Animal Spirits Podcast - Talk Your Book: Investing in Freedom

Episode Date: March 12, 2021

On today's show we speak with Perth Tolle of Life + Liberty Indexes about freedom as an investment factor.  Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions and the securities discussed in this podcast. We're joined today by Perth Toll. She is the founder of Life Plus Liberty Indexes. And full disclosure, I am on the advisory board,

a proud member. There's no financial incentive for me, but there certainly is a personal incentive for me to see Perth succeed. So I just wanted to get that out of the way. All right, Perth, tell everybody, where did this idea come from? And wait, hang out. I should say, before I ask you, Where are the ideas? What is the idea? What did you do here? Yeah. So what we do is freedom waiting in the emerging markets. And so as you guys know, in emerging markets, because of the nature of the types of countries that are in this universe, there's a lot of autocracies and countries just coming out of autocracies. So the biggest emerging market is China. And then you have Russia, Saudi Arabia, Egypt, Turkey. Some of these are countries that have very poor human rights records. And so

investors sometimes shy away from emerging markets because they don't want 60 percent of their emerging markets allocation, going to autocracies and funding these types of regimes. So what we do is freedom weight, the emerging market, so that the freer countries get a higher weight, the less free countries get a lower weight, and the worst human rights offenders are excluded altogether. And we look at both personal and economic freedoms. So there's 76 different variables used by our data providers. We use data from the Cato Institute, the Frazier Institute, and the Friedrich Nauman Foundation. And they look at 76 different personal and economic freedom variables.

We take the overall composite score and turn those into country weights. How did you come up with that score in the first place? So a little bit about my background. I grew up in China and the U.S. I was born in Beijing, and I came to the U.S. around age nine. After college, I went back and lived in Hong Kong for about a year, and I had some experiences there that opened my eyes to the lack of freedoms and the difference that freedom made in my life and also in these markets.

And I can go into a little bit about those stories later on if you'd like. But after I came back, I worked at Fidelity. I was an advisor and I had clients who were similar to me. They wanted emerging markets exposure, but they didn't want all these altocracies, especially from their home country. So I'd have Russian clients that say I don't want to invest in Russia because it's like funding terrorism, basically. That was their word.

So, you know, and I had clients from the Middle East, from Saudi Arabia and Chinese clients as well. When we first came up with the idea, the difficulty was the metrics, because at that time, there wasn't a quantitative composite human freedom score. And by human freedom score, I mean both personal and economic freedom together. And so we developed our own. And we had a provisional patent on this kind of human rights quotient quantification system. And then when I eventually left Fidelity to stay at home with my very young child at the time, I think she was around three or four. I went to score the countries using the system. And scoring the countries is a major job. It's like four months out of the year. It would take me to score all the countries in the

universe. So I started scoring the countries and I went to one of our sources' websites, Frazier. And I saw that they now had a human freedom index and data set. We were using them for their economic freedom dataset. So I called my contact there. His name is Fred. And I said, Fred, what is this? And so we compared notes with my system and their system. And they almost match. perfectly. So I said, Fred, can I just use your scores because they're the same and you guys have much better resources and can save me basically four months out of the year. So they said, yeah. And so by doing that, I also get third party objectivity. So there is no subjective opinion in the weights and the scoring because I work independently from those guys and they work

independently from us. So there is no influencing the score in any way. And so when you saw the output, it was exactly what you expected to see based on the input. I mean, there's always surprises. We don't know everything that's going on in these countries. I don't keep up with every protest that's happening in India. So when I saw the scores this year, there were actually some surprises. Some years, there's not as many surprises. So, for example, when we rebalanced once a year, when we rebalanced last year,

there were no changes to the countries at all. So we just went back to the target weights in the securities. This year, two countries got dropped and two got added. So the ones that are small in their allocation, they are in danger of getting dropped and the ones that are just under the cusp are possible to get added in any particular year. So we had a big turnover this year in our rebalance. It was one of the higher turnover rebalance. Sometimes there are surprises. And what surprised me this year was India getting dropped. They have to meet a certain threshold for decline and score before they would get dropped

out of the index, even if it's a smaller allocation. And India did barely get dropped. And I looked into it further. And it does seem they had some very problematic human rights issues in the past year. They basically blacked out the internet in places that had protests. They intimidated reporters. They repressed the Kashmir people. So Kashmir is kind of like the Xinjiang region for India. Now, I don't want to compare them to China, though, because it's a very, very different situation, not even close. So I don't want to compare them to all these other countries that are never in the index that have a much more score. That is your biggest one is that China's not in. And I think for the MSCI, I shares one, it's probably like 37 to 40 percent of the index. Is this something that

you think would take a very long time for China to ever get in there? Do you expect it to just never be part of your index? Or how do you see that? Yeah. So China is a country that has a lot of potential and I hope to see them in the index at some point. But in order to do so, they would have to literally change directions. So they're literally going the wrong direction at this point. Their score is not only bad, but it's declining. They made some progress on the economic freedom front in the last few decades, but now their personal and economic freedoms are going the other direction. So when you run this thing, you see it going down every year almost. Yes.

Can it go negative? It is negative. The algorithm spits out the weights based on the composite scores and the excluded countries are excluded because their weights come out negative. So let's talk about that. How do you actually quantitatively screen out countries by their freight of weighting? What are some of the very specific inputs that we're looking at? Okay. So we're looking at inputs from three different categories as far as freedom.

So there's civil freedoms, political freedoms, and economic freedoms. So that's the categories that I put them into. I think our data provider actually puts into two categories, personal freedoms and economic freedoms. But what I consider civil freedoms are things like terrorism, trafficking, torture, women's rights would be in this category. Does everything get an equal weight in the composite? Yeah, everything is an equal weight. And the reason why that is, is Jim Gortony is one of the people that came up with this scoring system. He's a professor down in Florida.

And he basically said that freedoms are like the parts of an automobile. You can't have a steering wheel without a transmission. The car won't run. So they all work together. So you can't have like, you know, independent judiciary without free media. So there's no accountability if you don't have a free media. So basically the idea is all the freedoms are important and they all work together to make the economy or a country run. So every single indicator is equally scored. So the U.S. has had a premium

valuations over emerging markets for quite some time now. Part of it is just because the U.S. has outperformed for a while. And the other part is obviously emerging markets are still developing. They're more volatile by nature. Do you think some of this is, though, the government's involved and by taking away some of those governments that takes away some of that valuation premium that U.S. gets over emerging markets? Okay. So instead of calling it governance, which sounds like the government interfering in private markets, I would call it there is a foundation of freedom in place. So with the foundation of freedom in place, you have the conditions for wealth growth and innovation. So that's why we invest in the freest countries in the emerging markets, because they

are launch paths for innovation, because one, they're coming from a very low base. The United States obviously is coming from a higher base. And they have the conditions on the ground for micro level wealth creation and innovation. So yeah, governance absolutely matters if you're talking about having the conditions in place for wealth creation. Innovation is another segue, I think, because I think a lot of people misunderstand emerging markets and they think about it in terms of the early 2000s, and it was all materials and commodities and you had this big commodities boom because of China, but technology is such a bigger weight now.

So for years, just looking through your fund, technology is your biggest sector waiting. I think that surprises some people that you have this emerging tech scene in the emerging market countries. Maybe you could talk about that and how emerging markets have changed over time in terms of their makeup. Hey, Parth, before you jump in, let me just put some meat on that. So in June 2008, this is according to a piece that Ben Johnson did, which we'll link to. In June 2008, energy and materials were 40% of the MSCIEM index. So 40% in 08, that went down to 12.5% at the end of 2020. So it is not what we probably think it is. Yeah, internet growth in emerging markets

has definitely added a lot to the changes that we see. And the technology sector is one of the fastest growing sectors in the emerging markets. So some of these funds that focus on that sector actually have done very well. Our index definitely does have a very high allocation to tech. And that's because of our high allocations in Taiwan and South Korea. So in some of these countries, like Taiwan and South Korea, I think China is putting a lot of R&D behind their technology sector as well. Just like in the U.S., technology has become the biggest driver of stock market returns. So, yeah, in emerging markets, even more so, there's more potential for growth there just because of the growing consumer base, the growing use of smartphones. Not everyone's going to

have a computer, but everyone has a smartphone. I think their smartphone usage in Internet access is better than the U.S. in some of these countries. So which countries do score highly on your freedom metrics? Yeah. So our highest weightings are in Taiwan, South Korea, Chile, Chile, in Poland. Poland is one where we get a lot of questions. Like, why is that in there? Why is it one of the included countries? Because they've seen a lot of erosion of their freedoms, kind of like we did the last administration. So they have a very similar extremist right-wing administration in place right now. And they've had this for several years now. So I mentioned that we work with these freedom think tanks from around the world. There's about a hundred in the

network. One of them is from Poland. And I met the Poland think tank probably in 2015 or 16. And what he told me was, hey, if Kaczynski's party gets into power, the PIS party, we're going to lose constitutional majority and things are going to be pretty crazy for a while. And we did see that. They got into power. The other side lost constitutional majority. They saw erosions in things like judicial independence, women's rights and things like that. But this guy told me, like, it won't affect the markets for a couple years. And it happened just as he said. So the first couple of years, the markets weren't affected. Poland was the best performing emerging market in 2017. And then in the beginning of 2018, they dropped from number one most free allocation to number four in our index and they stayed there since. So after they dropped, they've been a smaller allocation. But this is a good example of how we use a relative scoring methodology. So basically, we're not drawing a line in the sand saying you have to be a certain level of freedom score or saying you just have to be freer than your peers. So as long as you are more free than, say, China, Russia, Egypt, Turkey, then you know, you're in. You don't have to be a certain line in the sand.

If you look at the stats, I've seen it's something on the order of 40 to 50% of global GDP comes from emerging markets, but it's only like 10% of stock market cap. Yeah. What's going to cause that to get more in balance? Are the financial markets there becoming more organized and better so that like this is the century of emerging markets potentially where they place some catch up? Yes. I think this also plays into your previous question about what's different about emerging markets now versus like in 2008. So a lot of these countries are playing catch-up, and there's an effect, like the catch-up effect, right? In these emerging markets, China went through this, where you're coming from a very low base to kind of a not-ass-low base, and that creates, or in China's case, they went from abysmal policies under Mao to not-so-bad policies, like under Deng Xiaoping and his ears and following in Huijintel and now we're kind of going the other direction. But they're coming from a very low base, and they improve their policies a little bit, and it creates this illusion of economic.

miracle. And that catch-up process is a huge growth driver for a lot of these markets. But once they go through that, if they don't couple those economic freedom improvements with personal freedoms, they hit this plateau. Even though they have a huge population that could benefit from being free and being more creative and just not having these restrictions on them, they haven't done that. So China, for example, I think, is a growth story of the past because they went through this catch-up process and now they've caught up. And so the growth is going to slow and stagnate unless they can become more free. So I think that catch-up process is very real. But like you're saying, in emerging markets, the ones that are going to become the next developed markets out of the

emerging markets country set are, in our opinion, the freer ones because freedom sets the foundation and the conditions in place for development. And if you notice all the developed markets, the reason why we did this in emerging markets and not developed markets is because all the developed markets are already free. And that's probably why they became developed markets. So it's not an accident. That's a good segue to maybe a softball question. Why is economic freedom conducive to economic growth? Same goes to personal and civil and all that sort of stuff. How does this tie into business and the stock market and performance? Yeah. So when you are in a very unfree market, so you have to be one of the elite to basically have access to wealth and there's no really wealth

creation. How about the book? Yeah. Oh my God. I'm drawing a blank. The investment. The investor who went to Russia. What's his name? Bill Browder. I'd notice. Yes. That read like a Tom Clancy novel, but that was a true story. Can you talk about that? Yeah. So basically, Bill Browder was an investor. He's a hedge fund investor in Russia in the days when they were first privatizing everything. The way they did it was a very inefficient process where there was huge arbitrage opportunity for the investor, for someone who knew how to value a business. And so he went over there and used this huge arbitrage opportunity to make a lot of money. He made so much money doing this that the Russian state basically came up with a scheme

to steal the taxes that he was paying out of his profit. So he was paying so much in taxes that the taxes alone was worth coming up with a scheme to steal. And so the Russian government stole the taxes from basically the Russian people, gave the money to oligarchs. So they're not very friendly towards shareholders to state the obvious. There's a huge lack of shareholder protections in these unfree markets. You see that in Russia, in China, in Turkey and Egypt.

So his lawyer, Sergei Magnitsky, some of you guys might have heard his name from the Magnitsky Act. Wasn't he murdered? Yeah, that was his lawyer. And this lawyer uncovered the scheme. They put the whole story on YouTube. So they, on YouTube, told the story of how the Russian state stole these taxpayer dollars after they uncovered it. So once they did that, Bill Browder was detained. The lawyer was taken out of his home and put in jail.

His entire hedge fund offices were ransacked by government officials. And he was basically detained at the airport and not allowed to come back. This lawyer, Magnitsky, was tortured, beaten in jail, and died. He was beaten to death. So after that happened, Bill Browder gave up the hedge fund business and became a full-time activist. And now he goes around the world, lobbying for the Magnitsky Act, which basically punishes the human rights offenders in all these various countries, including the people that killed Serg Magnitsky. When you started this fund and

you're getting into these issues like this, you probably weren't even really on the radar of like the ESG stuff. You just kind of fell into that and it seems to be building more after you already had gotten pretty far along this path, right? ESG was on the radar when we first started, but we are not the traditional ESG. So if you look at emerging markets ESG funds, they have the same amount. They have to mirror their parent index as far as the country allocations. So they have the same amount in these autocracies. They have 40% in China. They have the same two or three in Saudi Arabia, Russia, and so forth. So you still end up with 50% plus in autocracies in the emerging markets ESG funds, which I find at best laughable and at worst, it's deceptive. Because ESG funds, they are coming across as,

hey, we're doing what's best for the investor. We're benefiting mankind, you know, so forth. And so they're excluding alcohol, tobacco, gambling, corn, but countries that have millions of people in concentration camps, that's totally fine. So I find this a little bit hypocritical. And some of these ESG companies hold themselves out to be the arbiters of social justice because they're excluding these minor infractions. And some of these are even fuzzy lines of infractions. For example, Lockheed Martin is excluded because of weapons, right? But they provide weapons to Taiwan to defend their democracy. How do you justify that? It's very hard to untangle this web. I mean, it's so subjective of the ESG stuff.

Yeah. So that's why we don't want to be associated with the traditional ESG because we find it's ineffective in emerging markets. It works fine in markets where you have full transparency of information and that information is available to everyone and it's pretty reliable. But in the emerging markets, that information is very easily manipulated, it's self-reported, and you don't have the basis for ESG in a market where there isn't freedom. So freedom is the basis of all other ESG.

You can't have environmental protections if you don't protect your own people. You know, you can't have, you know, you can't say we know tobacco, alcohol and all this stuff when you have torture and disappearances and things like that. So yeah, I mean, we just find that ESG in emerging markets has to start with a basis of freedom. Once you have that basis, then you can talk ESG. Can we talk a little about sector stuff, like how this actually filters into the holdings of the index? Because, for example, Tencent and Alibaba and Baidu, those are the huge names in the Emerging Markets Index. So how different do you end? end up looking versus that.

So ours actually doesn't look that different because we have a high high allocation Taiwan semiconductor and Samsung. So we actually have to cap those securities. We have an 8% cap at time of rebalance. Otherwise, they would be like 16% of the index each. And I think it was you that when we were deciding to do this made the comment that, hey, we're not making a bet on two securities. We're making a bet on for your markets.

So we know how the countries are scored, which is ultimately what drives most of the decision-making, but what about the actual securities? How do you then say, okay, we're going to own this or not? Yeah, so once we have the countries selected and weighted, we take the top 10 largest most liquid securities within each of those markets, and then we exclude state-owned enterprises defined as 20% or more state-owned just because those, we're taking the economic theme all the way through to the security level, or the economic freedom theme all the way through. And state-owned enterprises tend to be a little more inefficient because they're serving two masters, the state, and the shareholders, and typically one of those wins out over the other.

So that's basically just trying to get a good representation of the market within that country in an easily tradable manner for ETF usage. We're not making any sector selections here. We're just taking, you know, whatever sector more represents that market is going to be the top sector in that country. So in Taiwan, it is tech. In South Korea, it is tech. And in some of these other markets, it is the more traditional, like banking or

mining like in South Africa. So it depends on whatever top sectors are in that market. So Jeremy Grantham and GMO have been pounding the table on emerging markets for a while saying that they are just ridiculously cheap. Do you pay much attention to that valuation stuff? Do you see that too where you think that the spread between U.S. and emerging markets make sense that these countries are really cheap? Yeah. I mean, I think that is the consensus. I mean, Rob are not our partner in the firm also has said that for a while. Grantham recently said that U.S. is ridiculously expensive expensive, but emerging markets is respectably priced. And he's expecting, you know, of course, US, he's expecting it to crash. And then he's expecting emerging markets to go down

less in that crash. So I don't know. Those are his predictions. And I think he probably knows what he's talking about. I do think that emerging markets as a whole is a value play, like the entire emerging markets. Because not only the sectors, there's the more value sectors, but I'll say this, that that doesn't apply in countries like China, where you do see a little bit of overvaluation in some of these tech companies because in a country like China, you've got to be careful because you make it or break it based on what the government says. And so the government has been very supportive of tech companies in the recent past, but these tech companies have done very well. Jack Ma was found, right? He's alive and well. So Jack Ma is an interesting story, right?

So he said something that displeased government officials. And so then he disappeared for a while. We don't know if he was disappeared or if he was just out of the public eye. And his and financial, the IPO was scrapped. So nobody expected this to happen. And it was just kind of like the government in China telling us, hey, we are still running the show here. And, you know, I don't care who you are. You can be Jack Ma, but you can still disappear. I don't know if you guys remember when this famous actress funding being was disappeared a few years ago. And I think Josh tweeted about it and was like, hey, this is if Scarlett Johansson was disappeared for a year. You know, something like that. Anybody can be disappeared there, basically. And Jack Ma wasn't seen for,

I think over a month or so. And then he appeared in some random village and he was just like, I'm fine. But sometimes when people get disappeared in these countries, they are told to appear. There's things like forced confessions. There's also things like they're told to go on their social media and act like they're alive and nothing's wrong. So we don't know. We don't know if he was disappeared or not just because he reappeared doesn't mean he wasn't. And you'll notice that all the other tech entrepreneurs over there are silent right now. And that is not an accident. So when you you're in an unfree market, you have to be in favor of people in power to succeed. And when that pendulum starts swinging the other way, that's where as an investor you want to get

out because, and right now, that's what I see with China Tech. Interesting, because those names have done incredibly well recently. Yes, and that's great. Why is that great? Because you made money. But get out before it's too late. Have you looked at the inverse of what you. you're doing? Like, what if you did the anti-freed of waiting? Would that portfolio do poorly or not

necessarily? I have not done that. I think, I mean, I'm not interested in doing that. Right. Long short, next. Yeah. You talked about developing countries that could become developed. So I'm guessing that's like South Korea. Have you looked on the other end of the spectrum of frontier markets, say some countries in Africa that are working their way up and could potentially be in your index someday? Is that a possibility? Are there any countries that stick out that look like their scores are improving enough that someday they could be part of your universe? Yeah. So there are the smaller emerging market countries like Peru, which are very interesting and very free, but just smaller and doesn't meet our minimum liquidity and size requirements. There's also Estonia, which is a frontier market. If you look at the frontier universe, Estonia is the freest one. Estonia is known as the Silicon Valley of Europe. They have this thing called digital citizenship. And you can literally anyone in the world, I can and so can you, become an east citizen of Estonia and establish a business there and get funding and things like that. Michael's going to start an NFT shop there.

I was just thinking, like, let's be angel investors in Estonia. I want to get in. Yeah, no, totally. We should seriously do that. I actually have been talking with the finance ministry of Estonia because we're looking at Frontier and we're like, we want to include Estonia, but like my index calculator doesn't even have access to their data right now

because they're so small. And so I'm like, I have to pay as much as I pay for the whole index calculation just for access to Estonia. I'm like, can you guys tell me out here? So I'm actually talking with them. They've sent me the link to e-residency, so I'll forward that to you. And let's all become e-residents here of Estonia. Because, no, they've done very well in their digital residencies, and they've been leaders in that zone.

Oh, this works out well. Estonia is just a stones throw away from Helsinki, Finland. I love it there. Yeah. Yeah, no, definitely. We should all make a trip. And actually, are you familiar with the Oslo Freedom Forum? I've heard of it.

I don't know what it is. We should all go to that. It's in Oslo, obviously. Probably in May. I don't know if they're doing it this year. If they do it this year, it'll be in August. May is tight. 2022, Mike.

There we go. Harth, this was so much fun. Thank you for coming on today. Yeah, you're welcome. Thanks for having it.