Instead of feeling resigned about international indexes having “increased their allocation to securities in authoritarian states” in recent years, Julie Cane, a former Naval aviator, spied opportunity and founded Democracy Investments.
The company recently launched the Democracy International Fund, an ETF that overweights more democratic countries while underweighting those less democratic.
“Many investors have no idea what is in their portfolios. They just see an international index but when you look inside it, what and where are the allocations?” asked Cane, who has more than two decades of experience in financial services, including positions at Wells Fargo, Charles Schwab Advisor Services, SEI Investments, and Autodesk Ventures.
“Democracy is declining globally. It's a trend. If you want to help turn that around, everyone agrees the number one way to do that is economically.”
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Still, there are democracies — and investment opportunities — abound. Cane shared where those are, her observations of ESG and impact investing, and the future she envisions for her asset manager in an interview with RIA Intel.
What is Democracy Investments and how did it come about?
Around 12 years ago, I became very interested in ESG and impact investing. At the time, I was at a large bank that was also trying to figure it out. I watched all the back and forth debates about returns and metrics. Interestingly if you're doing a bottom-up ESG thematic approach and just looking at the E [environmental], for example, you might be investing in a company that's using forced labor and stolen technology to make wind farms and solar panels etc. Everything that's still in dialogue today I've been watching from the beginning and wanting to figure out how to do something high impact with measurable impact in the investment world.
Last summer, I was brainstorming with our Chief Economist, Rick Rikoski. He had been modeling coronavirus death rates using The Economist’s Democracy Index, which analyzes countries’ democracy scores based on 60 indicators that roll up into the themes of electoral process and pluralism, civil liberties, functioning of government, political participation, and political culture. Rick has a Ph.D. in marine robotics from MIT and frequently runs all kinds of sophisticated algorithms bringing together different data sets. He suggested, ‘Why don't we reweight an international equity index using the Democracy Index and then you’ll have a neutral, transparent way to stop what's been going on, which is more and more indices passively investing in authoritarian states.’ A brilliant idea! So we did.
What else compelled you to launch the company and the Democracy International Fund ETF (ticker: DMCY)?
I've been passionate about democracy my whole life. I'm a former Naval aviator and my grandfather was a POW and a fighter pilot in WWII. My dad was an immigrant from Germany and then US Navy. I grew up feeling very strongly about democracy and am even more so today. To be able to bring that to the forefront of the conversation is very exciting. And of course, I've been a loyal subscriber and fan of The Economist for over 20 years.
Last summer, I reached out to The Economist to see if we could work out a licensing arrangement. Sure enough, they love what we're doing and I was able to negotiate an exclusive global license. Once we finalized our product strategy, we started looking around for the best partners. My first job out of the Navy was at SEI Investments and at the time, they were cutting edge in mutual funds. Now they are also distributing ETFs. So we're on their platform and it's a lot of the same great leadership from when I was there in the 90s. I was in their first class of junior military officers and, fast forward, our relationship managers came to SEI same way. They were both Navy so that's been very fun.
So that’s how we started from an idea last summer. Then I brought in Christopher Browne, a former colleague from Autodesk to be our Chief Investment Officer. He and I have both been in financial services for over 20 years and he holds a CFA. We founded the company in August, found seed investors, and launched on March 31st. And now we're off to the races!
What are your top priorities? Given your short history, I would think that spreading the word ranks high.
Yes — very high. That as well as raising awareness of the products we compete with, which more and more over the past five years have increased their allocation to securities in authoritarian states. Many investors have no idea what is in their portfolios. They just see an international index but when you look inside it, what and where are the allocations? If it's just returns we have very similar returns and you could argue we have less political risk. So even for investors who aren't worried about impact, we’re a great solution. But we're hoping to appeal to their values, too. If you want to be highly diversified in international, you can feel good knowing you're getting similar returns and you're helping democracies grow. That’s our pitch.
The Economist’s methodology seems more transparent than many ESG evaluations.
It's also interesting in that with ESG you have so many funds crowding the same place while trying to differentiate themselves. To the extent you see this as ESG it seems quite differentiated.
Exactly. I like to describe it as a brand new category and that we need to add a D to the ESG. Some might argue, well, you're governance but, no, it's really broader than that. We are top-down. You're starting with countries that have rule of law, free and fair elections, freedom of speech. It's interesting because most people, generally, know who all the authoritarian states are but they don't know who the highly democratic countries are.
We did a radio interview recently and the majority of the talk was around geopolitical trends and the rise of the mafia states. We're coming at this with a whole new angle. It’s important to know what your money is touching and what's in your portfolio. International is an attractive place to invest right now and with our product, you are having an impact on the world at large but supporting democratic values and countries.
China’s weighting in the Solactive GBS Global Markets ex U.S. Index (the fund’s starting universe) is 11.4% while its weighting in the Democracy International fund is 3%. It looks as if the difference is invested in more democratic countries, such as Japan.
What would you say to someone who asks, ‘Why have China in there at all?’ Wouldn’t the fund be even more embracing of democracy if you, for example, omitted the bottom 20 or 30 percent of its holdings?
We started with a product that is completely neutral with the vision that institutions could pick our product over our competitors knowing, ‘They're not kicking anybody out. They're neutrally reweighting according to a highly recognized international standard of democracy and every country is welcome to improve their democracy score.’
With this product, once we get bigger, we're hoping that countries will realize, ‘I want to improve my democracy score so I get more capital. What do I need to do?’ Well, look at The Economist’s Democracy Index. There are 60 indicators and the report will tell you exactly where you need to improve and focus. Every country, even the ones doing well, will want to keep their rankings. We're trying to create a market-based incentive for democratic reform. That's the vision. Carrot and stick.
If a large institution wanted something purer like you described, in other words, say just taking out the bottom 25%, which are labeled by The Economist as authoritarian regimes, that would be another kind of neutral way of saying, ‘Well, we're just anti-authoritarian and reallocated to others.’ But no one has asked for that yet. This way, we're not anti-China. We're not anti-Russia. We're anti-authoritarianism. If you want to promote democracy, our product could be very powerful in shifting capital flows.
I imagine you could eventually have a fund comprised solely of holdings in say the 10 most democratic countries, according to the index. This way, investors could reward the countries that most embrace democratic values with even greater precision.
Absolutely. There are limitless ways we can apply this methodology. Other strategies we've talked about are frontier markets and helping smaller countries that are right on the verge of becoming more democratic and helping them improve to get over finish line toward democracy. There's some interest in that as well.
More broadly, is it better for democracy to have money invested overseas in highly democratic countries or in U.S. companies that derive most of the revenue domestically? I'm curious about the calculus of that.
From purely a market valuation perspective, international equities are trading at a significant discount to US equities. Given that, we believe it is prudent to have a healthy allocation to international, and if you are going to do that — who would you rather give your money to? Democracies or authoritarian states?
The U.S. is a flawed democracy. We have a lot of work to do. We chose to be ex-U.S. because we didn't want to get caught up in the fray of all the noise going on at home right now because it's just so polarizing. And most people are a little more familiar with how to invest domestically.
Indeed. Home country bias is alive and well. The average American has far more U.S. exposure relative to its global market weighting.
Yes, and over the past 10 years, that strategy has paid off. In the 80s and 90s, international equities were viewed as a risk diversifier against US equities, due to their lower correlations. However, as the global market converged, so did correlations. Now it is purely about expected returns. But going forward, we might see a reversal of the policies and conditions of the past 10 to 15 years. Given the current valuation attractiveness of international equities, investors might want to take another look.
At an even higher level, we're hoping to try to get people away from home bias and to talk about democracy globally. Our motto is to affirm democracy at home by investing in it abroad. Then we can elevate the discussion into all the ways we can improve our own democracy as well.
Where did the U.S. rank in the 2020 rankings?
We scored 7.92, placing us (21st globally) between France and Portugal, both of which fell this year. We didn't move in our ranking because our functioning of government went down in 2020 but our political participation went way up so it balanced out.
Norway, Sweden, New Zealand, Canada, and Finland ranked highest. Where was the U.S. most deficient?
Function of government. Congress. That's been steadily going down over time but it was really bad last year.
How is the fund constructed?
We use a base Global ex-US market capitalization index to start with. Most of these types of indices are large and mid cap. For our initial offering, we wanted to ensure there were no liquidity issues or constraints. We assign a country of risk for each security, then apply the appropriate Democracy Score from The Economist’s index and multiply through. Once that is done, we proportionally normalize so that the total weights for the portfolio add up to 100%
Because we're so small right now, we are using an index replication strategy. We have half our holdings in country or regional ETFs and the other half are in the actual securities. As soon as we get up to about $100 million, we'll take a lot of those ETFs out and match all the securities in the index. We have thresholds and a plan to get to the full portfolio as soon as we can.
The S&P 500 derives roughly thirty percent of its revenue from overseas. Are your fund’s stock investments based simply on where companies are domiciled or do you drill deeper to look at sources of revenue? Because you could have a company, for example, based in Ireland that derives 60% of its revenue from China.
Great question. We've addressed that. That's in our methodology. We use country of risk, a proprietary value assigned by Refinitiv or Bloomberg. We then go through manually to make sure that’s where they're primarily doing business and assign the appropriate country and then it's very simple math. A very simple overlay. People keep asking if we're active. We respond ‘No, we're passive but we have democracy as a factor.’
Tell me more about democracy declining globally.
It’s sadly a geopolitical trend and authoritarian states are figuring out how to use our own systems against us. They're winning in certain areas that we're going to have a hard time turning around in the market. And they are stealing our tech, manipulating our social media, messing with our elections. It goes on and one. And how about Cyber?
The democracies are not doing a good job of banding together to overcome these threats. Authoritarians are winning over and influencing smaller states. They've figured out very crafty social media campaigns to bring down people that are trying to speak the truth and discredit them and they're getting ahead in certain technology sectors like AI and quantum and information warfare.
We can turn it around but there's so much noise. Are people focused on the facts? Are people focused on what's real? Getting back to the basics of really understanding what are you measuring, what is the impact? What is really going on globally? It's important.
Per countries embracing democratic norms, it seems there is less awareness about those that are doing well compared to those that are not.
Yes. Taiwan and South Korea jumped up in the rankings. Norway, Sweden, Canada, the UK, New Zealand, Australia, Japan and Switzerland continue to do well.
Developed Europe fares well generally.
What's the vision for the company? What do you hope to see one, two, three years down the line?
Our vision is to grow large so that countries recognize the shift in capital flows and are incented to improve their democracy scores in order to get more capital. Ideally, investors become more aware and measuring democracy becomes more transparent. And they understand that our competitors are passively investing in authoritarian states. Then we'd like to expand into fixed income and the other products we talked about earlier, other flavors of democracy-weighted products.
If we assume returns should be at least comparable between this fund and its peer index, the loose parallel to ESG is that an investor can expect similar returns while supporting a cause.
Right. With ESG you're often giving up performance. You're not giving up anything with our product.
The fund, which is thinly traded and has $1.3 million in assets, charges 0.5%. Some of the largest international index funds charge a fraction of that. How do you persuade people to invest with you?
We are not that far off from larger complexes that charge over 0.30% and have billions in assets. As a smaller and innovative company, we needed to come out of the gate with a fee structure that was economically viable in the short term. Being a mission driven firm, we are committed to lowering fees as we get larger and to not let fees get in the way of adoption.
More importantly, three years or so from now, you'll have the peace of mind knowing you were one of the first in to help us grow to be at a point where we can get our expense ratio down and move capital towards democracies and away from authoritarians. You will know that your portfolio is incentivizing democracy, not incentivizing authoritarianism.
I'm also watching the youth. They are another reason I went into this. Millennials and Gen Xers are the next generations that are going to change the world. I've heard anecdotally that there aren’t enough products out there for people that want to do impact investing on certain platforms. I'm hopeful that our product will appeal to those generations as well.
Democracy is declining globally. It's a serious trend. If you want to help turn that around, the number one way to do that is economically. If you want to be part of the movement that helps bring democracy back to the world, your international investments should not be in our competitor's products. They should be in DMCY.
Thank you, Julie. And thank you for your service.
Greg Bartalos (@gregorianchance) is editor of New York City-based RIA Intel.