What Price Evil?

William Ehart

MUCH HAS BEEN written about the virtues and pitfalls of index funds that weight stocks based on their market value. In theory, every company’s stock market value reflects the collective wisdom of market participants. Apple the biggest stock in the world? Must be for good reasons, the thinking goes, so it should get a big index-fund weighting.

Well, the market cap of Russia in the Vanguard FTSE Emerging Markets ETF (symbol: VWO) as of Oct. 31 was 3.5%, bigger than Thailand, Mexico and Malaysia. That’s both low—reflecting the obvious risks and the small size of Russia’s kleptocratic economy—and, as it turned out, too high. I don’t claim that investors should have seen the expanded war in Ukraine coming four months ago, when iShares MSCI Russia ETF (ERUS) rose to its highest level since its 2010 inception. The fund has since plunged 76% from Oct. 25 through March 1. But there have been huge red flags about Vladimir Putin’s regime for more than a decade.

Those of a value bent, thinking they can beat the market with cheap stocks, might have seen opportunity in the Russian market’s price-earnings (P/E) ratio of seven as of Dec. 31, based on trailing 12-month earnings, versus 26 for the U.S. market. Perhaps the market isn’t pricing Russia correctly, some may have felt. The theory goes there’s a price at which everything becomes a bargain, even the bonds of a bankrupt company. But instead, Russia’s trailing P/E ratio has since fallen to three. Investors have lost billions bottom fishing.

A ballyhooed alternative to market-cap indexing is fundamental indexing, weighting stocks based on characteristics such as the size and sustainability of their dividend yields. How has that approach fared? As recently as October, iShares Emerging Markets Dividend ETF (DVYE) had nearly 23% in Russia, even more than it had in China. At the time of its June shareholder report, WisdomTree Emerging Markets High Dividend Fund (DEM) had 15% in Russia. In August, Schwab Fundamental Emerging Markets Large Company Index ETF (FNDE) reported 13% in Russia.

I pointed out the risk in these funds in an August 2019 article. Am I a genius? Believe me, given my many investment missteps, I’m best thought of as a contrarian indicator, hence my embrace—too late in life—of indexing.

Yet how smart did anyone have to be to realize that 23%, or even 13%, in Putin’s Russia was folly? But the dividend-weighted index creators had their blinders on. In a way, intentionally so.

Fundamental indexing has similarities to market-cap indexing to the extent that it seeks to take individual judgment—such as a stock-picker might exercise—out of the equation. Instead, it’s a rules-based system attempting to capture a universe of stocks exhibiting characteristics historically associated with market outperformance. A value judgment about Russia—or China, for that matter—was never part of the equation.

But should it have been? It’s dangerous to think you know more than the market—that’s nearly always an ego-driven loser’s bet. That’s one reason I inserted the caveat in my article two-and-a-half years ago that, with Russia’s P/E so low, the risks might be priced in. Yet, as fraught with emotion and fallibility as our judgment is, at a certain point, we must exercise it.

That judgment may be based on our moral values: Personally, I have tried for years to avoid much exposure to autocratic regimes that abuse their people, and there’s a lot of that among emerging markets. But I could also chalk up my judgment to common sense: It’s smart to avoid countries where an autocratic regime has the power and inclination to meddle deeply in its economy, its companies and its markets, and offers few protections to individual—especially foreign—shareholders.

There is one fund manager who cares deeply about the moral dimension, while also asserting that countries lacking freedom are fundamentally bad places to invest. I interviewed Perth Tolle, creator of the Freedom Emerging Markets 100 Index Fund (FRDM), in July 2020 and have since become an investor in her fund. Based on her unique “freedom-weighted” index, the fund has no exposure to Russia, China or Saudi Arabia, among others.

It’s an approach with risks of its own: 17% of the fund is in Poland and 15% in Chile, both hugely outsized positions relative to the market-cap indexes. Yet since inception in May 2019 through February, the fund is up 39%, outperforming Vanguard’s emerging markets index fund, which is up 30%, and iShares Core MSCI Emerging Markets Index Fund (IEMG), up 29%, and it’s even further ahead of the big fundamental-weighted funds mentioned above.

My suggestion: With Ukrainians fighting for their freedom—and indeed their lives—maybe we should give greater weight to our values not just in our political decisions, but also in our investment choices.

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