How to Invest in Emerging Markets and Why Most Are Doing it Wrong with Perth Tolle
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My experience having half of my childhood in China and half in the U.S. and then going back there and seeing how different my life would have been had I grown up completely in China versus my formative years being here in a more free society. That's what made me realize that freedom makes a difference and an impact in not only my life but in markets as well.

Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today we are talking about freedom. My guest is Perth Toll, and Perth is the founder of Life and Liberty Indexes. She also sponsored an exchange-traded fund that was recently launched called the Freedom 100 Emerging Markets ETF. The ticker is FRDM, like freedom for short, if you want to look it up. What

With her help today, we're going to be diving deep into the world of emerging markets. Here's the deal. In my opinion, emerging market stocks belong in a long-term diversified investment portfolio.

In a traditional 60% stock, 40% bond portfolio, my firm allocates close to 10% to emerging markets. So a million dollar retirement portfolio might have around $100,000 in this volatile, often difficult to understand asset class, which is a meaningful position.

But why? Why invest in emerging markets at all? Why invest overseas if the US stock market has done so well? And what are emerging markets anyways? We're going to be answering all of these questions and more in today's interview. For all the links and resources mentioned in this episode, visit youstaywealthy.com forward slash 56.

I just shared in the introduction that I recorded that my firm allocates close to 10% to emerging market stocks and a traditional 60-40 portfolio, which is... I think both you and I would agree that that's a meaningful position. But...

But in your own personal investment portfolios, you allocate over 50% to this extremely risky asset class. So I'd love to just start there. Why do you personally take such a large position in emerging markets? I think 10% is a very reasonable approach. And I would say that's a very good standard among strategic 60-40 portfolios. I commend you for having that allocation for your clients.

My own philosophy for my own personal investing is buy cheap and hold for a long time. So this is something that I think my partners at Alpha Architect would agree with as well. They're, I would say, the kings of that, even more so than me. But I am investing, you know, for the long term. And I believe emerging markets have

favorable valuations and growth prospects for the long term that more so than their developed market peers. So yes, I am a very overweight emerging market at this time. I don't recommend that for everyone. But since I'm a very long term investor, I'm okay with the volatility in that portion of my portfolio. And you know, my actually my daughter who has even longer timeframe has a

very overweight emerging markets as well in her portfolio, but her 529 is more diversified. I would add here, though, that I am biased. Obviously, I have an emerging markets strategy and 100% of my emerging markets strategy

allocation is in that strategy. So I am investing in my own strategy here and is more biased than most people. So you take that with a grain of salt. And we'll dive deeper into that. Maybe first we can just break down really simply, what are emerging markets? I feel like sometimes when we talk about emerging markets, people's eyes glaze over. They're like, what is that? So what is an emerging market and what makes a country an emerging market?

So an emerging market is what you would think of traditionally as third world countries. So it was actually a term coined by a World Bank economist in the 80s to replace a fund that invested in third world countries. So and the reason why they call it emerging is because they're typically countries that are coming out of autocracies or more autocratic types of governments into a more market economy with more opportunities.

developments in their institutions, their economic freedoms, and just rising share of global output. And so what would be a few examples of emerging market countries that most of us would know? So some common emerging markets that we all know about are the BRIC countries. So Brazil, Russia, India, China, and South Africa are probably the most common. So because we're familiar with BRICs, we think of those as emerging, but some of the less

Well-known emerging markets are countries like Chile or Poland, Malaysia, and so forth. So some of those markets may not be as well-known, especially in the more commonly used indexes, but probably the most well-known emerging markets are China, India, Brazil, and Russia.

And you mentioned BRICS, which is an acronym, B-R-I-C. So if anyone wants to look that up, you can go just type in BRIC into Google and learn more about that. Why do you think someone would ever want to consider even a small position, let's just say 5% of their investments, why would they even want to consider a small position in emerging markets? What do you see as the benefit or the opportunity for allocating some money to that asset class?

There's a few benefits and opportunities here. So one is diversification. You're lowering your overall risk by diversifying to these markets that are different fundamentally than the developed markets.

So some of these markets are, you know, growing their middle class, they have more of a consumer culture, and their demographics are a little bit better than you see in most emerging markets. I mean, most developed markets, the exception there being China, who has the worst demographics in the world. But in most of these countries, like Indonesia, for example, and some of these other bigger frontier markets, smaller emerging markets, like Vietnam, very favorable demographics.

The other reason is they're expected to grow faster as far as projected growth in the future than developed markets. And also right now, their valuations are extremely favorable compared to developed markets and even US. So US valuations, our stock market has been going up for quite some time. We've had a nice bull run here. And so our valuations, our companies are more expensive now. Whereas in emerging markets, they're much cheaper.

So, you know, if you believe in reversion to the mean, the emerging markets are much more poised for recovery here.

This is said another way, US stocks have been doing really, really well over the last 10 years or so. Emerging markets haven't been doing as well. It's like Warren Buffett always says, buy when there's blood in the streets or buy things that nobody else wants to buy. And emerging market stocks seem to fall in that camp today. Would you agree? Yes, I would agree with that. I want to talk about home country bias, but first, and you've kind of alluded to it, you're

So your home country is China. You were born in China. I'd like for you to just tell us a little bit about your experience in China growing up there and then kind of what you've learned over the years and how that ultimately inspired you to create the Life and Liberty Indexes, which ultimately ended up you sponsoring the Freedom 100 ETF, the ticker being FRDM. So talk to us a little bit about your experience of China and everything you learned and how that led to kind of what you're doing today.

I was born in Beijing and I grew up there until I was about nine years old, at which time I moved to the US and grew up here until after college and then went back to Hong Kong to live for about a year before returning to the US. So my experience having half of my childhood in China and half in the US and then going back there and seeing how different my life would have been had I grown up

completely in China versus my formative years being here in a more free society. That's what made me realize that freedom makes a difference and an impact in not only my life, but in markets as well. When I went back to Hong Kong after college, it was around 2003 and 2004.

And I traveled extensively to the mainland, to Beijing and Shanghai and Shenzhen and other areas. So I saw some things there that kind of shocked me as someone who grew up in a mostly free society. And it opened my eyes to the impact of freedom. And I was born free.

just after the one child policy was instituted in China. So my entire generation is basically a whole generation of single children. And

There are exceptions, of course, like in the countryside, sometimes you can have more than one. Or if you have a girl first, sometimes you can have more than one. Or if you pay, you can have more than one. And that policy has been now changed to the two-child policy. So now you're allowed to have two children in China. But just having a government that has so much control over each person's individual choice is

To the point they can tell you how many children you can have. And then doing this thing with the one child policy, it changed the entire culture of my generation. So now, even though they allow two children, very few people are having two children as they're seeing here. And the reason why they're doing that is because the demographics are so bad after having 30 years of the one child policy that they now need people to have more children for the future productivity of the country.

But having had that policy in place for 30 years, the values of a whole generation have changed. The policy itself has led to huge gender imbalance. So there's for every 100 girls born in the country, there are about 118 boys. So you can see the gender imbalance is a huge issue, which leads to also more militarization of society, because what does a boy do?

if there's no prospect of ever getting married because there's no women. And it also leads to trafficking and drives trafficking in surrounding regions inside China, in the Asia Pacific, and also as far as there are reports of women from Colombia being trafficked to China. So actually, you know, changes in that one policy had a huge impact on me and made me realize that, hey, governance is actually important to society and to markets.

And I want to dive deeper into China and how that kind of translates to your typical emerging market mutual fund or ETF that you might buy today. But really quick, so we can kind of set the stage for that conversation. I'd like to briefly talk about market cap weighting. So when any of us invest in an index fund, whether it's an index mutual fund or index ETF,

which we're huge fans of here in the Stay Wealthy community, the fund's job is to track a particular index. So for example, you might buy a fund that tracks the S&P 500. But as you and I know, you don't own an equal share of all 500 of those stocks. If you actually look at the holdings, you'll find that you own a higher percentage of some stocks like Microsoft, Apple, Google. You'll own a higher percentage of those larger companies than smaller ones like Hewlett Packard or United Airlines.

So the companies are being weighted

in that index fund by their total market capitalization. Higher market cap companies like Microsoft carry a higher weighting percentage than smaller cap companies like United Airlines. So let's just start with, in general, do you think that there's a problem weighting stocks this way and why? And then we'll get into kind of the emerging market space. Yeah. So market capitalization weighting has its advantages and disadvantages. So

Some of the advantages are it's cheap, it's easy. It's an, you know, in an efficient market, it generally captures a good representation of the stocks in that market. And that's because the more efficient the market, the more market capitalization makes sense because the more information is available and transparent and reliable, the

the more prices capture the actual value of the company based on all of that available and reliable information. So in a developed market, it's generally the accepted default to use market cap weighting. And that

is fine, you know, as long as the information in those markets is freely available. But that's not always the case in emerging markets where information isn't available, reliable, or transparent. So in emerging markets, sometimes you have

bad data. Sometimes you have data that's unavailable or is unreliable. And sometimes you have different sets of data for different people. So in addition, in the emerging markets, political risk matters as much as economic risk. And market cap weighting just doesn't consider any of those risks.

And I would add here that especially in emerging markets, market capitalization weighting leads to a very high allocation to China, which I think has contributed to the underperformance of emerging markets as a whole.

Because China has been such a huge part of the market cap weighted emerging markets indexes. And when you're investing in a less free market like China, where central planners and the state controls a lot of the market activity, investors don't efficiently capture so much of that growth. So if you look at the Shanghai composite, for example, over the last 10 years, it's basically the

flat, despite all that China has obviously grown over the last 10 years. Okay, so market cap waiting in, let's say, the S&P 500, US stocks, maybe it's not perfect. There are people like Rob Barnett out there that make some arguments. So maybe it's not perfect, but it's pretty darn good. It's a pretty good representation of the US stock market. It's a good representation of the market in an efficient market, yes.

But moving over to emerging markets, a market cap weighted index has some bigger problems. So maybe talk to us a little bit more about what those problems are when you look at a market cap weighted emerging market index fund. Like you're just stereotypical, you go to Vanguard or Fidelity and just buy like your plain vanilla market cap weighted emerging market index fund.

Any plain vanilla market capitalization weighted emerging markets index fund, which is 99% of the emerging markets index funds out there, are going to be based on either MSCI Emerging Markets Index or FTSE Emerging Markets Index, and there's some based on S&P. The main problem with

market capitalization weighted emerging markets indexing is that you get a very heavy concentration in the biggest emerging markets, which happens to be China. So China is the biggest emerging market. And it gets a very high weight in these indexes because of that market cap weighting. About what percentage? So in Vanguard, which are based on FTSE, you're going to get

about 35% and growing because of the addition of A shares. And in I shares based on MSCI, you're going to get about 32% currently in China and also growing because of the addition of A shares. So if you buy your low cost, plain vanilla emerging market index fund through a Vanguard, let's just say Vanguard, if you look under the hood, about 30% of your money is being invested directly in China. More than 30% and growing.

Yes. Okay. And that's just direct China exposure. You also have in emerging markets, a lot of indirect China exposure.

So, you know, for example, a South African company, NASPERS, which is in my index as well, made a huge investment in a Chinese company, Tencent, a while back, you know, in the very beginning of the company. And that has grown to be a huge portion of NASPERS market cap. So now that Tencent exposure has now been moved. They did a spinoff to another company called Proces, which is

listed in Amsterdam. So the process shares are no longer in my index. But you can see from that example that most of these emerging markets do trade with China, or they invest in China. So there's also indirect exposure to China. In addition, most of these big, broad market cap weighted emerging markets indexes have about 70% in the Asia region. So you have 30 plus percent in China,

If you include Taiwan, Hong Kong and South Korea, which are all very well correlated to the China market, you have in all of those indexes more than 50% in the China region, if you call it the China region, surrounding China. And then you have 70% in Asia. So it's a huge allocation or a huge concentration in one country and one region.

And also it's becoming a more, as we can see in recent events, kind of a risky area to be investing in. Kind of the conclusion here is that, like you said, 99% of emerging market funds, if you just go buy one of these low cost Vanguard like emerging market funds, just know that you're making a highly concentrated bet on China and Asia in general. Yes. China, especially. China, especially. Yeah.

So this kind of problem that you uncovered led you to found and create the Life and Liberty Index. And just so we don't confuse people here, there are indexes and then there are funds that track that index, right? So the S&P 500 is an index that was created and then

And then there are mutual funds and exchange traded funds, and it's their job to track that index if they so choose. So you created the Life and Liberty Index, and then subsequently you sponsored the launch of an ETF to track that index, which is called the Freedom 100 Emerging Markets ETF. Again, ticker is FREEDOM or F-R-D-M.

Someone wants to look it up. So talk to us about the weighting methodology that you used for this index and how it's different than the traditional market cap weight that we just bashed on there for a few minutes.

and kind of why you landed on that and how it helps solve some of these problems that you've uncovered. Yeah, so our index is created using freedom weighting instead of market cap weighting. So instead of using the size of the market, we use freedom metrics on the country level to determine the country's weight and inclusion in the index. So we're looking at how well a country protects the human freedoms and economic freedoms of their citizens, and

And if the level of protection is higher, they get a higher weight in the index. If the level of protection is lower, then they get a lower weight in the index. And the worst offenders are excluded altogether. To determine the freedom scores per country,

We use 79 indicators, and these are compiled by the Cato Institute, the Fraser Institute, and the Friedrich Naumann Foundation for Freedom in their joint project called the Human Freedom Index and Dataset. And these data I categorize into three categories, the rights of life, liberty, and property.

So the rights to life are things like terrorism, trafficking, disappearances, torture, and so forth. Rights to liberty are things like rule of law, due process, freedom of speech, freedom of religion, freedom of the press, freedom of assembly, freedom of movement, and internet freedoms, and so forth. And then property, rights to property are your economic freedoms. So these are things like the level of government interference in private markets,

legal system and property rights, sound monetary policies, freedom to trade internationally, and other regulations.

So the higher a country scores in these, the higher its weight. What would be an example of a country that's been eliminated from the index? Very different from the other market cap weighted indexes we just discussed. We have actually no allocation to China currently. So there's no China, no Saudi Arabia, no Egypt, and no Russia. Saudi Arabia is another one that is notable because MSCI is currently adding Saudi Arabia to their emerging markets index. And it's

not an insubstantial weight. So it's not going to be one of the smallest countries once added. Some might put you in the camp of socially responsible investing or SRI or ESG, kind of that camp of investing. And a lot of times investors are willing to put their money in a socially responsible investment, knowing that they may get lower returns on

but they're supporting their beliefs and morals and values. And so they're okay getting a lower return by doing that. I'm just curious, your goal for this fund, this index, is it to match the broader based emerging market returns? Or do you think that by weighting it how you're weighting it, you expect outperformance or underperformance? How do you view that?

We do expect the freer countries to perform better, more sustainably, to recover faster from drawdowns, and to use their human capital and economic capital or their capital and labor more efficiently. And you see this throughout history that over time, the freer markets are the ones that become tomorrow's developed markets. They're the ones that grow faster. They're more sustainable.

and are more efficient because you don't have the constraints of central planning or autocracies. So we do expect alpha in the long run, but we created this for investors to be able to replace their market capitalization weighted emerging markets index products. So we created it to be very broad, very diversified and to highly correlate to

So when I say beta, that means the market capitalization weighted index funds. So basically, it's designed to correlate well to market cap weighted indexes.

But we do, yes, expect that in the long run, freer countries do perform better. But that's in the long run. So emerging markets, half of them are still autocracies and coming out of autocracies. I mean, it's not developed. It's still an emerging situation. So you have to be aware that if you're investing in emerging markets, that is a more long-term play. Some of the alpha is going to take time to play out. So I wouldn't invest in it expecting that anytime in the short term. But I would expect high correlation to...

the other broad-based market cap weighted indexes. And you talked about a few of the countries that don't show up in the index because of some of the rules that you've applied. What are some of the countries that do show up in the index fund or in the index? And is there a country or two that someone might do kind of a double take and say, wait, why the heck is that country included? Or maybe it's a little controversial and how do you address something like that?

The biggest countries in the index currently in order of size are Taiwan, South Korea, Chile, and Poland. Taiwan being the biggest one there, the controversy being, oh, is it a part of China? And yeah, there are questions surrounding its sovereignty, but Taiwan is very much an independent country and they have different laws than China. They're actually independent.

They have China cannons pointed at them every day. So they're constantly on the front lines of the fight for freedom in the region. And you'll see that in current events, how they've always, since day one, supported the Hong Kong protesters and offered asylum to anyone fleeing Hong Kong after protesting and so forth. So Taiwan is the biggest holding. And after that, South Korea. And because both of these countries are

very free and therefore the highest holdings in the index, it's a happy accident. And that because they're highly correlated to China, we get very high correlation to the market cap weighted benchmark indexes without having that direct exposure to China. So that was just the way it worked out there.

The next to Chile and Poland, Chile, of course, there's some protests going on there as well currently. And I think their government responded to it a lot better than the way Hong Kong government has responded. So it should be resolved much faster. So

So Chile also does a lot of trade with China. So about 25% of their trade is with China. So some people have used Chile as kind of a China proxy as well. So if you expect China to grow, then you invest in copper in Chile or lithium to grow their smart car efforts. So, you know, we don't penalize these freer countries for doing trade with

less free countries, we're all about that. So we're all four countries benefiting from free trade with the less free countries. So that's perfectly fine. And we don't penalize that in our index.

And make sure you highlight for everybody, you've created this rules-based strategy. Like you and your team are not deciding what country is going to go in and what country is going to go out. You've designed the methodology and the rules here, and it kind of is what it is, right? So maybe you can just expand a little bit on this rules-based quantitative approach.

that you don't have full control over all the time. You might see a country in there that maybe you personally don't really want to see in there, but it's in there because of the rules in place. So some of the other countries included in the index are South Africa, Philippines, Mexico, Indonesia, Thailand, and India. And some of these countries, like for example, Thailand and Philippines, has some questionable rules

human rights practices. And if this were an active index, I would not choose to have these allocations in there. Thailand is very small at less than 3% and Philippines is around 6%. So they're small. But

One of the things that you've got to be aware of with an index like this is that it's a rules-based approach, and we have to follow the methodology. And these country scores are given to us by a third-party think tanks that we operate independently from. So I personally don't decide what countries get to be in the index. I can't say, oh, I don't like Thailand, so you can't be in the index. Or I saw a newspaper article about what's going on in the Philippines with the drug wars, so I'm going to kick it out. So

Everything is based on the predetermined rules and the algorithm that's set in the methodology. And I can't game the system to exclude or include any country. Okay, so if we've convinced somebody that they should be investing in emerging markets, even if it's just for diversification purposes...

Is it your opinion that they should fill that sleeve of the portfolio with a fund like Freedom that has this freedom weighting approach to it? Or do you think someone should put some in a Vanguard type solution, market cap weighted, and then put some in Freedom? Should there be a balanced approach? Or are you in the camp that says, no, there's a lot of problems with those market weighted indexes. You should put all your money in Freedom.

So yeah, so if you're looking for what I think is the best way to allocate your emerging markets portfolio. So if I'm giving you my best idea, my best recommendation here, I would say absolutely freedom waiting makes sense.

lot more sense than using market cap weighting in emerging markets because those markets are not that efficient using the size of the market alone without considering human and economic freedoms. That doesn't make sense. So I would say this product was designed to capture emerging markets growth using a different exposure to emerging markets and

and that exposure is in the freer markets. So that to me makes the most sense. And it is well diversified across four different regions. So it can be used as a core on its own. That said, a lot of people cannot stomach having no China at all. So there's two camps here. There's one camp that cannot stomach having no China. There's another camp that cannot stomach having China. So I'll address both of those here. So the people that

can't not have China. And so they want some China in the portfolio, I would say to the extent that you want to have direct China exposure, allocate a portion of your emerging markets to a market cap weighted approach like EM or VWO. So have a portion in that other market cap weighted approach, and then a portion in the freedom weighted approach. And that gives you two different

kind of exposures to emerging markets and you don't lose China completely by having that combination. So any combination, whether it's 50-50, 20-80, 80-20, whatever is appropriate for however much you want to have in there.

The other camp that wants no China at all in the portfolio, which is a new camp these days, but I appreciate those guys. I would say, you know, ask yourself, why do you not want China in the portfolio? Is it because it's not free? And if that's the case, then why?

you know, we have the solution for you with the freedom weighted approach. Now, there's also other ex-China indexes out there that are market cap weighted. And I would say that those indexes are kind of like a bandaid. So it's just a market cap weighted index that kills China

by objective. So that's the whole point of the index is to have no China in there. I would say that's a bandaid to the problem. You're addressing the symptom and not the cause, and probably doesn't make a lot of sense. So if you don't want China in your portfolio, and that's because of some of these human rights practices out of China, then I would put 100% of that in the freedom weighted approach. You've said the word tracking error a few times.

And some financial advisors or professional money managers are judged by how well their portfolio performs relative to an index such as the S&P 500. So if their returns veer too far from these broad-based index returns in, let's say, any really given quarter, then

Even if it's proven to be beneficial over long periods of time, if their returns kind of veer from these big indexes that we all talk about, they run the risk of getting fired because they're not keeping pace with these indexes on a short time period. So even if freedom, even if your freedom ETF is the best ETF to own in the emerging market space,

Professionals like myself or hedge funds or professional money managers for institutions, they may not adopt it because in the short term, it might not track the broader based emerging market indexes. It might veer from those indexes, which could get them fired. So

They end up just hugging the emerging markets index that's full of China and it helps them keep their jobs. But I take issue with it because it hardly sounds like the role of a fiduciary, which is something we've talked a lot about on this podcast. So I know you don't have any answers, but I'm just curious if you have any thoughts on this, any brief thoughts and maybe how that problem can be solved or how maybe you're working to help solve that problem. Yes. So I have talked about tracking error in the past and I think I probably was...

addressing institutional investors.

in those instances. So I think as individual investors and advisors to individuals and families, we have an advantage over these big institutions that have a lot of constraints around tracking error. Tracking error is not necessarily a bad thing. So you can have outperformance tracking error as well as underperformance tracking error. And if it's outperformance, then obviously that's good. So sometimes high tracking error is a very good thing over time. And it just means you're capturing alpha.

So I wouldn't worry too much about tracking error, actually. This particular index has a tracking error of about 7%. I know some people calculate it differently as well, and that's the Bloomberg calculation. And it has correlation errors.

to the MSCI Emerging Markets Index of about 88%. Well, I really appreciate you coming on and sharing all of your knowledge with us. It's really fascinating. I learned a ton today about the emerging market space. I really appreciate it. If people want to learn more, if they want to learn more about you, where would you send them? So the website is lifeandlibertyindexes.com and I'm on Twitter at Perth underscore toll. And we'll link to all of your websites and everything in the show notes, which can be found at youstaywealthy.com forward slash 56.

And Perth, again, thank you so much for coming on. I really appreciate it. And I look forward to seeing you soon. Yeah, thank you.

Hey, it's me again. I just wanted to say thank you one more time for listening and remind you to please, please, please leave a quick review. If you're on an iPhone, leave a quick review on iTunes. If you're enjoying the show, I'm getting great feedback from listeners just like you. And I really want to keep the momentum going. So if you have a chance on your iPhone, leave a quick review on the Apple podcast app. And thank you so much in advance for all of your help and support.

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