Top Emerging Market ETFs Are Flawed

Kevin T. Carter is the founder of Big Tree Capital, an investment firm focused on emerging and frontier markets. He is also the founder, chairman & CEO of AlphaShares, an investment firm that offers emerging-markets-focused ETFs in partnership with Guggenheim Investments.

Carter will be a panelist at the imminent Inside ETFs conference in Hollywood, Florida, where he will discuss the outlook for the emerging market consumer. ETF.com recently sat down with Carter to get his take on the latest developments in the emerging market space.

ETF.com: Why are emerging market stock markets and currencies plunging across the board?

Kevin Carter: People are afraid. They’re afraid there are global growth problems. They’re afraid there are problems with China. I think there’s a real and large disruption happening with the precipitous drop in oil prices.

There are many countries—and millions of jobs—that have benefited from the high price of oil. Some of these countries are now faced with a significant challenge; namely, that their cost to produce oil is now higher than the market price for that oil. This is a real and major problem for countries like Brazil and Nigeria.

And it’s not just oil. Countries like Russia and South Africa are also facing similar problems with the price declines of other natural resources that have provided jobs and revenue to these countries and their people.

What does it all lead to? I don’t know, but it seems to me it has to have very large repercussions. It also seems to me there must be a positive as well, as the world’s consumers of oil—all other things being equal—will have more money in their pockets.

ETF.com: Are the concerns about China warranted or overblown?

Carter: Both. China is now the world’s second-largest economy and the largest contributor to global growth, so the state of the Chinese economy should be a concern to investors.

However, in my decade dedicated to China, I’ve found that the concerns about China as a bubble are overblown. The “crash” of the Chinese economy has been imminent for 10 years. I think people lack an understanding of China, and our media coverage helps propagate these misperceptions.

Maybe this time it really is on the verge of collapse, but I highly doubt it. China is growing and will likely continue to grow at a pace that is higher than ours or any other developed economy for some period of time. And if you think all Chinese growth numbers are made up, read the annual reports for Starbucks and Nike.

ETF.com: Is the emerging market consumer story still intact long term?
Carter: I believe so, notwithstanding the head winds discussed. The growth of the emerging markets consumer is a long-term secular trend. There are billions of people in the developing world that are trying to join the consumer class, and lots and lots of them already have.

This is a secular story that should persist. Just look at the Chinese consumer. This week, we got more bad data on the legacy manufacturing part of the Chinese economy, but retail sales were up over 11%.

There is something big happening with emerging market consumers that investors need to understand—they are going online. We take the Internet for granted. We’ve had high-speed cable covering our country for a long time. We’ve had the income to buy desktop computers with 25 inch monitors.

The emerging market consumer has not had access to the Internet the way that we have. Less than 30% of people in emerging markets have Internet access today. Now think about two other very recent advances: the smartphone and mobile broadband. The smartphone is changing how we consume.

My family used to go to Target four or five times a week. Now we go once a month. Instead, nearly every day a brown or white truck pulls into our driveway and leaves a package at the door.

Consider also how these trends have played out with our companies and stock markets. Sears and Walmart are closing stores, while Amazon flourishes. Newspapers are going bankrupt, while Google has created hundreds of billions of dollars in value.

Cheap smartphones and broadband mobile are bringing the Internet to the emerging market consumer largely for the first time. And these consumers never had access to what we can think of as “traditional” consumption infrastructure. No SUV, no paved roads, no Target stores. This is creating a “leapfrog” effect and driving incredible rates of revenue growth and value creation.

The total revenue of the 48 companies in the Emerging Markets Internet ETF (EMQQ | F-23) have grown at an average annual rate of over 40% for the past five years, and will likely be close to 40% again for 2015.

This growth has also led to returns that have beaten the broader indexes handily. For the five years ending in 2014, the EMQQ Index was up 110% versus about 10% for the iShares MSCI Emerging Markets (EEM | B-100) and the Vanguard FTSE Emerging Markets (VWO | C-86). In 2015, EMQQ was up 5%, while EEM, VWO and the EGShares Emerging Markets Consumer (ECON | C-49) were each down about 17%.

ETF.com: Where are the buying opportunities?

Carter: The indexes are making five- and 10-year lows. It’s hard for investors to buy things that have gone down, but the fact is that long-term investors should buy when fear is high, and fear is high. That doesn’t mean we can’t or won’t go lower, and as discussed earlier, there are some fundamental head winds.

I am partial to the emerging markets Internet sector and EMQQ for the reasons cited above. Considering that it is down about 20% since inception, and the companies underlying the ETF are 45% larger fundamentally than when launched, I think the time is quite compelling. These companies represent the future of emerging markets.

I would also buy ECON. It owns many of the leading traditional consumer names—the food and beer companies of emerging markets.

ETF.com: Would you recommend or avoid broad emerging market ETFs such as the Vanguard FTSE Emerging Markets ETF (VWO | C-86) and the iShares MSCI Emerging Markets ETF (EEM | B-100)?

Carter: Avoid them. I have come to the conclusion that the largest emerging market ETFs (EEM & VWO) have significant structural flaws and are not optimal ways to get exposure to emerging markets.

That conclusion is only being strengthened by the collapse of oil and natural resource prices. The biggest problem with these ETFs is the large allocation to state-owned enterprises, which account for about 30% of EEM and VWO.

These are massive, legacy, government-owned Chinese banks, Brazilian oil companies, etc., that are inefficient, conflicted and frequently corrupt. Just look at Petrobras in Brazil. If you read the newspaper, you know that the country is reeling, as dozens of Brazil’s government officials and business leaders stand accused of looting billions of dollars from Petrobras through a string of kickbacks and bribes.

The other big problem is that VWO does not own companies like Alibaba and Baidu, because these companies list in the U.S. and are thus not included in the FTSE Emerging Markets index.

It seems crazy that these companies choose to list on the most transparent markets with the highest listing standards, but get “punished” from an index perspective for that decision.

Of the 48 companies in EMQQ, only two are included in VWO. Just think about that. Petrobras is in VWO in multiple places (local listing, ADR, preferred), while Alibaba and Baidu aren’t.

Contact Sumit Roy at [email protected].