It's tempting to dismiss what Kevin Carter, co-founder and
head of index development at AlphaShares, has to say about China.
After all, AlphaShares is an indexing firm focused squarely on
the Chinese economic juggernaut that began to take shape a
generation ago under the leadership of Deng Xiaoping.
But when he gets to talking, as he did recently with
IndexUniverse.com Managing Editor Olivier Ludwig, he's nothing if
not completely enthusiastic. More importantly, when he talks
about the way he and his business partner Burton Malkiel, the
Princeton economics professor, think about China, it's hard not
to think twice about it. What's the takeaway? Investors are not
only underweight in China, they're very underweight in China.
Carter made his point by arguing that global emerging market
indexes are broken and that the term "emerging markets" has
I know you feel strongly investors should have more allocated to
China. But tell me why.
Well, the IMF last month changed its forecast:It's now China's
economy will pass up the U.S. in 2016. So you have this juggernaut
of China, but here's the problem: Investors don't have any money in
China and there are two evil factors at work here.
You have this system of either calling markets emerging or
developed, which has outlived its useful life. This is a huge
problem. Because most investors, the way they build their pie
chart, they put 10 percent in emerging markets. If you're the
you probably don't have anything in emerging markets; if you're a
David Swensen disciple, maybe you put 20 percent in emerging
markets. But 10 percent is about average. If you then look at the
emerging market benchmarks, which are also broken in a major way,
you only have 17 percent in China.
So you multiply 10 percent by 17 percent and you get 1.7
percent. This is a fact:Most institutions have about 1.5 percent of
their money in China.
:So, we're getting into the float-adjustment issue?
Well, that's part of it. The first issue is the categorization of
emerging versus developed. That might have made sense to think
about the world that way about 40 years ago, but we can't do that
anymore. Are we going to wait until China has the biggest economy
and then say, "OK," you've made it?" China is really two
economies:The east coast of China is about as developed and
advanced as you can get. Now, the middle and the West have a lot of
catching up to do. The categories are just broken. I mean, Ireland
and Greece are developed, and China's not? And Argentina was
developed, but it's been demoted. It's now a frontier market.
Again, that just speaks to the kookiness of it all.
That's about governance and some real shrinkage to the economy.
Yes, the index guys have a checklist, and you've got to check
the boxes, and if you don't look like what you should look like,
then they call you one thing or another. I'm just telling you that
that system is broken.
Yes, and then the second thing is the float-adjustment factor,
which is just an evil force in my mind. With China, if you used the
MSCI All Country World Index (
) with a pre float-adjustment, China would be about 8 percent of
your portfolio. And, after float adjustments, it becomes 2 percent.
China gets the biggest float adjustment in the world. The Chinese
government certainly owns a lot of the stock, so that's part of the
float adjustment, but the other thing is that they don't count the
A-share market. Those are the stocks in Shanghai or Shenzhen, and
they get completely left out.
I'll give you another dumb example of what's wrong with the
indexes and the whole system. Baidu, China's Google, is not in
anybody's index. It's not in the China index from MSCI, and it's
not in the emerging markets index. MSCI does not include New
York-listed Chinese companies.
Yes. New York is where Baidu is listed and so is every other
Chinese Internet company of any importance, other than Tencent,
which is listed in Hong Kong. And every one of those is excluded
from the MSCI Emerging Markets Index, because they don't include
Chinese companies listed in U.S. This has to change.
So regarding float adjustment, you're basically saying investors
can't take that lying down?
Well, float-adjustment factors, in my mind, are bad from start to
finish. The only reason there are float adjustments is for index
funds. If you go and find S&P's description, the very first
thing they say is:"Index funds are a means to an end, the end being
liquidity. If the stocks in an index are not liquid, index funds
will have trouble replicating them." That's the premise, and, yes,
you could think of an extreme case with a small company that's 95
percent-owned by a single family where it makes sense.
But what if I'm a $300 billion company and I only have $70
billion in float? Is anyone going to have problems buying a stock
that has $70 billion in market cap? The thing that bothers me even
more is that the index providers go on to say that a float-adjusted
index is a better gauge of the opportunity set for active
investors. That's just preposterous.
But their idea is predicated on what's actually available to
If there's $60 billion of PetroChina, is there any manager that
can't get what he wants? I understand the reason for it, but the
reason has gone too far, people apply it as a measure for something
it's totally irrelevant to.
But even if I grant you the float-adjustment thing, the bigger
problem is that the entire A-share market cap doesn't get counted
because it's deemed to be uninvestable. But that's not even true.
If you're Harvard University and you have a QFII quota *qualified
foreign institutional investor) and you can go in and buy stock.
Plus, I can go onto the New York Stock Exchange right now and buy
two different A-share products:A Van Eck product, that doesn't
track very well, or a Morgan Stanley closed-end fund selling at a
discount. But the index providers remove all of that market
capitalization from the global benchmarks-4 full percentage points
of China gets sliced off.
So after float-adjustment you end up with more money in France,
and Australia and Canada than you do in China. I don't have all the
answers, but I'm just saying that doesn't make any sense. China
accounts for 30 percent of global growth, and you have 1 percent in
You said you don't know what to do about it, but it sounds like
what you should do is overweight China, no?
That's exactly it, but the problem is, call it "overweight" and
a flag goes up, and it sounds like you're taking on risk. We talk
to institutions and they say:"We have a huge bet in China, we have
3 percent in China." And they're serious. They're thinking they've
gone so far from their benchmark that they might get fired for it.
It's just preposterous.
We used to say you should have 5 to 10 percent in China. Burton
has now upped that number, and now we're saying 8 percent at a
minimum. Nobody has 8 percent. Nobody has close to 8 percent.
How does Prof. Malkiel feel about the emerging markets overall?
Burton is bullish on India and Brazil as well. But the bottom line
is that the way people make their pie charts is so out of whack
with China that you've got to look at the whole system and
ask:"What are we doing here?"
I've come to believe that the GDP for 2050 should be your global
allocation, because then you capture growth. You could do it
GDP-weighted, which is better. But a next step is to look out
farther. One product we've started to develop is to make not just a
GDP-weighted benchmark, but a kind of future-GDP-weighted
benchmark. If you think about it, it's sort of like fundamental
indexing at the global level.
Again, I don't have all the answers, but one of the things I
enjoy about this is digging into these global indexes, and finding
that there are some problems. Look, Burton recommends the Vanguard
Total Market ETF (NYSEArca:VT), but it only has 2 percent in China.
Other than that, it's a great product.
How many China ETFs have you done indexes for now?
We have four that are managed by Guggenheim:(NYSEArca:YAO,
(NYSEArca:HAO), (NYSEArca: TAO) and (NYSEArca:CQQQ)-all-cap,
small-cap, real estate and technology.
Don't forget to check IndexUniverse.com's ETF Data
2011 Index Publications LLC
. All Rights Reserved.