How betting on democracies beat 97% of emerging-market funds

An ESG fund manager that shuns investing in nations classified as unfree is having one of his best years after the strategy helped him dodge meltdowns in a number of emerging markets.

Thierry Larose, Zurich-based manager of Vontobel’s $330 million sustainable emerging-market local-currency bond fund, tracks rankings from Washington-based Freedom House and blacklists any countries ranked “not free.” That leaves one third of the emerging market universe off limits, including some of the largest countries in it.

Freedom House’s rankings of 210 countries and territories take into account elections, freedom of expression and rule of law. Among countries ranked “not free” are China, Russia, Egypt, Turkey and Thailand. The fund’s strategy is based on the assertion that autocratic regimes tend to have more instability over the long term because they lack the checks and balances typically present in stronger democracies.

“This filtering framework has helped us a lot,” said Larose, who co-manages the fund with Carl Vermassen for family-owned Vontobel Asset Management, which has $230 billion under management. “If you don’t have minimum democracy or freedom in a specific country, the chances are high that the institutions of the country will be weaker, implying higher uncertainty on all levels, and for financial markets, higher probability of volatility and erratic returns.”

The fund’s rule of not financing authoritarian regimes has saved it from meltdown in Russia after Vladimir Putin’s invasion of Ukraine, and losses in Egypt and Turkey. Combined with this year’s rally in Latin America’s democracies, that’s put it ahead of 97% of more than 5,000 fixed-income emerging-market funds tracked by Bloomberg. Vontobel’s fund has generated 17% total returns in US dollar terms over a year, compared with 4% on the Bloomberg benchmark EM local debt index.

Avoiding Russia

Russia, once an favorite of investors in emerging markets, was kicked out of benchmark EM indexes and heavily sanctioned by the US and Europe. Turkey, ranked “not free” by Freedom House for suppressing dissent and limiting public discourse, topped local emerging-market debt losses this year with a nearly 40% plunge. Egypt, where it says meaningful opposition is virtually nonexistent, lost 18%, according to data compiled by Bloomberg.

On the other hand, three of the top five performers this year  — Colombia, Brazil and Poland — are rated as “free,” while two others — Hungary and Mexico, were ranked “partly free” by the think tank’s annual Freedom in the World report. Larose allows investment in “partly free” countries and while there may be differences of opinion about the designations, “we prefer to rely on rankings provided by a third party for objectivity,” he said.

“You cannot be too strict if you want to invest in emerging markets,” he said. “If you’d like full democracies, then you end up with a portfolio with Canada, New Zealand, Switzerland.”

While autocracies often try hard to avoid a default in hard-currency debt that could destabilize their regimes and risk seizing of international assets by US courts, the risk set is different for local debt.

“Our conviction is that if there is not enough freedom and democracy, there is a higher risk that non-pragmatic and irresponsible decisions will be taken leading to more uncertainty and eventually more asset volatility,” he said. “Those countries are more prone not to take orthodox, pragmatic measures and historically have more often defaulted on their local debt than free or partly free countries.”

Top picks

EM countries that should benefit the most from falling US rates and robust China demand are mostly ranked free, Larose added. His basket of favorites includes bonds of South Korea, Malaysia, Czech Republic, Israel, South Africa, Brazil and Mexico.

His strategy hasn’t always worked, though. In 2019 he underperformed peers when Egypt and Russia handed investors top returns, while Argentina and Chile had the biggest losses. Over the longer run, the fund has outperformed 75% of peers over the last five years, according to data compiled by Bloomberg.

“We are happy use this strategy as we see it as a safeguard,” he said. “Sometimes you will miss out but on average it is beneficial.”