This Is How to Create the Top Emerging-Markets ETF

(Bloomberg) -- Chinese consumers are optimistic this year.

In fact, consumer confidence in China reached its highest level in more than 20 years in the second quarter. That’s good news for plenty of people.

One of them is Kevin Carter, the founder of 2017’s best-performing emerging-markets exchange-traded fund. What’s his take on the rise of the consumer in developing markets such as China? “I believe with strong conviction that it’s the greatest growth story of our lifetimes,” says Carter, 47.

“The consumer story is the whole story,” he says. Start with the observation that 80 percent of the world’s people are in emerging markets, then add that 90 percent of the planet’s young people—age 30 and under—are in those countries. “Smartphones are getting cheaper, and more people are getting the internet,” Carter says. So, of course, those consumers are increasingly shopping online.

The $311 million Emerging Markets Internet & Ecommerce ETF, whose ticker is EMQQ, gained 63 percent this year through Oct. 5, making it the No. 1 emerging-markets ETF, excluding leveraged funds, according to data compiled by Bloomberg.

 
How did EMQQ rack up those returns? In a nutshell, the ETF invests in every publicly traded company in the world whose main business is internet- or e-commerce-related in emerging markets, Carter says. A couple of other constraints: Market cap must be more than $300 million, and stocks need to trade more than $1 million of volume a day. “That’s how the companies are selected. There’s no judgment—no ‘We like this one, we don’t like that one,’ ” he says. “It’s a rules-based index, and every company that fits the criteria should get included.” As of September the index comprised 43 companies.

What are they? The ETF’s biggest position was a 9.3 percent holding in Alibaba Group Holding Ltd., China’s largest e-commerce company. Carter says Alibaba’s first-quarter earnings report in August was a big deal. “They reported 56 percent revenue growth,” he says. “That’s staggering for any company—let alone one of the biggest in the world.”

Also among the ETF’s top holdings was Alibaba rival JD.com Inc. “If you wanted to find a business in China that looks the most like Amazon, it’s actually JD,” he says. The Beijing-based online retailer is the leading developer of drone-based delivery, according to Carter. “They will almost certainly become the largest commercial user of drones,” he says.

Eric Balchunas, an ETF analyst at Bloomberg Intelligence, notes that EMQQ gives an investor a lot of exposure to tech—and only about a 15 percent overlap with an ETF that tracks a broad emerging-markets index. “You’re definitely getting original exposure, but is there anything else you’re exposed to?” he asks, pointing out that 65 percent of the country allocation is to China. “You’d better be happy with China if you want to buy this.”

Balchunas has a theory about thematic ETFs. “The new active equity manager, in many ways, is a thematic ETF,” he says. “People seem to be willing to bet on higher-risk/reward themed ETFs that they can believe the story in. They’re essentially making an active bet.”
 
 
The back story of EMQQ weaves together active and passive in a couple of ways. For one thing, it includes a legendary proponent of indexing: Burton Malkiel.

The story starts with Carter, a graduate of the University of Arizona, interviewing at Robertson Stephens & Co. in San Francisco in 1992. After talking about Pac-10 basketball for 20 minutes, he was offered a job and told to start on Monday. Carter objected, saying he didn’t know anything about finance, so his interviewer told him to read Malkiel’s book A Random Walk Down Wall Street. He went to a bookstore, bought the book, and read it over the weekend.

Carter first contacted Malkiel in 1998, when the dot-com bubble was inflating. A company called K-Tel International Inc.—known for its cheesy TV commercials hawking gadgets and compilation records—announced that it would start selling music online at the internet address ktel.com. That sent its stock soaring. “I saw this K-Tel, and I said, ‘Oh, my goodness, I’ve read about this,’ ” Carter says. A section in Random Walk discusses companies glomming on to the 1960s investment boom for space-age electronics, in that case by changing their names. So Carter found Malkiel’s phone number on an early search engine, called him up at his office in the Princeton economics department, and told him about K-Tel.

The next year, Carter started a company in San Francisco known as EInvesting. The broker enabled investors to buy stocks in any dollar amount—$75 worth of shares, for example. Carter asked Malkiel to join the advisory board, and Malkiel wanted to meet in person to discuss it. “We had a couple of very nice lunches,” says Malkiel, 85, who agreed to join the board. In 2000, EInvesting was acquired by ETrade Financial Corp.

In 2002, Carter and Malkiel started Active Index Advisors LLC. The San Francisco-based company’s flagship Active S&P 500 strategy was designed to provide bespoke exposure to an index. “The idea was that rather than buy the S&P 500 ETF, we could build you a customized index for yourself,” Carter says. “So you could say, ‘I want the S&P 500 without tobacco stocks.’ ” AIA would build an optimized portfolio designed to track the performance of the index, using, say, 50 stocks.

What AIA also did, Malkiel says, was tax-loss harvesting. “Instead of holding everything, you hold a sample,” he says. “Suppose the drug stocks are down and you’ve got some capital losses—well, you realize the capital loss on Pfizer and buy Merck. You get a tax alpha.”

Before Google Inc. went public in 2004, the company held an investment-planning event for its employees that featured two speakers: William Sharpe, of Sharpe ratio fame, and Malkiel. Carter says some engineers who were early employees of Google heard about what AIA was doing. “I ended up spending lots of time down at the Google campus, sitting with a pen and paper explaining to these guys how we did the Active S&P 500,” he says. After Malkiel gave another talk at Google on investing in China, some of those engineers wanted exposure to the market, Carter says.

In 2005, Natixis Global Asset Management acquired AIA, and when Carter’s contract expired, he left the company. So in early 2007, Carter says, he was freed up to try something new: “Burton was pounding the table on China. He said, ‘We have to do China, we have to do China.’ ”

In fact, Malkiel says he’d been interested in China for a long time. “China’s a very fast-growing economy,” he says. “And yet you have a section of the economy that’s inefficient state-owned enterprises, which may have minority public ownership and therefore get into the indices.”

Founding another company in 2007, called AlphaShares LLC, Carter put together a series of China and emerging-markets ETFs. “I was always superbothered that Baidu was not in the index,” he says. “On Day One, when I went through the index and got to the bottom, I said, ‘Where’s Baidu?’ ” The answer: Because it was listed on Nasdaq and didn’t trade on the mainland, Baidu Inc. wasn’t considered Chinese and hence wasn’t included.

Then, working more broadly on emerging markets, Carter came across MercadoLibre Inc. “I opened up the income statement, and I got goose bumps,” he says. “This is an internet company, and it was growing at 40 or 50 percent.” Based in Buenos Aires, the Latin American online market had a number of similarities to Baidu: It was listed on Nasdaq, and it wasn’t included in the index. “I said wait a minute, these internet companies are killing it, but they get left out of the index,” he says. Same thing with Yandex NV: The Moscow-based search engine is also listed on Nasdaq. “I kept saying these are the best companies in these markets,” Carter says. “This consumer story is booming, and the companies who deliver the future of consumption aren’t in the index.”

He says his lightbulb moment came in early 2014. A friend asked what would be the best emerging-markets ETF to buy, and he started to answer but then caught himself and said, “Actually, the best one doesn’t exist yet.” He recalls thinking: “This is what I’ve got to do—I’ve got to make the emerging-market internet ETF.” EMQQ started trading in November 2014.

In the end, Carter says, his epiphany was pretty simple—and close to home. “My wife used to go to Walmart,” he says. These days, thanks to online shopping, she doesn’t have to. “Now boxes show up at our door three times a day.”
 
Asmundsson is <GO> editor of Bloomberg Markets.
 

To contact the author of this story: Jon Asmundsson in New York at jasmundsson@bloomberg.net.

To contact the editor responsible for this story: Joel Weber at jweber66@bloomberg.net.