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AlphaShares’ Carter: Float Adjustment Is Evil

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 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 become useless.

Ludwig: I know you feel strongly investors should have more allocated to China. But tell me why.

Carter: 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 Plumbers Union, 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.

Ludwig :So, we're getting into the float-adjustment issue?

Carter: 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.

Ludwig: 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.

Ludwig: The categorization?

Carter: 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 ( ACWI ) 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.

Ludwig: Like Baidu?

Carter: 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.

Ludwig: So regarding float adjustment, you're basically saying investors can't take that lying down?

Carter: 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.

Ludwig: But their idea is predicated on what's actually available to investors, right?

Carter: 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 it?

Ludwig: 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.

Ludwig: How does Prof. Malkiel feel about the emerging markets overall?

Carter: 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.

Ludwig: How many China ETFs have you done indexes for now?

Carter: 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.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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