EEM - Partake In The FRDM To Outperform In Emerging Markets

2023-03-23 18:58:31 ET

Summary

• Emerging markets are likely to outperform the benchmarks in the long term; however, not all emerging markets are equal.
• Evidence suggests that emerging markets in politically liberal regimes experience more growth than emerging markets in illiberal regimes.
• Accordingly, investors looking for the best performance in emerging markets should focus on ETFs that acknowledge this liberal/illiberal divide and favor the liberal side.
• Despite its flaws, FRDM fits the description, and is therefore a good emerging market investment for the long term.

Background

In the early 1990s, the world breathed a sigh of relief after the fall of the Soviet Union/USSR, marking the official end of both the Cold War and the possibility of a global nuclear holocaust. As the world’s most prominent autocratic government dissolved, leaders and observers in democratic governments started taking rhetorical victory laps. Among the politicians and pundits throwing in their two cents, one notable opinion on the situation stands out to me. Francis Fukuyama’s 1992 book The End of History and the Last Man declared that after the downfall of the USSR, the ascendance of liberal democracies around the world was no longer a mere possibility, but the inevitable trend that would be followed by governments over time.

After 30 years, one could be forgiven for thinking Fukuyama’s thesis a bit naïve. Less than a decade after publishing his work, the world’s most prominent democracy suffered a major deadly attack at the hands of a terrorist group reportedly aided by an illiberal government , and fought the aggressors in vain. You probably know the details of this story – in the aftermath of the September 11 ^th attacks in 2001, the United States (US) unilaterally went to war with multiple terrorist groups and their supporters in illiberal Middle Eastern countries, with the intent to, among other things, democratize/liberalize their governments . But 20 years and trillions of dollars later, those places are no closer to becoming liberal or democratic than they were before. In fact, ironically, the US itself has shown a more illiberal streak in recent years since its War on Terror. Meanwhile, illiberal nations China and Russia, the latter having risen from the ashes of the USSR, have gained power, influence, and economic might since the 1990s. Russia picked itself back up after the USSR’s fall , while China became “The World’s Factory” and gained all the perks of such economic importance, including entry into the World Trade Organization in 2001 and permanent normal trade relations with the US. Other contrasts with Fukuyama’s thesis include the proliferation of illiberal African and South American nations; US-backed coups against democratic/liberal governments; and the decline of the US and other liberal governments into more illiberal and nationalist states, with recent political leaders threatening the liberal framework of these nations.

In fairness, Fukuyama’s work is often misinterpreted. Fukuyama did not claim that the march of nations toward political liberalism (i.e. the spread of rights and privileges by governments to many groups of citizens and noncitizens) would be smooth or steady, or that it would be complete by the 30 ^th anniversary of the USSR’s collapse. He claimed only that eventually, liberalism would be much more common in nations around the world than illiberalism. I am inclined to agree.

Illiberal nations have a bad track record of instability and reduced economic prosperity in the long run. The best examples by far are China, Russia, and Iran. All three nations are facing severe economic and diplomatic consequences for their illiberal actions, with Iran having suffered them for decades by this point. If ever illiberal nations experience a period of success (or mere stability) resembling liberal peers, their destructively domineering tendencies eventually prompt them to enact laws and policies that muck it up, like China and Russia did. This usually results in alienation from leading nations of the world, proxy wars or outright military conflict against them, and/or an increase in domestic conflict and dissatisfaction among the populace.

By contrast, even the most embattled liberal nations can find some form of success in the long run. The nation of Taiwan was formed from the remains of the government that ruled the Chinese mainland before the ascendance of the People’s Republic of China ('PRC'), the current regime in mainland China. After fleeing from the mainland due to defeat in civil war, the soon-to-be Taiwanese government had suffered great losses: loss of almost all its national territory, loss of much of its army, loss of its global influence , and loss of its relations with many nations as the PRC took its position atop the world stage. But over the decades, Taiwan continued to liberalize , turning itself into a liberal democracy, an attractive business partner, and a critical “world’s factory” of its own: its semiconductor giant, Taiwan Semiconductor Manufacturing Company or TSMC ( TSM ) is the most powerful and prolific semiconductor manufacturer on earth. Furthermore, the PRC’s latest antics are actually gaining Taiwan new allies and broad international support , and in turn Taiwan is demonstrating to the international community how to stand firm against powerful authoritarian governments.

All this to say, even a cursory and anecdotal look at the broad geopolitical landscape suggests that the benefits of being part of the liberal world are greater than those of the illiberal world, which is why the expansion of liberalism can credibly be argued to continue over time. Likewise, investing in emerging liberal markets vs emerging illiberal markets may yield greater benefits as well. As such, funds that pay attention to the liberal/illiberal divide when investing members’ capital should be given a closer look, especially if they lean toward the liberal side. With this in mind, I decided to take a look at the Alpha Architect Freedom 100 Emerging Markets Exchange Traded Fund ( FRDM ), or the FRDM ETF, to see where it stands as an emerging markets investment.

The Benefits of Having FRDM

Established by Chinese immigrant Perth Tolle, FRDM and the index it tracks (The Life + Liberty FREEDOM 100 Emerging Markets Index) was built to allow investors to park their capital in emerging markets while avoiding investment in entities hostile to people’s personal and economic freedoms. In a 2021 interview , Tolle cited her experiences growing up in both China and the US, and her return to China as an adult, as her inspiration for the index and the fund. After comparing these two societies she lived in and how their different approaches to freedom affected ordinary citizens’ lives and national economic prospects, she concluded that differences in individuals’ personal and economic freedoms can tangibly affect societies and economies.

Indeed, there is data to back up her viewpoint. An empirical analysis on how democracy and personal freedoms affect economic performance concluded that, with a few caveats, an increase in liberal democracy, personal freedoms, and economic freedoms either catalyzed or directly caused increased economic growth in a given nation; this compared to a lag in growth in nations that went the opposite route, i.e. illiberal regimes that restricted freedoms. Additionally, an analysis by the International Monetary Fund ('IMF') concluded that state-owned enterprises (SOEs) are less capital efficient, more prone to corruption, and more capable of precipitating financial crises in their home countries compared to private entities. The analysis also concluded that they were essentially unnecessary in liberalized/privatized economies that offer efficient distribution of goods and services. These findings are particularly noteworthy because SOEs are more common in illiberal nations, demonstrating yet another concrete advantage for liberal emerging markets.

Regarding emerging market ('EM') investment on the whole, a Morgan Stanley analysis suggested that EMs as a group are set to outperform over time, a view supported by an article published in The Journal of Investment Consulting . While this view may be at risk due to the marked underperformance of EMs during the coronavirus pandemic, a recent article in Vision-The Journal of Business Perspective concluded that EMs are still good investments when tracking their performance in non-traditional asset classes. The asset classes it focused on included Fintech, artificial intelligence, and green investing, all of which are becoming popular with investors today and show significant, sustainable growth potential going forward.

These analyses on EMs’ outperformance do not account for differences in liberal or illiberal regimes, instead lumping EMs of both types together. Considering the performance benefits brought about by personal and economic freedoms in liberal compared to illiberal EMs, it appears that Perth Tolle and FRDM’s prioritization of liberal EMs could supercharge EM investors’ returns on invested capital, setting up a strong investment case for FRDM.

FRDM Isn’t Free – Risks to the Investment Thesis

Despite the noble and initially promising investment thesis of FRDM, a Seeking Alpha contributor has highlighted some inconsistencies and drawbacks regarding the fund.

For starters, while FRDM markets itself as an emerging markets ETF, it has much of its capital invested in firms in Taiwan, South Korea, and Chile. These three nations may be less developed than powerhouses like the US, but their status as EMs, especially the former two, is dubious at best. This complicates the fund’s EM status and clouds its true EM performance, since it includes at least two major outlier nations in its holdings.

The contributor also noted that one of the fund’s biggest holdings, Sociedad Química y Minera de Chile S.A. ( SQM ), is largely owned by a Chinese lithium firm and a Chilean dictator’s son. In other words, one of FRDM’s biggest holdings is supposedly liberal due to the freedoms of its country of origin, but is supported by at least two illiberal entities. Needless to say, this makes the presence of SQM in the FRDM fund ripe for some cognitive dissonance.

Finally, the contributor points out that the fund’s rules for choosing holdings, involving more than 70 variables to measure freedoms at one stage of the process, are a bit opaque. As this introductory article states, transparency is beneficial to investors just as personal and economic freedoms are, and a lack of transparency is unlikely to benefit FRDM if it persists long term. The fund’s standards regarding what constitutes personal and economic freedom also give rise to the question of what philosophy or philosophies should win out in deciding how free a nation’s people are, since freedom(s) can be defined differently by multiple schools of thought.

The flaws pointed out by this contributor suggest that despite the fund’s goals, there are some kinks to work out. The fund’s complex, and at times inconsistent, investing strategy may cause the fund’s managers to go astray from the main mission, and could cost investors who put capital into the fund if it does lose its way. However, I believe that the fund has time to work out the kinks and orient itself to take advantage of the EM investment opportunities before it. It was only created in mid-2019; it is a young ETF, and some growing pains are to be expected. It can settle on a sole workable freedom-based philosophy to better orient its investment approach if it hasn’t already, and its holdings can become more intelligible and consistent as the fund’s managers gain experience and remain open to constructive criticism. Since FRDM’s index is set to be reweighted every January to only include firms in countries that adhere to its freedom metrics, then as long as management stays true to the fund’s founding ideals and standards, the fund is likely to remain a haven for those seeking liberal EMs to invest in.

While FRDM’s flaws should not be dismissed, the fund’s probable outperformance after its short term growing pains will likely be worth it for long term investors.

The Encouraging Stats of FRDM

FRDM has an expense ratio of 0.49%, fairly average for an ETF. It has good liquidity for an ETF as well, with daily volumes averaging ~100 thousand shares and ~$3 million. It pays a dividend that yields about 2.6%, a pleasant, if mildly conservative, percentage. The fund has also grown its dividend every year since its inception, with a doubling between 2020 and 2021 from $0.35 to $0.72 per share, and an increase to $0.75 per share in 2022. This is certain to please dividend investors with an eye toward emerging markets. In the short term, though, growth investors may be less pleased with the fund, as the S&P 500 has tended to outpace FRDM’s growth for the last few years. However, as explained in the above sections, I think outperformance lies further in the future for this fund.

In addition to the foregoing analysis, a few data discrepancies also hint at future outperformance. Excluding its descent into the teens in the brief 2020 bear market at the start of the COVID-19 pandemic, FRDM’s share price since inception has hovered between $25-35. While its share price has remained stable, FRDM’s assets under management ('AUM') have climbed exponentially every year: in January, AUM totaled $15 million in 2020, $31 million in 2021, $100 million in 2022, and $280 million in 2023. What’s more, in just the first 2.5 months of 2023, FRDM’s AUM jumped from $280 million to $380 million at time of writing. Put another way, FRDM’s AUM growth is so massive that it has gained as much AUM in the last 3 months as it gained in its first 3 years. All told, FRDM’s AUM has gone up 25x from the start of 2020 to now; meanwhile, the share price has traded flat in the same period. The share price and the AUM growth are not aligned here, and by now they probably should be.

FRDM’s market cap is currently sitting at approximately $300 million at time of writing. While this is probably quite overvalued for a fund with AUM of $15-100 million, it seems undervalued for a fund that just shot up from ~$300 million to ~$400 million AUM in a single fiscal quarter, with no signs of slowing. In other words, the market appears to be lagging the opportunity, especially this quarter.

With empirical and geopolitical evidence backing the fund’s investment case, an increasing dividend with a respectable yield, and clear AUM acceleration, investors of all kinds can find something to like about FRDM. Accordingly, I think investors of all kinds will soon start to pile into the fund, as insiders recently have , and the share price will finally see significant upward movement.

The Instructive Peers of FRDM

Sticking with the idea that FRDM is, in fact, an emerging market ETF, it would make sense to compare it to other EM ETFs. I will look at three: The First Trust Emerging Markets AlphaDEX ETF ( FEM ), which has AUM comparable to FRDM and ignores the liberal/illiberal regime divide; The iShares MSCI Emerging Markets ETF ( EEM ), a leading EM ETF that is also regime-agnostic; and the iShares MSCI Emerging Markets ex China ETF ( EMXC ), a leading EM ETF that removes a prominent illiberal regime from its fund’s holdings.

The First Trust Emerging Markets ETF

Let’s start with FEM. Incepted in 2011, this ETF has had more time to grow than FRDM, and grow it certainly did. Around the time of FRDM’s inception in mid-2019, FEM had AUM of $600-700 million, and a share price of ~$25. All well and good, but fast forward to today, and things get a bit less rosy. Like FRDM, FEM’s shares have mostly traded flat from 2019 to now, but its AUM is a different story . FEM’s AUM has had a rocky path down to the $400 million level; it first plummeted to this point in the 2020 pandemic crash, rose a bit to a high of ~$520 million in mid-2021, then marched steadily down to less than $300 million by October 2022, only rising to $400 million again in the past six months. Again, compare this to FRDM’s AUM exponentially rising to nearly $400 million in the same period. In terms of assets, FRDM has been the epitome of growth, unlike FEM. As FEM’s share price is still hovering in the $20 range, there may be more downside ahead if its AUM trend starts to deteriorate further.

To be sure, FEM has at least one perk: an enviable dividend yield of over 6% at time of writing, which it has grown it for 4 of the past 5 years (the outlier being 2020 when its AUM first crashed). Still, while the IMF documented a drop for many EM investments in 2022, like many growth stocks that year, the fact that FEM's lackluster performance falls in line with that of EM investments overall does not excuse its lack of growth in my opinion, since other EM investments like FRDM bucked the trend. FEM’s lack of attention paid to the liberal/illiberal divide probably didn’t help the fund during this period, either. As the relevance of this divide becomes more apparent in EM investing, capital may flow out of the fund, and into attentive competitors like FRDM, unless it makes major changes beneficial to investors’ long term capital growth.

The iShares MSCI Emerging Markets ETF

EEM, another regime-agnostic ETF, is one of the largest EM ETFs, as it is connected to one of the most prominent EM indices in the world. Unfortunately, it is experiencing essentially the same trends as FEM: a high AUM around the time of FRDM’s inception ($32 billion), a sharp fall in the 2020 pandemic (~$20 billion), a slow rise through mid-2021 (~$32.5 billion), then a mostly sustained march downward to current levels (~$23 billion), all while the share price traded mostly flat ($45-55). Again, I don’t think EEM’s lackluster performance in line with other EMs should be excused here due to the presence of competitors who buck the trend, and like FEM, growth investors may have little to look forward to when investing in this ETF for the long term. But where FEM at least has a sizable dividend to offer investors, EEM doesn’t even have that – EEM has not consistently grown its dividend since the year of FRDM’s inception, and has actually lowered it 2 years out of the past 5. Even worse, its yield is only about 2.6%, which is comparable to FRDM’s now but is likely to fall or stagnate. Considering the headwinds from the illiberal regimes included in its index, along with the aforementioned dividend and AUM issues, the long term picture for EEM looks even more unimpressive than FEM’s. With a much higher expense ratio of 0.69% to boot, I expect EEM, like FEM, to experience fund outflows, or at best reduced investment, in the long term.

The iShares MSCI Emerging Markets Ex China ETF

Finally, a fund different from the others, EMXC. Unlike both of the above peers to FRDM, this leading ETF excludes all Chinese firms. Interestingly, the statistical trends for this name could almost be confused for FRDM’s: after inception, it grew AUM exponentially while its share price remained mostly stable in that time ($50-55, ex-pandemic drop and 2021 rise). Dividends grew 4 of the past 5 years, and while the amount per share is lower now ($1.35) than in 2019 ($1.67) after a large 2020 cut, the dividend yield is still nearly 3% for the trailing 12 months, the best out of all the funds mentioned here. On top of all this, EMXC sports an ultra-cheap expense ratio of only 0.25%.

This ETF’s rise is also part of a welcome new trend. Ex-China EM ETFs, a growing category of ETF investment, all seek to maximize EM growth by excluding holdings from China, a large, arguably matured illiberal nation. As a short-to-medium term tactic, it appears to be working if EMXC AUM is any gauge.

Nevertheless, I am troubled by this ETF. My primary concern is that this fund, and every other ex-China ETF, isn’t a liberal EM investing ETF at all, but rides the growing long term wave of people interested in such investment. As summarized by one investment firm , the primary arguments for investing in ex-China ETFs center on how China’s large economy eclipses other opportunities in EM indices. Assuming this is the rationale for EMXC’s inception, it implies that this ETF and most ex-China ETFs have an incomprehensive understanding of the geopolitical dynamic that incentivizes China's removal. That China should be removed because it hurts investors’ EM growth is indeed an accurate statement, but the underlying sentiment fails to make the connection that all illiberal regimes hurt EM growth, not just China. Yet ex-China ETFs can still include holdings in Vietnam, Saudi Arabia, and other illiberal countries that will drag down EM investment performance. Such a misunderstanding of the dynamics underpinning their investment strategy rules out EMXC and the related ex-China space as candidates to recommend for long term growth investors in my opinion. For truly maximized EM growth, all illiberal regions must be excised from one’s EM holdings – as Perth Tolle explained, nixing China is not enough .

On a related note, if you look closely at EMXC’s AUM chart (as of late March 2023), the trend in growth is exponential, but also seems to be peaking; meanwhile, FRDM’s AUM chart shows continued exponential growth. While I have no direct evidence to support this theory, I believe that the apparent slowdown in this prominent ex-China ETF is fueled in part by investors starting to pivot to true liberal EM investments like FRDM, prompted by the multiple instances of illiberal EM nations, most notably China and Russia, shooting themselves in the foot and tanking their economic growth.

Given the evidence, I think the investors who generalize all illiberal regime holdings as being detrimental to growth are on the right track. While ex-China ETFs may do well for several more years, I believe they too will eventually start to perform in line with ordinary EM ETFs as other illiberal governments start to weigh heavier in these indices to make up for China’s absence. Instead of waiting for these ex-China ETFs, or some other future ETF trend, to play illiberal regime Whac-A-Mole to remove whatever regime is dragging down performance in a given year, it would be much simpler for investors to seek out funds that exclude these regimes as a general rule.

Thus, looking at its peers, FRDM is still the best choice for maximized long term EM investment outperformance in my view.

Summary and Conclusion

The future for emerging markets is bright, and many exchange traded funds will allow you to participate in the above-average growth these markets stand to experience in the coming years. Evidence suggests that the more liberal your emerging market investments, the better your long term performance. However, the rise of new ex-China emerging market funds notwithstanding, I don’t think most, if any, ETFs focusing on emerging markets are taking the benefits of political liberalism into account when weighing their holdings. The one exception I know of is FRDM, which does its best to lean heavily into liberal emerging markets.

Therefore, for long term growth and income investors interested in maximizing the outperformance offered by emerging markets, I recommend they partake in FRDM, and I rate the shares a buy.

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