A quick perusal of news headlines underscores why the risk of holding firms exposed to dictatorships, seizure of assets, sanctions and disruptions must be closely managed, to an extent that arguably is not yet fully appreciated. We talk to a European asset manager that quantifies diversification and has influenced the wider industry.

Investing in companies exposed to authoritarian regimes such as Russia or China creates added risks of losing money without a chance to recover. Genuine diversification must take “autocracy risk” into account. 

This view is held by TOBAM, an asset management house established in 2005. In July 2023, the firm unveiled a new strategy range called LBRTY®, which aims to mitigate portfolio exposure to autocracies. To some extent, it is an extension of ESG ideas on investing, but with a more clearly pronounced focus on freedom, respect for property rights and due process of law.

Considering how Russia’s invasion of Ukraine shocked the world, slamming markets in the process, and how mainland China’s moves against certain sectors two years ago wrongfooted advisors, autocracy risk is no mere academic concern.

Yves Choueifaty, who founded TOBAM, and built an internationally-recognised quantitative measure of portfolio diversification, argues that his firm’s approach to autocracy risk is part of its governing philosophy. In today’s fraught geopolitical environment, it is a stance that appears in tune with the times.

“You don’t want to be exposed to autocracy when you are building an equity portfolio,” Choueifaty told this news service in a call. 

TOBAM manages more than $5 billion (as of December 2023) in equities, fixed income, and multi-asset strategies as well as digital assets. The firm also offers the TOBAM Maximum Diversification® Index series, a set of indices based on its Maximum Diversification approach as well as the Diversified Benchmark Index series. The firm, which is authorised in France, is also is a registered investment advisor regulated by the US Securities and Exchange Commission, as well as being registered in South Korea and Canada. 

TOBAM has obtained patents for its diversification methodology in Canada, the US, Australia, and Japan. 

Obtaining diversification rights involves, for example, avoiding the risk of allowing a handful of large-cap stocks – such as the “magnificent seven” tech and engineering stocks – leading investors astray. (These are Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla.) Choueifaty said there have been repeated episodes of big-name firms, such as banks until 2007/8, or energy companies in the 1970s, faring well for a period before hitting a wall, leaving investors to lick their wounds. Choueifaty argues that TOBAM’s diversification approach avoids investors falling into this trap.

“It is the folly of [benchmark] concentration,” he said.

Why does this mistake keep getting made?
"It’s effectively a mystery! They [asset owners] seem more focused on relative risk and return than on their actual growing absolute risk… fascinating. They are supposed to pay pensions, they are not going to pay them with relative returns. They’d better focus on absolute risks and concentrations," Choueifaty said.

The focus on diversification, and its way of avoiding autocracy risk, helps drive TOBAM’s support for pro-liberty causes. In 2009 it chose Democracy and Human Rights as its field of philanthropy and made its first donation to Amnesty International; it has supported  Reporters Without Borders and Human Rights Watch as well as Ukraine. 

Choueifaty is clearly passionate about democracy, liberty and rights, and is determined to use his quantitative investment approach to push the needle in the right direction. He is a mathematician who spent his entire career in the asset management industry. Before creating TOBAM in 2005, he was the CEO of Credit Lyonnais Asset Management, where he had been working for 12 years. His current business employs 40 people in Paris, New York and Dublin. Some 18 of those people are involved in research. More than 60 per cent of its clients are state entities. Wealth managers make up a chunk of its client base.

To illustrate autocracy risk, Choueifaty cited work done by the Yale School of Management showing that more than 1,000 companies based outside Russia had to close their businesses in Russia after Russia's invasion of Ukraine. In total, companies have lost more than $240 billion from their retreat from Russia. The names of firms pulling out of Russia or suspending activity there include American Airlines, Deloitte, KPMG, BP, BlackRock, Salesforce, Reebok, Uber, HP; IBM, Levi’s, Nike, Oracle, Paramount, Starbucks, UPS, Societe Generale and Xerox. 

“We have a huge concern. Democracy over the long-term progresses, but with moments of regression and recession. The situation [now] is extremely alarming,” he said.

Diversification pays off
This news service asked Choueifaty more about his general thinking on diversification.

Choueifaty cited comments of US investment thinker, Harry Markowitz: “Diversification is the only free lunch in finance.”

"The market is a long succession of concentrations and de-concentrations, the consumer discretionary bubble until 1973, the oil bubble until 1980, the internet bubble, the financial bubble, The market cap weighted portfolio always maximises its concentration at the peak of the of the bubble, at the worst moment. TOBAM has discovered the measurement of diversification, now part of the curriculum of the CFA, and also used in botanics and biology," he said.

Proof of concept
What is the hard evidence that this approach to risk, coupled with TOBAM’s diversification focus, delivers results?

The firm shows that, when back-tested, its TOBAM LBRTY Emerging Market Equity Index (base currency – dollars) delivered returns from August 2008 to December 2023 of 183.18 per cent, against the Bloomberg Emerging Market L/M TR benchmark of 76.78 per cent. That equates to an annualised return of 7.02 per cent for the strategy, almost three times the benchmark’s result. Volatility, at 18.36 per cent, was slightly below that of the benchmark.

The new LBRTY® strategy is available via three UCITS-Luxembourg-registered equities vehicles, a global fund, a global ex-US fund and an emerging markets fund. The new LBRTY strategy is the “fourth pillar” of TOBAM’s core investment capabilities, which include its Maximum Diversification methodology and range of indices, the research-based Solutions division that builds solutions for institutions and the first open-ended Bitcoin fund in the world.

In its presentations, TOBAM cites academic research that considers 122 democratisations and 71 reversals from democracy based on data from 1960 until 2010. The data shows a positive causal effect of democracy on economic growth. A country that transitions from non-democracy to democracy achieves about 20 per cent higher GDP growth per capita in the next 25 years than a country that remains a non-democracy.

Away from all the number crunching appears to be a simple truth, which is that if you want to grow wealth over the long term, freedom and the rule of law work far better than authoritarian regimes. It’s an insight as old as recorded history, but it is good to see it validated in hard numbers.