It’s tempting to dismiss what Kevin Carter, co-founder and head of index development at AlphaShares, has to say about China. After all, AlphaShares is an indexing firm focused squarely on the Chinese economic juggernaut that began to take shape a generation ago under the leadership of Deng Xiaoping.

But when he gets to talking, as he did recently with IndexUniverse.com Managing Editor Olivier Ludwig, he’s nothing if not completely enthusiastic. More importantly, when he talks about the way he and his business partner Burton Malkiel, the Princeton economics professor, think about China, it’s hard not to think twice about it. What's the takeaway? Investors are not only underweight in China, they’re very underweight in China. Carter made his point by arguing that global emerging market indexes are broken and that the term “emerging markets” has become useless.

Ludwig: I know you feel strongly investors should have more allocated to China. But tell me why.

Carter: Well, the IMF last month changed its forecast: It’s now China’s economy will pass up the U.S. in 2016. So you have this juggernaut of China, but here’s the problem: Investors don’t have any money in China and there are two evil factors at work here.

You have this system of either calling markets emerging or developed, which has outlived its useful life. This is a huge problem. Because most investors, the way they build their pie chart, they put 10 percent in emerging markets. If you’re the Plumbers Union, you probably don’t have anything in emerging markets; if you’re a David Swensen disciple, maybe you put 20 percent in emerging markets. But 10 percent is about average. If you then look at the emerging market benchmarks, which are also broken in a major way, you only have 17 percent in China.

So you multiply 10 percent by 17 percent and you get 1.7 percent. This is a fact: Most institutions have about 1.5 percent of their money in China.

Ludwig: So, we’re getting into the float-adjustment issue?

Carter: Well, that’s part of it. The first issue is the categorization of emerging versus developed. That might have made sense to think about the world that way about 40 years ago, but we can’t do that anymore. Are we going to wait until China has the biggest economy and then say, “OK,” you’ve made it?" China is really two economies: The east coast of China is about as developed and advanced as you can get. Now, the middle and the West have a lot of catching up to do. The categories are just broken. I mean, Ireland and Greece are developed, and China’s not? And Argentina was developed, but it’s been demoted. It’s now a frontier market. Again, that just speaks to the kookiness of it all.

Ludwig: That’s about governance and some real shrinkage to the economy.

Yes, the index guys have a checklist, and you’ve got to check the boxes, and if you don’t look like what you should look like, then they call you one thing or another. I’m just telling you that that system is broken.

Ludwig: The categorization?

Carter: Yes, and then the second thing is the float-adjustment factor, which is just an evil force in my mind. With China, if you used the MSCI All Country World Index (ACWI) with a pre float-adjustment, China would be about 8 percent of your portfolio. And, after float adjustments, it becomes 2 percent. China gets the biggest float adjustment in the world. The Chinese government certainly owns a lot of the stock, so that’s part of the float adjustment, but the other thing is that they don’t count the A-share market. Those are the stocks in Shanghai or Shenzhen, and they get completely left out.

I’ll give you another dumb example of what’s wrong with the indexes and the whole system. Baidu, China’s Google, is not in anybody’s index. It’s not in the China index from MSCI, and it’s not in the emerging markets index. MSCI does not include New York-listed Chinese companies.

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