Consider this quote from a local investment professional in Malaysia:
When foreigners sell, that’s the best time to buy. [Foreigners] buy only when the market is going up, and they push the price way up. And they sell all the way down. They do all the wrong things. They are willing to sell all the way down to owning nothing in the Malaysian stock market.
And this one:
Fund managers in foreign houses are exposed to a lot of things. They don’t look at one angle, they look at several angles. Same topic, but they look at different angles. If you can look at a certain situation in a different way, you will win points. So it’s good to talk with foreign funds. Most of them have been longer in the industry than most [Malaysians]. And they are exposed to analysts from different countries, and these analysts have different ways of looking at things.
Which one is right?
Aaron Pitluck, a sociologist, looks at why traders invest in emerging markets, and asks why locals either seem to replicate the foreign traders’ trades, or trade against them. One explanation is that locals perceive foreigners to be less knowledgable or less skilled (and therefore the locals try to trade against them); another is that locals view foreigners as being at least as well-informed, or better-informed, than locals, causing the locals to imitate the foreign investors. But which is the more persuasive explanation?
Pitluck suggests a different explanation altogether: neither is correct. Instead, he posits that local and foreign participants are playing different games and that the games can’t be compared directly. And this, he suggests, can be good for liquidity:
[O]ne significant contribution to a market’s liquidity may be a market with heterogeneous participants with respect to strategic intentions for trading. Additionally, markets may be more liquid when participants have heterogeneous information sets (i.e., having heterogeneous views of what information is salient and heterogeneous interpretations of public information). Conversely, one cause of illiquidity may be when market participants’ strategic intention sets or information sets become more homogenous, and/or when traders with heterogeneous strategy or information sets increasingly avoid trading.
In other words, although they are usually buying and selling the same securities, local and foreign participants may be guided by divergent motivations that make them willing to trade against each other even though they all have the same information. Foreign exchange rate fluctuations, for example, may induce foreign investors to sell because it reduces their IRR, even as local investors see a buy opportunity because the new exchange rate promises a favorable benefit to a local listed company. Or the foreign investor may be liquidating a position in one country to take advantage of an opportunity in another, while local participants are limited by regulation or resources to stay in the local market. In either case, their strategies are incommensurable; they can’t be described as either “following the herd” or “separating the fools from their money.” They’re just playing different games.
The point here is that regulations and policies that encourage participation by players with heterogeneous motivations may promote liquidity, because it increases the likelihood that rational participants will meet as counterparties. Market operators and apex regulators looking to improve liquidity in a local market should therefore consider steps they can take to create the conditions for heterogeneous motivations, whether through loosening barriers to foreign direct investment, or promoting local regulations that will shift the motivations of local participants.
MarketReg Advisors 