The trouble with emerging and frontier markets indexes

After years of negligible returns investors have become disenchanted with emerging markets. These days, it seems like much of the headline news from that part of the world is negative. But in spite of all the turmoil and risk, emerging markets are growing. In fact, they are growing at twice the pace of the U.S. and the rest of the developing world. And some countries and sectors within emerging markets are growing at quite spectacular rates. So these markets simply represent what they always have — a classic risk/reward conundrum: to get exposure to higher rates of growth you have to be willing to take on more uncertainty, in this case some of which is political and some economic.
Nearly everyone believes that the primary driver for future frontier and emerging market growth will be rapidly expanding consumer spending, a trend that’s well established from China to Nigeria. Dozens of studies and reports by investment banks, consulting firms and fund companies describe how billions of humans are moving from subsistence income levels to levels where they begin to consume more and better food, clothing, appliances, cars, etc. It’s a very good story. It’s a big story. One report, titled “Going for Gold in Emerging Markets,” McKinsey & Co concludes that the growth of consumption in emerging markets is “the biggest growth opportunity in the history of capitalism.”
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A PROBLEM FOR ADVISERS
But there’s a problem for advisers and investors seeking exposure to this development, particularly if their investment vehicle of choice is exchange-traded funds. Much of current frontier and emerging market index construction does not effectively capture growth in the consumer market, with the consumer sector getting a meager 16% weighting in the major emerging markets ETFs.
Many of of the methodologies underlying the indexes employ market capitalization to determine weightings, an approach that tends to overweight countries with large banks and financial companies and small populations. As a result, a country like Kuwait ends up with a much larger weighting in frontier markets indexes than Nigeria or Vietnam. Yet from a “growth” point of view, the latter two are more promising — Kuwait has a population of just under 3.4 million compared with 173.6 million in Nigeria and 92.5 million in Vietnam. Furthermore, Kuwait already has a per capita GDP in excess of $52,000 which is on par with the U.S. figure, 15 times the $3,000 per capita GDP of Nigeria and 25 times the $2,000 of Vietnam. How much room for growth is there with 3.4 million rich people?
Also weighing most heavily on the indexes is their enormous allocation to state-owned enterprises (SOEs), which account for nearly 30% of the weight of the largest emerging markets ETFs. These companies represent the past of emerging markets, but not the future. The largest of these SOEs are Chinese, Brazilian and Russia banks and oil companies. Many adjectives describe SOEs including, monolithic, inefficient, conflicted and corrupt.
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‘ECONOMIC FUGITIVES’
You need not look far to see the problems with investing in SOEs. Recent news has been filled with reports of the investigation of top Brazilian government officials suspected of plundering state-owned oil giant Petrobras of over $1 billion in kickbacks and bribes. The Chinese government has launched a campaign to return 150 “economic fugitives” living in the U.S. who have fled China after allegedly looting or defrauding state owned businesses. And in Russia, where do you even start?
So if the experts are right, an investor would want to have exposure to the consumer market and, by extension, to those companies providing the infrastructure supporting the growth in consumer spending. This is the second wave generally missed by the major indexes and ETFs. All over the developing world, consumers are getting Internet access via wifi and mobile broadband. At the same time, a new breed of manufacturers is offering smartphones for as low as $40. And prices are going to keep dropping.
Consider the case of Xiaomi, a Chinese manufacturer of entry level smartphones. The company, which is less than five years old, will sell about 100 million smartphones this year, up from 60 million units in 2014. Over the next 10 years, billions of consumers will emerge with a $40 smartphone in their hands. The result of this trend is fantastic growth. Ecommerce clocked an impressive 39.9% growth in 2014.
Yet Alibaba, Baidu and most of the 50 or so publicly traded emerging markets ecommerce companies benefitting from this growth are excluded from the major indexes and ETFs because they choose to list on U.S. exchanges. The companies are essentially being “punished” from an indexing perspective for listing on the exchanges that will give investors greater liquidity and transparency than their “home” markets. In short, the indexes are leaving out the future.
For advisors and investors, there are a couple of lessons in this. First, it’s more important than ever to understand the assumptions that underlie index construction and what you own in an index-based product. Second, it’s as difficult as ever to decouple risk from reward; expect these markets to remain volatile. Third, go where the money is — look for companies and funds that provide exposure to the fastest growing segment of frontier and emerging markets — the consumer.
Kevin Carter is founder and CEO of Big Tree Capital, an investment firm focused on emerging and frontier markets and developer of the Emerging Markets Internet & Ecommerce Index.