Tourist Dollars

Mohamed El-Erian’s new book, The Only Game in Town, is all about the dominant role central banks have played in steering the global economy since the 2008 crisis. It’s a great read for anyone in business, policy, or finance, and one section in particular stuck out for me.

I spent years trading emerging market currencies, and even wrote my undergraduate thesis on Malaysian capital controls. Emerging market capital flight has been something I’ve looked at for a long time. However, now living in the orbit of technology and venture capital, the concept he outlines of tourist dollars takes on a whole new meaning.

El-Erian discusses an unfortunately recurring phenomenon in emerging market investing:

During periods of large capital flows induced by a combination of sluggish advanced economies, robust risk appetites, and highly stimulative central bank policies, emerging markets serve as destination for a huge pool of crossover funds, or what I refer to as tourist dollars.

Because these crossover funds have such large total assets under management, the flows they devote to emerging markets — while small for them — tend to be a multiple of those invested by more knowledgeable dedicated funds (what I refer to as the “locals”). And their drivers have a different and more volatile mix.

Rather than “pulled” by a relatively deep understanding of country fundamentals, this type of capital is typically “pushed” there by the prospects of low returns in their more traditional habitats in the advanced world. Instead of being associated with specialized vehicles, they tend to come from more general accounts typically managed against benchmarks dominated by advanced-country securities. Searching for higher yields and/ or greater possible price appreciation, their investment managers are “crossing over” into smaller (and typically off-benchmark) market segments.”

Does this sound familiar to anyone who has been watching technology investing over the past few years?

• Chasing higher yields in non-core, off-benchmark market segments.
• Rationalizing such aggressive moves as being only a tiny slice of your overall portfolio.
• Those nominal amounts carrying real weight for the target investment and severely distorting market normalcy.

It certainly resembles the trend of mutual funds like Fidelity, T. Rowe, Wellington, Janus, Blackrock, etc. into late-stage, private technology company investing has been very well documented. The run up was certainly epic, producing a herd of unicorns and decacorns.

However, it’s worth remembering what happens to tourist dollars when things go sour. El-Erian reminds us:

Once they are invested, it doesn’t take long to observe that crossover flows lack the conviction and staying power of the dedicated funds. As such, they often act as tourists rather than locals. At the first sign of instability, they essentially tend to rush to the airport, looking to get out quickly; this can even occur when the initial source of instability has little to do with the emerging markets themselves.

Crossover tourist investors are usually inclined to stay in emerging market investments for only a limited amount of time. They have a decisive home bias, and they tend to overreact to unanticipated news. The resulting fluctuations in capital inflows and outflows have tended to overwhelm financial markets in the emerging world.

Remember, the flows are not driven primarily by individual country fundamentals. Rather, they are more the product of credit factories in the advanced world and central bank policies there. And they are large relative to the absorptive capacity of the local financial system.

That last sentence is the most ominous parallel. Now that we’re on the way down, quarterly unicorn markdowns of mutual funds have become ritual. But what’s really dangerous is that “local” effect, something emerging market policymakers and politicians have been dealing with forever. Writing off a non-traditional investment might not have a game-changing effect on a huge investor, but it can have relatively disastrous effects for the investee.

If you are a Fidelity Blue Chip Growth Fund and manage over $20 billion, marking down a $20 million Blue Bottle or Zenefits investment by 50% doesn’t mean much. You’d prefer to just clean up your books, mark a loss where you might need to. However, it definitely means something for the private company.

It’s not exactly identical to emerging market “hot money” capital flight, as mutual funds probably won’t (or can’t) pull their money out, but the downward spiral is the same. We already see the resulting external effects of negative press coverage sapping private company momentum and morale. Just like in the emerging market crises of the past, it just takes a spark to light the fire. An unwinding never takes place in a predictable manner.

All the signs are there: Chasing yield in sparkly new arenas because of depressed returns where you traditionally invest. Keeping those investments small enough that they don’t seriously affect you, yet completely distorting the market of your investment. “Tourist Dollars” have been a long-known and dangerous quantity in emerging market investing circles. The scary part in unicorn-land, how long before the tourist dollars pack up and head home?