It is a simple thought experiment. Would you rather invest in South Korea, “a world leader in electronics, telecommunications, automobile production, and shipbuilding,” or in North Korea, where “corruption is endemic at every level of the state and economy”? The obvious choice is South Korea. Making the choice to favor the free countries of the world over their more repressed counterparts is what we call Freedom Investing.
We have been advocating Freedom Investing since 2004. Every year, the Heritage Foundation evaluates all the world’s countries using their Index of Economic Freedom, where a high score correlates to nearly every positive measure of a country. We then use this ranking and efficient frontier analysis to craft our Foreign Stock investment strategy that we call “Freedom Investing.”
Although in past articles, we have taken the simple approach of back testing the current country-specific allocations, for this 2020 article series I wanted to do a more complete retrospective. In my previous article “A 25-Year Review of Freedom Investing,” I tested our methodology — how we pick which countries to invest in, how we determine their weights, and how those selections change in response to data. In this article, I am reviewing the quantitative measurements and performance metrics of Freedom Investing to see how its risk and return compare to the EAFE Index, its benchmark.
To this end, I have downloaded the Index of Economic Freedom data from 2020 back to their first year of data in 1995. I have also downloaded the monthly country-specific MSCI fund returns for each country as well as the EAFE Index returns to use as a comparison from January 1995 to April 2020. Along with this data, I have also used the size weight of each country to develop what our static country-specific asset allocation would have been each month of those 25 years if we had been doing Freedom Investing for the whole time.
Throughout this analysis, it is important to remember that you can’t invest directly in an index. Index fund returns lag their index by the fund’s expense ratio plus or minus a tracking error. The lower cost the fund and the more holdings it has the better the return will follow the index.
Over the time period, the EAFE had an annualized rate of return of 4.2708% while Freedom Investing had an annualized rate of return of 6.3233%. This shows that over the time period Freedom Investing has a higher annual return by 2.0525%.
Over the same time period, the EAFE Index had a standard deviation of 16.118 while Freedom Investing had a standard deviation of 17.898. This suggests that Freedom Investing has higher expected risk by 1.78 of standard deviation.
To evaluate if the extra risk is justified by the extra return, there are several quantitative measurements that we can use.
First, the coefficient of variation is a simple calculation that evaluates how many units of risk you are having to tolerate in order to achieve one unit of return. A portfolio that has a smaller coefficient of variation may have either of both more or less risk and more or less return, but its smaller coefficient of variation suggests that it has a superior risk-adjusted return.
The coefficient of variation is calculated by dividing standard deviation by average return. In the cases of these two funds, the coefficient of variation is 3.77 for the EAFE Index and 2.83 for Freedom Investing. This suggests that Freedom Investing has a superior risk-adjusted return. To achieve one more unit of expected return, you have to tolerate 0.94 more units of risk with the EAFE Index than you would have with Freedom Investing.
A second measurement that can be used to evaluate deviations from a benchmark is correlation. If two strategies or portfolios are highly enough correlated (higher than 0.84), then their types of risk overlap sufficiently to be part of the same asset class or to serve the same strategic purpose in a portfolio.
Over the time period measured, the EAFE Index and Freedom Investing showed a correlation of 0.89. This suggests that the two are comparable strategies.
The coefficient of determination, which is the correlation of two assets squared, describes the percentage of one asset’s movement that can be explained by the movement of another asset, typically a benchmark. In the case of Freedom Investing, we use the benchmark of the EAFE Index.
The coefficient of determination for Freedom Investing as compared to the EAFE Index over the time period was 0.79. This suggests that 79.48% of the movement of Freedom Investing can be explained by the movement of the EAFE Index. The remaining 20.52% of the movement is explained by unsystematic risk, meaning risk specific to the investments of Freedom Investing. Because the coefficient of determination is relatively high, this suggests that Freedom Investing is not an effective diversifier for the EAFE Index. Instead, investors would do well to consider adding only one strategy to their portfolio. They do not need both.
A third measurement we can use is Beta. Beta compares the volatility of two assets. A beta of 1 means that the evaluated strategy is just as volatile as the benchmark. The Beta of Freedom Investing as compared to the EAFE Index is 0.99. This suggests that Freedom Investing theoretically experiences the same volatility as the EAFE.
Used frequently by active managers, Jensen’s Alpha is an extension of the capital asset pricing model (CAPM). CAPM is a theory of portfolio design that assumes that, if you know the volatility (as measured by Beta) of a fund or portfolio compared to a benchmark or index, then you can calculate what the so-called required return of that fund or portfolio should be. For example, if you have a portfolio which is twice as volatile as its benchmark, then you would expect that it would have something like twice as much return as the benchmark.
Jensen’s Alpha uses the so-called risk-free rate to calculate what portion of the benchmark’s return is due to the benchmark’s risk. This risk premium is then multiplied by Beta to calculate the stock risk premium, the amount of extra return you’d expect from an asset that volatile. By adding back in the risk-free rate, you get the required return, the total return you’d expect for something that volatile.
By subtracting this required return from the average return the portfolio actually had, you get Jensen’s Alpha. Alpha is then measuring the advantage the portfolio had above-and-beyond the return you would rationally require from its risk.
For the risk-free rate, I used 3-month treasury bills. From January 1995 to April 2020, the annual return of 3-month treasury bills was 2.4029%. Over the same time period, the EAFE had an annual return of 4.2708% while Freedom Investing had an annual return of 6.3233%. Freedom Investing has a Beta of 0.99 compared to the EAFE.
This makes Jensen’s Alpha of Freedom Investing for the time period +2.0711.
This implies that Freedom Investing overperformed the EAFE Index by 2.0711% when you take into account the amount of risk taken.
While the coefficient of variation measures how much risk you had to take in order to get one unit of return, the Sharpe ratio measures how much additional return you were able to capture per unit of total risk you took. The Sharpe ratio is calculated by taking the difference of the return of the portfolio and the risk-free rate divided by the standard deviation of the portfolio.
Over the time period, the EAFE Index had an annual return of 4.2708% and a standard deviation of 16.118.
Freedom Investing had an annual return of 6.3233% and a standard deviation of 17.898. Meanwhile, the annual return of 3-month treasury bills was 2.4029%.
This makes the Sharpe Ratio of the EAFE Index +0.1159 and the Sharpe Ratio of Freedom Investing +0.2190.
This suggests that for every additional unit of total risk taken, Freedom Investing captured 0.219% more return over the risk-free rate and 0.1031% more return over the EAFE Index.
The Treynor Ratio is like the Sharpe ratio except that it uses Beta as the denominator instead of standard deviation. While standard deviation measures total risk, Beta is thought to only measure systematic risk. A Beta of 1 means that the portfolio has the same amount of systematic risk as its benchmark. Higher numbers have more risk; lower numbers have less risk. With a Beta of 0.99, Freedom Investing has almost exactly the same amount of systematic risk as the EAFE Index.
This sets the Treynor Ratio at +2.0732 and suggests that for every additional unit of market risk taken, Freedom Investing captured 2.0732% more return.
The Information Ratio uses a calculation called “tracking error” or “active risk” to calculate the excess return captured by a given portfolio or fund. The numerator is the return of the portfolio minus the return of the benchmark while the denominator is the active risk. The active risk is calculated by the standard deviation of the difference in returns between the portfolio and its benchmark.
To calculate this, I first calculated the advantage or disadvantage of Freedom Investing for each month compared to the EAFE Index. Then, I calculated the standard deviation of this advantage / disadvantage. The standard deviation of the difference was 8.109, called the active risk. Using this and the EAFE Index’s annualized rate of return of 4.2708% and Freedom Investing’s annualized rate of return of 6.3233%, this makes the Information Ratio +0.2531.
This means that for every unit of active risk taken over by Freedom Investing it earned 0.2531% more return than the EAFE Index.
Together, all of these quantitative measurements suggest that Freedom Investing increases an investor’s expected return while maintaining a comparable risk level.
These findings together demonstrate how Economic Freedom seems to have been a valid factor for higher expected returns than investing in the EAFE Index alone.
If you would like to get started with Freedom Investing, we implement our freedom strategy at all service levels of our portfolio management. You can simply give us a call or drop us a message, and we would be happy to talk with you about how to get started as a client.
Photo of Australia by Dan Freeman on Unsplash