regulatory environment, legal system transparency, civil rights, media freedom, and the rule of law.

Beyond a minimum level of market capitalization and trading volume threshold, the lower a country’s Freedom Score, the lower its weight in the Index. We mentioned China being excluded as a high-profile example, along with Saudi Arabia, Qatar, and India as other notable countries that do not cut for the ETF's investing purposes.

Another key feature of the strategy is that it excludes state-owned enterprises ((SOEs)), considering companies with 20% or more of government control. Finally, the 10 largest companies from each country are included and ultimately weighted by their market capitalization.

Going through the current FRDM portfolio, stocks from Taiwan and South Korea represent approximately 41% of the fund. This is consistent with both the size of their respective capital markets among publicly traded stocks along with generally high scores in the Freedom Index.

The largest current holdings are Samsung Electronics Co. ( SSNLF ) and Taiwan Semiconductor Manufacturing Co. ( TSM ) both with an 8% weighting in the fund. Here we can highlight a relative "tech" tilt, but there are also plenty of banks and financials, along with mining giants such as Vale SA ( VALE ).

Overall, companies from Chile, Poland, Brazil, South Africa, Indonesia, Malaysia, Mexico, and the Philippines are represented across the portfolio of 100 stocks.

Here we can draw a contrast between FRDM and the iShares MSCI Emerging Markets ETF ( EEM ), recognized as an EM benchmark and among the most widely traded ETFs in the market.

Naturally, without the Freedom weighting, EEM is dominated by Chinese firms that currently represent approximately 30% of the fund. EEM also includes India and Saudi Arabia which are not featured in FRDM.

The result here is a significant difference in underlying exposure, which explains much of the performance difference between the two over the last few years. Over the past three years, FRDM has returned 18% compared to a -12% loss in EEM.

In this case, China has underperformed significantly with the separate iShares MSCI China ETF ( MCHI ) lowering more than 40% of its value over the period, dragging EEM lower.

The factors at play include both a shifting macro environment as well as country-specific factors. Headline-making regulatory crackdown in the region targeting tech firms along with trade restrictions enforced by the United States based on national security concerns have resulted in some measure of risk aversion to the region.

We can also mention that FRDM distributes a quarterly dividend which has been variable based on the underlying company payouts. The current yield is listed at a compelling 4.7%, although we estimate the figure to be closer to 3.5% on a forward basis, given some exceptional payouts over the past year among energy and mining names that should normalize lower.

What's Next For FRDM?

We're fans of FRDM but recognize the fund benefited from the timing of its launch and the particular market environment in recent years. It's very possible that the Chinese stocks eventually rebound, resulting in an underperformance from FRDM which excludes what remains the most important emerging market and the largest country in the world.

According to the International Monetary Fund ((IMF)), China and India are expected to lead the world in terms of GDP growth this year and into 2024. The understanding is that these two countries represent the engine of growth not only for other emerging markets as trade partners but also with implications for the broader global economy.

While FRDM holdings can still benefit from these trends indirectly, it's a difficult bet to suggest China will always underperform. This is where investors need to consider that tradeoff between maximizing potential returns against moral values or ideological beliefs.

The parallel we can draw here with the Freedom angle is to the theme of environmental, social, and governance ((ESG)) investing that systematically avoids the natural resources and energy sectors, or other industries seen as counterproductive. Permanently underweighting segments of the market or non-Free countries comes at the expense of diversification.

The point we're getting here is that it's unclear whether the FRDM strategy can or will consistently deliver excess returns over the long run. That being said, we still have a good reason why the fund is worthy of consideration beyond its "intended" purpose.

As we see it, EM investors that already have large exposure to China can consider adding FRDM as a method of balancing the allocation into other regions of the world.

FRDM does a good job of presenting a relatively extensive large-cap EM profile including companies that are otherwise not widely held. In many ways, FRDM can work in conjunction with EEM or another broader fund like the Vanguard FTSE Emerging Markets ETF ( VWO ) which is concentrated in China.

Final Thoughts

FRDM is a high-quality fund that has delivered an impressive return since its inception, backing up its thesis that "freedom" can be a driver of positive returns. In our view, the fund is a good option for investors to consider in the context of a diversified portfolio as a core holding for emerging markets exposure.

Overall, we are bullish on EM and FRDM with an expectation that region stocks can trade higher going forward over the next year. In terms of risks, FRDM would likely not be immune to a broader market selloff. Investors need to consider that the EM markets carry FX risk where the potential appreciation of the U.S. Dollar negatively impacts underlying earnings for most companies at the corporate level.

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