Investors weigh so many risks in markets, such as financial, corporate malfeasance, inflation and, increasingly, environmental risk.
Now, some asset managers are revisiting an old risk made new again: autocracy.
Institutions putting money into emerging market countries recognize those governments may not respect economic and political freedoms, as well as the rule of law, available in markets in developed nations like the G-7. The risk of autocracy can be all but inevitable when investing in emerging and frontier markets.
"There's an awareness that to be in a position to direct assets – other people's money and a lot of it – that is a position of power and privilege," said Perth Tolle, Houston-based founder of Life + Liberty Indexes in an interview. "People are starting to wake up to the fact that there's an impact on how we allocate this money. And in emerging markets, there's no neutral, you're either supporting autocracies or you're supporting the free countries."
Life + Liberty operates an emerging markets exchange traded fund, the Freedom 100 Emerging Markets ETF, with $447 million in assets as of market close on April 20. The ETF weights companies inside of countries based on how they fare on issues of political and economic freedom. The ETF has 102 holdings, the largest being Samsung Electronics Co Ltd and Taiwan Semiconductor Manufacturing co.
Tolle said that the methodology comes from the Cato Institute and Fraser Institute's Human Freedom Index, a measuring tool that ranks nations based on their levels of personal, civil, and economic freedom and which is updated annually. She added that though there are other freedom indexes, the HFI takes into account economic considerations as well.
Pension funds and other institutional investors can't expect realistic ESG ratings, for example, in markets without freedom of speech, she added.
"If you have a country that doesn't have, for example, freedom of speech, freedom of media, freedom of expression, you can't have independent verification on any data, including ESG data that comes out of companies and out of countries," she said.
Investors who poured money into Russian-based countries and funds saw their money evaporate after Russia invaded Ukraine. Companies such as McDonalds Corp., Netflix Inc. and PepsiCo Inc. withdrew from Russia in response, prompting losing revenues which in turn weighed on the share price. Russian equities themselves fell apart, resulting in firms like BlackRock Inc. liquidating its Russian ETF.
Democracy Investments, headquartered in Orinda, Calif., is an ETF provider with the stated goal of shifting capital flows towards democracy and away from authoritarianism.
"(Authoritarians) are harnessing racism, often for political gain, but the same need to harness that means that they're very, probably not going to be the best business partners," said Rick Rikoski, chief economist and partner at Democracy Investments. "Because if you're of a different ethnic group, and it gets your money back and earn a profit, they may not see it that way."
He added that even with parliamentary systems, corruption can still be present, which can be a risk in and of itself, and said that high GDP within a nation does not necessarily correlate to investment returns.
Democracy Investments runs the Democracy International Fund ETF (DMCY), which was founded in 2020 and has $11.8 million in assets under management. The ETF tracks an all world ex-US Index that incorporates The Economist's Democracy Index country scores. The Economist's Democracy Index judges countries based off of 60 indicators which are grouped into five categories: Electoral process and pluralism, civil liberties, functioning of government, political participation and political culture. Countries are also scrutinized as to whether national elections are free and fair, the security of voters, influence of foreign powers on government and capability of the civil service to implement policies.
The DMCY ETF is a passively managed strategy that has a basket of 2,700 large and mic cap international equities, primarily within developed markets excluding the United States. Each security is assigned a "country of risk" based on Refinitiv, the democracy index score is applied to each security by "country of risk". The index then gives greater weight to companies in countries that have higher democracy scores and lower weightings to those with lower scores. The index is rebalanced and reconstructed each quarter.
According to promotional material for the ETF, Democracy Investments claims that since inception on April 1, 2021, the ETF has returned -1.45%. Though still a loss, that is still an improvement of its peers in the realm of all world ex-US index ETF products. Over that time the other competitors in that space such as VEU, CWI and ACWX have declined by more than 5.5%.
Companies that are headquartered in one country but do significant business in another are assigned that country as a risk. For instance, with a company like Apple Inc., it's an American company with its country of risk being China.
Given that emerging markets often have differing levels of legal and judicial independence and contract law from one another, some nations may be tough to simply refer to as an autocratic regime. Even countries that run their own democratic elections carry investment risks. The U.S. for example, has flirted with debt downgrades due to Congressional inaction on raising the debt ceiling, a conflict that will likely play out over the coming months.
"You don't know what the investment climate in a country is going to be from one year to the next, or one administration to the next," said Gregg Wolper, a Chicago-based senior manager research analyst, equity strategies, for Morningstar Research Services LLC.
"Sometimes an autocracy where the manager or the leader is in charge for many, many years with a reasonably pro-business agenda in the eyes of an investor, that may be a reasonable place to invest. Somewhere down the line, that may backfire, but that's not guaranteed."
Both Mr. Wolper and Ms. Tolle cited Chinese education companies as investments that backfired after the government barred them from turning a profit.
Mr. Wolper added that for emerging markets investors, avoiding any sort of investment within a nation that could be classified as an autocratic regime is difficult to avoid. When seeking returns, investors tend to keep in mind varying levels of political risk depending on what they're specifically looking at.
"I have had managers who are hesitant to invest in Brazil now or Mexico, because they say their leaders have policies leading towards the left that are risky for companies, that they could nationalize and they could be highly regulated or highly restricted," he said.
Global investors can more easily avoid risks posed by the whims of autocratic governments given that they're not limited to investments based exclusively inside emerging markets, he said.
But investment can lead toward an alignment in governance and law, and possibly orient these markets away from autocracy.
"Taking a 30,000 foot view, think about emerging markets as potentially attractive because they are in transition from low-income countries," said Alison Adams, a Portland, Oregon-based managing principal research consultant at Meketa Investment Group.
"With weak institutions of governance and law towards something that would be more aligned with the first world economy, it makes sense that they're on the path to developing more stable political institutions and legal institutions."
Ms. Adams highlighted the MSCI Emerging Markets Equity indexes an example of this concept at play. The index includes nations that have autocratic regimes, or regimes with autocratic characteristics, such as China, Brazil and Turkey.
"I've seen capital deepening and these markets mature, get better technology for example, more stable rules, where companies are able to access international capital markets," she said.
"Liquidity has substantially improved over the long run. So you can just look at the market capitalization of the MSCI index from where it began to where it is today. And all of that is supported by ever improving development of capital market rules, agreements and legal frameworks that assure marriage of foreign capital with emerging market capital."