Pimco's boss, Mohamed El-Erian, tells how to reduce risk and reap rewards in a fast-changing world. February 11, 2009 By Fred W. Frailey, Contributing Editor Mohamed El-Erian has a vision of the economic future that may both frighten and reassure you. He sees a tectonic shift occurring, as emerging economies in Asia and elsewhere join the established powerhouses, especially the U.S. No longer will the world simply march to our beat; the U.S. will have to share leadership with emerging giants, such as China and India.The good news is that this change in the global power structure is not altogether bad for America. El-Erian predicts that the new economic giants and other developing nations will buy more U.S. goods, easing our trade deficit and stimulating growth and jobs over time. Now, however, we're somewhere in the middle of the journey, and it's a rocky one. Because of all these changes, El-Erian suggests in his new book, When Markets Collide (McGraw-Hill, $27.95), that investors spread their money over a wider array of assets than was once thought necessary. That means shrinking U.S. stocks to just 15% of your total portfolio. Advertisement Unless you watch CNBC regularly, the name may not ring a bell. But El-Erian (pronounced el-AIR-e-ann) has been active in global finance for the past three decades. Born in New York City to an Egyptian father and French mother, he grew up both in the U.S. and abroad. He worked for the International Monetary Fund for 15 years, then did stints with Salomon Smith Barney and Pimco before running Harvard's endowment fund. He returned to Pimco, the bond powerhouse, in 2008. El-Erian is chief executive of Pimco as well as its co-chief investment officer (a title he shares with bond guru Bill Gross). We caught up with El-Erian at Pimco's offices in Newport Beach, Cal. Uppermost in our mind was how Joe and Jane Investor should react to the changes going on around us now. KIPLINGER'S: If you were writing your book right now, what would you change? EL-ERIAN: I would deal with the way the financial landscape is being re-defined without a master plan. This has become a crisis-management phenomenon that's very reactive and changes weekly. Advertisement What does that imply? It's inevitable that financial regulation is going to increase -- not just increase, but change the whole industry. After what we've seen recently, society will not leave unchanged a system that privatizes huge gains and socializes huge losses. Banks are being slimmed down. Bankers can still make a good living, but not as good as in the past. Do you trust the regulators to re-regulate wisely? No. The pendulum will probably swing too far, and it may be costly in terms of lost efficiency. I don't like that, but unfortunately, it's likely. Advertisement Why are you telling investors they need to diversify differently these days? The traditional approach to diversification, which served us very well, went like this: Adopt a diversified portfolio, be disciplined about rebalancing the asset mix, own very well-defined types of asset classes and favor the home team because the minute you invest outside the U.S., you take on additional risk. A typical mix would then be 60% stocks and 40% bonds, and most of the stocks would be part of Standard & Poor's 500-stock index. This approach is fatigued for several reasons. First of all, diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well. Second, it matters a great deal how you implement the asset allocation, because when the world gets bumpy, different investment types really do behave differently. Third, consider where we're headed. We are going toward a world where the U.S. will no longer be the most dynamic part of the global economy. Because of the debt excesses of the past few years, it will be a while before the U.S. economy returns to 3% or 4% annual growth. Therefore, the wise investor asks, "Where else can I tap into sustainable growth?" To do that, you need a more global approach. Advertisement And I would add one more thing. And that is? Don't become hostage to historical definitions of asset classes. Be flexible, because there will be opportunities that don't fit easily into those categories. In other words, look for the fat pitch? Exactly. You're used to facing someone who only throws fastballs and curves. If your mind-set isn't ready for the fact that you may get a change-up, you're not going to recognize it. What's a fat pitch today? One such pitch is that there will be huge opportunities in infrastructure, in everything from roads to energy production to water facilities. How can investors tap into these opportunities? Through exchange-traded funds and mutual funds. There are several vehicles that do this and spread the risk widely. [Three ETFs that focus on this area are iShares S&P Global Infrastructure (symbol IGF), SPDR FTSE Maquarie Global Infrastructure 100 (GII) and PowerShares Emerging Market Infrastructure (PXR).] The problem with buying a few individual stocks, such as those of companies building roads in China, is that changes in Chinese law can affect you in ways that are unpredictable. How can individuals participate in private equity -- another piece of your asset pie? This is one of the categories that individual investors may not be able to access easily because doing so requires a very large investment upfront. Why not buy stock in Blackstone Group or Kohlberg Capital, which are private-equity companies? You could, but I would not. The more you get away from the underlying investments, the more undefined risk you are taking. You also recommend that investors channel more than 10% of their assets into commodities. What is the best way? Individuals can gain exposure to a diversified basket of commodities through mutual funds offered by firms such as Credit Suisse Asset Management, Oppenheimer and Pimco, as well as through ETFs. What about individual stocks? Petrobras, the Brazilian company, sits on an ocean of oil. Petrobras is a commodity-sensitive stock -- but not a commodity. The crash in commodity prices makes this a good time to buy, doesn't it? This would be a good time. But will people be brave enough? Some may not. This brings to mind the story of the rational fool. It's an experiment with a donkey that's very, very hungry. The donkey faces two piles of hay, shaped differently but equivalent in volume. Which will it choose? The donkey is aware that people are monitoring its revealed preference -- as in, don't listen to what a person says, look at what the person does. The donkey knows that by making a choice, it will indicate its preference for one of the piles of hay. But being a smart donkey, it knows that there is no difference between the two, so it cannot make a choice. Instead, it starves. It's the rational thing to do. In the same manner, investors are often frozen by indecision. You co-manage a new mutual fund, Pimco Global Multi Asset. Is it structured along the lines of the asset mix that you suggest? Yes, it is. We call it a three-in-one approach. Approach number one is to have an asset allocation that makes sense looking forward, given the direction the global economy is headed. The second approach is to be alert for special opportunities that arise. And the third is to manage what we call tail risk, in addition to diversification. Is this an appropriate one-fund portfolio for an individual investor? Yes and no. It's appropriate for a slice of your total investments -- but not all of them. Think of diversification as a matrix. You want to be invested across a broad range of asset classes. But you also want to be invested across a range of managers. Beyond a certain point, it's not more asset classes you need, but more points of view. That's why it's important to invest with an array of managers. Which special situations is the fund invested in? Several, including certain agency mortgage securities trading at attractive valuations. Also, we're buying the debt securities of banks that have received significant assistance from the government. You're buying the bonds issued by the banks, but not the stock. Why? Because the stocks get diluted every time the government comes in. This speaks to a very big issue, which is that the balance between private and public ownership is changing fundamentally. A mistake a lot of people make is to say, "Here's a company so important the government is going to give it money to keep it going, so I'm going to buy its stock." They forget that the government becomes part owner. Exactly. The government is very open about this. Understandably, it cites three objectives -- to stabilize the company, calm the markets and protect the taxpayer. It looks at the capital structure of a company, which includes senior debt, preferred stock and common stock, or equity. The government has not bought equity because it's too expensive, being the most junior part of the capital structure. So in the case of Fannie Mae and Freddie Mac, the government came in at the level of senior debt, and that had the effect of diluting everything below it. In the case of the banks, it came in at the level of preferred stock, which diluted the common equity. So as an investor, it really matters to you where you are in the capital structure -- the higher the better in the case of entities aided by government injections. What are your expectations for this fund's long-term returns? Our objective is to do better over a full market cycle than balanced funds that invest 60% in stocks and 40% in bonds. We're also conscious that doing better than this group yet delivering negative returns is not good enough. That's why we pay attention to the tail risk. What does "tail risk" mean? Another name for it is Armageddon protection. It's the small probability of something happening that would overwhelm everything, as is occurring right now on several fronts. An example is earthquake risk in California. If people really thought the risk of a Big One was high, no one would live there. Yet the probability, though small, exists. So it makes sense to buy earthquake insurance, if it can be bought cheaply. If you manage this risk, why did your fund lose money in its first three weeks? Global markets came under pressure in November, and our hedges are designed to kick in to protect against losses exceeding about 15%. The fund never got to that stage. Think of it as the deductible on your car insurance. A zero deductible is expensive. So you normally choose a higher deductible to bring the cost of insurance down. For example, at the Harvard endowment in 2006 and 2007, we bought credit-default swaps against the senior tranches of the corporate-debt index. That was a form of insurance, and it was cheap at the time. All very good for you! But what about Joe and Jane Investor -- what's their insurance? A financial planner can do some of these things for them. The planner's job should go beyond just asset allocation; he or she should also look to clip off the bad tail risk. But you can also clip the tail yourself, in a less targeted fashion. Keep a cash balance that's bigger than you would have when markets are calm. If you normally keep six months of living expenses in cash, make it a bit more, so you won't have to sell assets when everyone else is selling. The critical thing about managing a bumpy journey is to never be a distressed seller. You don't anticipate a sharp economic recovery, do you? No. I see a saucer-shaped one. We've been driving at or slightly above the speed limit through the use of debt. I think the speed limit is going to come down on us so that the potential growth of the economy is going to go from 3% a year to 2% a year over time. And so you don't see a robust stock market around the corner? Correct. Lately, one of the smart trades that certain pension funds have been making is selling part of their exposure to stocks and buying high-quality corporate bonds at 8%, 10%, 12% yields. They're saying basically, "I would have been happy with an 8% return on my stocks. Now I can get that amount and be higher up in the capital structure." Remember, if you are in the sectors that are being embraced by the government, you don't want to be in common equity. Stocks will suffer because investors, just like those pension funds, will say, "Wait a minute. I can buy the stock and have massive risk, hoping to get 8% to 10%. Or I can buy the bonds and still get 8% to 10% from the yield." Yes, you'll give up some of the potential upside of stocks, but the upside hasn't been that great recently.