Libertarians and economists both recognize that countries with more economic freedom experience higher gross domestic product (GDP) growth. That growth translates into higher stock returns for investors savvy enough to look for governmental fiscal restraint rather than government stimulus.

Since 1994, the Heritage Foundation Index of Economic Freedom has used a systematic empirical measurement of economic freedom to evaluate countries worldwide. Their conclusions clearly show that economic freedom and higher rates of long-term economic growth go together. Investors can use the study to select countries for their foreign stock allocation.

The foundation defines economic freedom as "the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

A country's economic freedom score is based on 50 measurements. They fall under these 10 categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

Free countries impose few or no restrictions on foreign investment. Thus they represent the greatest opportunities for investment. More than a third of the world imposes serious restrictions on the ability to run businesses, purchase real estate, or transfer capital. These countries are best avoided.

Canada ranks as the sixth most free among 183 countries in the 2011 Index of Freedom.

Canada scores better than the United States in 7 of the 10 economic freedoms, tying the United States in investment freedom and scoring lower only in government spending and labor freedom.

The Heritage report elaborates, "Canada performs particularly well in business freedom, financial freedom, property rights, and freedom from corruption. Straightforward regulations and the competitive tax regime facilitate entrepreneurial activity and lure dynamic investment. The corporate tax rate is scheduled to decline further to 15 percent in 2012."

The U.S. corporate tax rate at 35% is currently the second highest rate in the world. In two years when the Bush tax cuts expire, it will rise to 39.5% and be at that time the most punitive tax rate in our global economy.

At that time, businesses in Canada's 15% environment can return 24.5% more profits to shareholders and investors and still remain competitive with U.S. companies. Is it any wonder that the Canadian stock market has soundly outperformed its U.S. counterpart over the past 10 years?

As of the end of July 2011, Canada's five-year average return beat the S&P 500 by 5.15% (7.54% versus 2.39%). And its 10-year return outperformed it by 9.78% (12.39% versus 2.61%).

Canada is not alone in its economic freedom, but it is in an elite group. There are only a handful of countries with high economic freedom. We've been writing about these countries for years now and analyzing their returns annually against their more restrictive neighbors. Freedom matters. Over the past decade these economically responsible countries have had an average return of 12.04% while the EAFE index has averaged 5.69% and the S&P 500 only 2.61%.

One of the Heritage Studies explains why the freedoms they track are so important: "All government action involves coercion. Some minimal coercion is necessary for the citizens of a community or nation to defend themselves, promote the evolution of civil society, and enjoy the fruits of their labor. This Lockean idea was embodied in the U.S. Constitution. For example, citizens are taxed to provide revenue for the protection of person and property as well as for a common defense. Most political theorists also accept that certain goods--what economists call "public goods"--can be supplied most conveniently by government.

"When government coercion rises beyond that minimal level, however, it risks trampling on freedom. When it starts interfering in the market beyond the protection of person and property, it risks undermining economic freedom. Exactly where that line is crossed is open to reasoned debate. The goal in the scoring of economic freedom is not to define these extremes--either anarchy or utopia--but to describe the world's economies as they are."

There is an easy low-cost way to invest in Canada. iShares MSCI Canada Index Exchange Traded Fund (EWC) follows the MSCI Canada Index. It is composed of more than a hundred stocks and has a low expense ratio of 0.53%.

Canada, not China, is America's biggest trading partner. Rich in natural resources, Canada's oil reserves are second only to those in Saudi Arabia. In fact, Canada is the largest foreign supplier of energy to the United States. The MSCI Canada Index is 27.6% energy stocks and 21.5% materials stocks. These include Suncor Energy, Potash Corp, Barrick Gold, Canadian Natural Resources, and GoldCorp.

And here’s another reason to emphasize Canada: it is the one major country that is not included in the EAFE (Europe, Australia, and Far East) foreign index. So for most investors who split their asset allocation between U.S. indexes and a foreign index, they may not have any Canadian stocks represented.

In our "gone-fishing" portfolio for a typical 40-year-old, iShares Canada represents 3.62% of the total portfolio allocation and 10% of the investments in foreign stocks. It is similarly represented in our managed accounts.

We believe this is one of the times when your asset allocation should tilt foreign and overweight the handful of countries with high economic freedom. Although many economists acknowledge that freedom matters, few investment strategies take advantage of this fact.

To learn more about freedom investing, visit our website at www.marottaonmoney.com/freedom-investing.

 

 

 

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