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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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Jack McHugh
Jack McHugh
8 months ago

I’ve been trying to reduce/eliminate China exposure and it’s hard. I too bailed on Vanguard Total International for a developed markets fund, and bailed on Schwab’s emerging markets fund for XCEM – the initials tell the story.

Partly that was for moral reasons, Uighurs et al, but also geopolitical concerns. Unfortunately most of of the latter revolve around Taiwan, and XCEM is 27% Taiwan!

So I’m still searching.

Our host here (J. Clements) recently wrote about the concept of moving all tax-deferred investments to Vanguard Total World – cap-weighted and around 40% international. That has appeal for the reasons he explained but does not solve this problem.

Last edited 8 months ago by Jack McHugh
dlnevins
dlnevins
8 months ago

I reached the same decision last fall, and commented on another site that I no longer feel comfortable owning the Vanguard Total International Index Fund because it holds companies incorporated in Russia and China. I have been slowly moving my assets into the Vanguard Developed Markets International Index Fund for that reason. I took some flack for my decision on that other forum, but in light of what has happened in Ukraine I feel even more comfortable about having made it.

That said, I do wish I could support some companies in emerging market economies that are democratic or at least trending toward democracy. Until I move off of the old Vanguard mutual fund platform and onto their brokerage platform I cannot buy the FRDM fund, but I will probably add it to my portfolio this summer after I have made the switchover. I’m grateful that this article brought it to my attention, as it sounds like it is exactly what I am looking for in terms of emerging market exposure.

Mik Cajon
Mik Cajon
8 months ago

Question…why is America buying Russia’s oil and gas when a year ago we were energy independent and selling the surplus?

Last edited 8 months ago by Mik Cajon
Guest
Guest
8 months ago

Seems far more efficient for funds like VWO to simply liquidate their maybe 1.5% holdings in Russia than for fund holders to liquidate our shares of the fund.

Harold Tynes
Harold Tynes
8 months ago
Reply to  Guest

Effectively, the position has been liquidated becasue of the decline in values for Russian equities. Investors took it on the chin.

Guest
Guest
8 months ago
Reply to  Harold Tynes

Perhaps. It will be enlightening to learn how much, if any, of VWO’s (and other funds) Russian holdings were liquidated leading up to the invasion. Of course the holdings could have been sold off-exchange as well prior to going bust. Regardless, I’m not interested in bailing out of VWO.

Brent Wilson
Brent Wilson
8 months ago
Reply to  Harold Tynes

I wouldn’t want all my Russian shares liquidated right now. There will eventually be a recovery right? But maybe EM funds should begin to underweight some of the EM countries with abusive and unpredictable governments.

It’s very difficult for me to think about. I want to index at heart. But that’s in a free, democratic world.

I don’t want to go full Jack Bogle and shun international entirely, but perhaps one day I will so I don’t have to worry about this. The world is changing and embracing democratic ideals more and more. Unfortunately, some of the International world refuses to catch up and I doubt they ever will.

Brent Wilson
Brent Wilson
8 months ago

This is a great article. Unfortunately, I have around half of my international exposure in VEMAX. I may need to re-think this as a long-term strategy.

I could try to eliminate certain emerging market economies from my portfolio as you mention, but I may instead opt for a total international fund long-term so I am no longer overweight EM.

Like many investors, I am tempted by reasonable valuations and reversion to the mean in emerging markets, but the points you make are undeniable from where I sit.

parkslope
parkslope
8 months ago

Despite using a “fully automated algorithm” the FRDM fund has an expense ratio of .49%, so giving weight to our values comes with a cost. While I respect those who decide to invest in such funds, I prefer to make donations to causes I believe in. Given that Russia will be a pariah for years to come, I also think we will see many funds dump their Russian company holdings because of their weak long-term outlooks.

dlnevins
dlnevins
8 months ago
Reply to  parkslope

Not giving weight to our values also comes with a cost, though. It’s not immediately evident, but we might find that down the road that cost is very high.

These are not easy issues to wrestle with, to say the least! (Especially since nations can change over time, and moving investments from one stock or fund to another one can be quite costly).

Mik Cajon
Mik Cajon
8 months ago

See above comment

Last edited 8 months ago by Mik Cajon

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