Structure Matters: Inside The GDP 'Factor'

his column is part of a new collection of our “Structure Matters” series of interviews with leading ETF and index industry figures. They are conducted by Dan Weiskopf, a portfolio manager at New York-based Access ETF Solutions LLC. In today’s piece, Weiskopf interviews Brendan Ahern, chief investment officer of KraneShares, the ETF sponsor focused exclusively on China.

Dan Weiskopf: KraneShares is primarily known for its China focus. What primary factors have led to the underperformance of the emerging markets over the U.S. markets since 2008? Has China been the driving issue?

Brendan Ahern: We recognized the onshore equities represented by the world’s fourth- and seventh-largest stock exchanges—the Shanghai and Shenzhen Stock exchanges—were excluded from broad emerging market (EM) indices. We believe a complete China allocation should go beyond Chinese companies listed in Hong Kong and include the onshore equities.

Since the end of the financial crisis, EM equities have not kept pace with U.S. equities. We identified three factors we believe negatively affected EM performance and could continue to do so. Working with FTSE, we found that a GDP-weighted EM country allocation reduces exposure to these factors versus traditional market-cap-weighted allocations. This led to the development of the KraneShares FTSE Emerging Market Plus ETF (KEMP).

Weiskopf: Let’s start with the factors you believe investors should be focused on.

Ahern: The first factor is U.S. dollar strength and the potential Federal Reserve rate hike.

Since its five-year low on July 26, 2011 through April 30, 2015, the Bloomberg Dollar Spot Index returned 28.95 percent. While the dollar has strengthened, some individual EM currencies have depreciated significantly as illustrated by the second chart below.

This foreign exchange exposure hurt market-cap-weighted EM indices due to their overweight to several of the worst-performing currencies. The specter of a potential rate hike from the Federal Reserve could exacerbate this situation, because when rates rise in the U.S., the dollar typically strengthens.

The second factor is increased U.S. energy production, which is a contributor to the collapse in global oil prices. Lower oil prices hurt the economies and stock markets of many EM exporters such as Brazil, Mexico and Qatar. The trickle-down effect of lower prices on these economies has been severe. Market-cap-weighted EM indices have high weights to these countries.

The third factor is China’s slowing fixed asset investment (FAI). China’s rate of FAI growth has been slowing in recent years. FAI is an economist’s term for building assets that are held for 10 years or more.

If China is building at a slower rate, fewer commodity inputs are needed. China is the largest trading partner for many EM countries that rely on it to buy its commodity and natural resource exports. If China’s FAI continues to slow, investors can expect a negative knock-on effect for these countries. Market-cap-weighted indices have large exposures to EM countries that depend on China to buy its resources.

Weiskopf: Will these factors contribute to a new investment paradigm with new winners and losers?

Ahern: While we believe these factors have taken some of the luster out of EM investing, savvy investors can still find plenty of potential opportunities within EMs. We don’t know when these factors will reverse from their long-term trend, but one can make the argument that we might be in a new paradigm. If this paradigm persists, we believe the GDP weighting scheme overweights the beneficiaries such as India, and underweights those hurt by it such as Brazil.

Weiskopf: You mention that the GDP weighting methodology is a more complete EM strategy. Would you elaborate?

Ahern: We recently launched the KraneShares FTSE Emerging Markets Plus ETF (KEMP) based upon the FTSE Emerging Plus Index. One of the key benefits is that it adds $1 trillion in market capitalization over the traditional FTSE EM index. This makes this index very liquid.

Currently, the definition of China—within country, regional and global indices—is Chinese companies listed in Hong Kong. U.S.-listed Chinese companies like Alibaba are excluded due to their U.S. listing. The Shanghai and Shenzhen Stock Exchanges—the world’s fourth- and seventh-largest stock exchanges—are also excluded despite the fact that they comprise 10 percent of the world’s market cap.

We have added these exposures in advance of traditional indices. GDP weighting also raises India’s exposure. We believe the GDP weighting scheme more accurately reflects the economic relevancy of countries. It also provides a glimpse of what EM indices are apt to look like in the future.

Weiskopf: How frequently do you review these factors and potentially reallocate or tweak the portfolio?

Ahern: The GDP-weighted methodology uses the International Monetary Fund’s five-year forecast to determine country weights, which is reviewed and rebalanced annually. Currently, for example, we are overweighted to China and India at about 43.4 percent and 17.8 percent, respectively. That’s about 18 percent and 5.6 percent, respectively, above the FTSE comparable EM index.

As the GDP growth engine of the EM region, we see these two countries positioned to outperform, and the methodology underweights countries like Taiwan, Brazil and Mexico, which are forecasted to show much less GDP growth.

We also believe this methodology puts investors in a relatively defensive position, as any slowdown in EM growth that is driven by fewer imports from China could also add economic pressure to countries that are also dependent upon China’s success. Given that the rebalancing is only once a year, we see the portfolio remaining current with the long-term GDP outlook of the region.

The GDP weighting methodology uses the IMF’s five-year forecast to determine country weights, which is reviewed and rebalanced annually. I think it’s important that even if investors don’t agree with our views on the U.S. dollar, U.S. oil production and slowing Chinese FAI, the GDP-weighting approach provides a look at how EM indices are apt to look in the years to come.

I believe the GDP-weighting methodology provides an overweight to India and China for tactical investors who want to maintain broad EM exposure and for strategic investors who want to proactively adjust for future index changes, such as the inclusion on China’s U.S.-listed and onshore markets.

Weiskopf: What factors do you believe GDP weighting highlights versus market-cap weighting?

Ahern: We believe GDP weighting is a better representation of countries’ economic importance than market-cap weighting. Market-cap weighting is indicative of a country’s capital market development, whereas GDP weighting is an indication of economic development and importance within the global economy.

The largest and arguably the most important EM economies—India and China—are underrepresented in market-cap indices, while many countries are overweighted. We created KEMP as a more sophisticated tool for investors to capture the most important economies within the emerging market space.