Kevin Carter's passion for emerging markets quickly put him at odds with the available ETF options for investors. Even in the largest offerings from established providers, he says the problem was apparent: investors weren't getting exposure to the innovative companies garnering global attention, such as Baidu, but rather staid, government-owned entities.
Frustrated with the industry's approach and methods, Carter set out to develop an index that tracks e-commerce companies in emerging markets, reflecting what he says is its most vibrant, well-funded and best managed segment. The result is the Emerging Markets Internet and Ecommerce ETF, which tracks the Emerging Markets Internet and Ecommerce Index created by his California-based firm, Big Tree Capital.
Carter, who is also chairman of the EMQQ Index Committee, spoke with Money Management Executive about what the industry gets wrong about emerging markets, and why that motivated him.
What's your opinion of the booming growth of the ETF industry? It recently passed the $2 trillion mark in terms of assets and keeps building.
I don't know if there's any significance to the $2 trillion mark, or a $3 trillion dollar mark. But clearly something's going on, and it's been going on for a long time, and it will continue to do so. As a qualitative point to that, you now have individual investors going to their advisors and saying, "I want to invest in ETFs." Without any discussion of stocks, bonds, international - it's caught on to the point where the guy on Main Street thinks he knows that he wants ETFs, but doesn't really know what that means. It's got a long way to go.
According to recent studies, emerging markets will play a large part in that growth story.
Similar to ETFs being adopted by advisors, institutional investors and advisors are increasing their emerging markets allocations. There's an evolution going on, and the net is that the dial is getting turned up. The average U.S. investor, according to Morningstar, has about 3.5% in emerging markets. Emerging markets are more than 80% of the world's population. They're now more than 50% of global GDP. They're currently about 12% of the global market cap, and eventually they'll be more than 50% of the global market cap. So I think people are underexposed, and at the high level, at the institutional level, they know that, and there's an evolution going on.
There's a concept of what I call "Emerging Markets 3.0," and you see this at big institutions. Emerging Markets 1.0 is when an investor says for the first time, "Ok, we need to add emerging markets to my portfolio." They get their toe in the water with a 2.5% or 3% allocation. After a few more years they get a little more comfortable, and increase the allocation to 5%, 6%, maybe 8%. That's Emerging Markets 2.0. Finally, they get much more comfortable, and Emerging Markets 3.0 is when they have a market cap weight, so maybe a 12% or a 15%, and when they get to that point, they start to do things a little more creatively. Instead of just buying a broad index, they're buying single country managers; they're buying sector exposures, things that get you exposures to consumers. I see this going on for a long time as well. There's going to be a lot of money allocated to emerging markets over the next 25 years.
U.S. institutions and investors are more comfortable with some emerging markets more than others - Latin America and Asia, for instance, are more palatable than the Middle East and Africa. So how does the U.S. investor get comfortable with the overall market?
It's a gradual process, but you're right. There are roughly 45 emerging and frontier markets. You can certainly lump them into regions, so Asia, Latin America, Eastern Europe, the Middle East and Africa. But I think the investor is just becoming more aware of these markets. Frontier markets, for example, just popped up on the radar screen over the last few years.
My main issue is that the emerging market indices are grossly inefficient. I've been a long-time partner of Burton Malkiel, who wrote A Random Walk Down Wall Street, and is one of the champions of efficient markets. As someone who prays toward Omaha - I'm a Warren Buffet investor, but I got into indexing with Burton. My first experience was with China. The first thing I checked when I got there were the index funds. The largest is the iShares China Large Cap ETF. I got the list of stocks, and I looked at it, and I said, "These are all state-owned banks, and oil companies. Where's Baidu?" And they said, "Baidu's not included in the index, because it trades in the U.S." That didn't make any sense to me. Baidu is the best Chinese company. For years I complained, and in fact we made some China ETFs with Guggenheim Investments that capture Baidu and max the weight at 5%, so the oil companies and banks, they're not quite as big in those indexes, but they're still included.
I think the Alibaba IPO raised the awareness about Chinese companies, and it also raised the awareness a little bit that these companies aren't in that index. On the day of Alibaba's IPO, even USA Today and Consumer Reports noted that it wasn't going to be in any of the big China ETFs. What bothered me the most was that you had Morningstar - and I truly respect them, I think they are one of the white hats for investors - their comment was, "Well it just kind of gets lost." One of the CNBC commentators asked, "Why do we even have these indexes?"
The person who said it best was Tom Lydon from ETF Trends, who basically said that the globalization of the capital formation process has happened. African startups are being funded by Silicon Valley, Brazilian companies are being funded by Silicon Valley, and those investors want those companies to trade in the U.S. We have the best exchanges and we have the highest standards. So Silicon Valley, with Ivy League endowment money, is funding these companies, but because they trade in the U.S. as of today, neither MSCI nor FTSE will include them. This is a real problem and people need to start asking questions. Because if you look at what's in ETFs that are FTSE-based, 30% of that goes into state-owned enterprises: oil companies, banks, commodities.
But there's a reason for that. These companies are the biggest, the most stable and they are the most organized. Many of these economies are hierarchical, so they have been the traditional choice.
When they first needed an index, you had to take these companies, because that's all there was - the phone companies, the oil companies. But most of those companies aren't really for profit. They're not made for you to make money. The Brazilian Petrobras is controlled by the Brazilian government, which serves the population of Brazil. So you're directly at odds as a shareholder with the ultimate power behind these companies. I know the Chinese companies best - the Chinese banks are basically the stimulus packages. So ask yourself, if the Department of Motor Vehicles was a publicly-traded company, would you want that?
One of the punch lines is that we have the S&P 500 in the U.S. This is a committee-chosen group of stocks. You have the Russell 1000. In emerging markets, everything's done like the Russell 1000: you just take the biggest companies. Again, you're putting a third of your money into stuff that's not trying to make a profit, and you don't own Alibaba or Baidu? It doesn't make any sense.
So the existing indexes might be great for measuring the performance of all of the companies, but as an investor you have to ask yourself, if you had to invest in China for the next 20 years, would you rather run the Agricultural Bank of China or Baidu? It's the same problem in Brazil. Do you want to own Petrobras, or do you want to own Mercado Libre. When you buy ETFs right now, you buy Petrobras. You don't buy the Amazon of Brazil.
Another thing that bothered me on 'Alibaba Day' was that some people asked, "Well, isn't this really risky? Jack Ma has his own special share class; the company is set up in the Cayman Islands, and that's really shady. Maybe the Chinese government might turn off the Internet." None of that made sense. Everything's relative. If you think about Alibaba, in our emerging market ETFs, 75% of the companies were backed by U.S. venture capital, which is why they trade in the U.S. and are not in the index. What would you rather have, a Stanford, Nobel Prize-winning economist on your board from day one, which is the case with Mercado Libre, the Amazon of Brazil, or a Chinese Communist Party official?
So the e-commerce part of emerging markets, which is what our new fund tracks, is the best governed part. And within our companies, you have an amazing amount of growth. So the consumer - the growth of the consumption, the growth of the middle class - that's the story of emerging markets. What's happening is that the iPhone and the Internet are leapfrogging traditional consumption models. Food, clothing, that's an 8% annual growth story, whereas the e-commerce space is growing close to 50%. In our portfolio, which is 42 companies, the average topline growth is about 45%.
The fanfare over the Alibaba IPO meant that the consumption story is right. But it's happening with Alibaba, not Wal-Mart. And it's still early. People don't realize there are hundreds of additional companies that are still private, that have raised money from Silicon Valley. One such company that will get attention is Flipkart, which is the Amazon of India. The other thing happening is that this is all spilling into the frontier markets, and markets that aren't even part of the frontier markets yet.
But when you look at a frontier index, that's when you have to take a step back and ask, "What are we doing here?" Because I think people are not getting what they think they are getting when it comes to frontier indexes. One of the problems is first to market. The iShares China Large Cap ETF is made up of literally the biggest state-owned enterprises, with almost no consumer, no Baidu. It's one thing to show the problems, but it's another to get people to use something other than the iShares ETF.
To develop the product, are you seeking institutional investors?
I'd certainly like to get the institutional investor. Everyone should have the exposure to emerging markets. But institutions have consultants who make pie charts and there's lots of people who have to approve those pie charts. The headline, emerging markets, e-commerce and Internet sounds sort of niche, maybe too narrow, but it's $660 billion market cap that's largely left out of indexes.