Played for Fools

William Ehart

“THE CHINESE PLAY the long game. We play checkers, they play chess.”

You hear such sentiments from Americans a lot. It’s one of the narratives that draws foreign money to China. The story is so good, it distracts investors from an important fact: The oldest China exchange-traded fund, the iShares China Large-Cap ETF (symbol: FXI), has lost a quarter of its value since peaking in 2007. Yet somehow—helped by Chinese government pressure on index providers—China’s weight in the emerging markets indexes is higher than ever. For instance, the country now represents 42% of the Vanguard Emerging Markets Index Fund.

Despite the iShares fund’s incredible run from inception in late 2004 until the financial crisis, and several huge ups and downs since, it has underperformed the S&P 500 significantly in that nearly 16-year span. If China were a value fund, you’d have sold by now. Beijing is indeed playing a long game, but at the expense of foreign investors—including little guys like you and me.

These thoughts crystalized as I chatted recently with Perth Tolle, founder of Life + Liberty Indexes and creator of the Freedom 100 Emerging Markets Index. To be sure, Tolle is “talking her book.” The year-old Freedom 100 Emerging Markets ETF (symbol: FRDM), which tracks the index, shuns Tolle’s native China. It also steers clear of many other developing nations where individual rights are trampled.

Tolle’s thesis is that stock markets of countries that respect the human, civil, political and economic rights of citizens and investors should be better for shareholders over the long run. So, no China, no Russia, no Saudi Arabia in the index. “This is for people who believe in the long-term benefits of freedom and want to stand up for that in their emerging markets allocations,” she says.

Index inclusion is determined not by Tolle’s preferences or by the headlines, but by metrics kept by three organizations: the libertarian Cato Institute in the U.S. and Fraser Institute in Canada, and the liberal Friedrich Naumann Foundation for Freedom in Germany. For instance, India’s weight is limited by its protectionist policies, while Brazil is excluded because of its high homicide rate. “Our think tanks determined that if you can’t walk down the street without getting shot, then you’re not free,” Tolle says.

What about that fast-growing Chinese economy, the one everyone wants a piece of? “Where did that growth go?” Tolle asks. “Why didn’t foreign investors get to participate in that? That’s one of the risks of investing in unfree markets. There’s a lot of government interference in business practices, without the rule of law and investor protections in place. A lot of that growth gets siphoned off to who they want it to go to.”

In Tolle’s view, Wall Street and index companies such as MSCI and FTSE have been bent to China’s will. Even the Securities and Exchange Commission has allowed Chinese companies to come to market without meeting U.S. accounting requirements, though Tolle notes that may be changing.

Recently, the SEC and Nasdaq had a bitter taste of Luckin Coffee, but initial public stock offerings (IPOs) of Chinese companies have been problematic for years. Billed as “the Starbucks of China,” Luckin once had a market cap of nearly $13 billion before a massive fabrication of sales was revealed April 2, about a year after its IPO. Unwitting iShares and Vanguard emerging markets index fund investors got burned: The funds were the largest shareholders.

Tolle reached out to a friend in China after the scandal broke. The joke there? “Luckin is the best company in the world because they give Chinese people free coffee and then they go to the U.S. and get the stupid money,” she says.

I obviously feel strongly about China (as well as Russia, Saudi Arabia and certain other emerging markets) and about investor protection, but this is not a recommendation to buy the Freedom 100 fund. I don’t own it myself, at least not yet, though I admire what Tolle is doing and want her to succeed. It’s important to note that her principled stand rules out about half the market cap of today’s broad emerging markets indexes. The fund is still tiny, with just $16 million in assets, and the expense ratio of 0.49% is well above average, though in line with many factor ETFs.

And I wonder if, in the short term at least, the world is moving away from her. I hope things get better, but it seems like they will get worse first. In addition to China’s increasingly aggressive behavior (summarized well here and here), there is a rising tide of populism and nationalism across the globe. Turkey got booted from the Freedom 100 index in 2018 as a result of President Recep Erdogan’s dictatorial behavior. Rightward-lurching Poland has seen its weighting cut.  

On the other side of the spectrum, many younger Americans are flirting with “socialism”—or some fuzzy notion of it. Do these developments threaten Tolle’s world view? The entrepreneur, who has experienced freedom in the U.S. and in the Hong Kong of two decades ago, but who grew up without it in China, says no. “My faith in democracy is not shaken,” she tells me. “But I can understand why it would be for some people.”

William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles include Right from WrongRed Flags and Averting My Gaze. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart.

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