When Markets Collide: Book Review, Model Asset Allocation

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The last book I reviewed was Financial Armageddon. Then I saw the title of this book: When Markets Collide. I almost stopped right there, as I was not at all in the mood for yet more doomsday talk.

However, I saw that the author, Mohamed El-Erian, ran the Harvard University Endowment for nearly two years, and is now the co-CEO of the huge bond investment company PIMCO. Throw in the fact that the tagline of this book is “Investment Strategies for the Age of Global Economic Change”, and perhaps this would be an insightful book about investing like David Swensen’s Unconventional Success. (Swensen ran the Yale University Endowment.)

Ease of Reading / Target Audience
The first I noticed about this book was that it was very difficult to read. The author tried to write this book for both experienced economic policymakers and the average investor. Not an easy feat. I felt that he came off as one of those guys who is just “too smart” and can’t simplify things for the rest of us. Here is an example of this high-level writing from the book:

The challenge of how to deal with consequential and volatile endogenous liquidity relates to another policy issue that I will discuss in Chapter 7: how to refine the traditional instruments of monetary control and ensure more meaningful and sophisticated supervision on a range of activities, with volatile leverage, that have been enabled by the ongoing structural transformations and yet are outside meaningful oversight.

Quick Summary: My Interpretation
The relationships between the economies of the world are changing. Emerging markets, which used to either be debtor nations or those who would only buy the safest thing available (US Treasuries), are growing fast and will start to invest their considerable wealth elsewhere, including equities. The U.S. can’t rely on other countries to buy our debt forever, just as the other countries can’t rely on U.S. consumers to prop up the world’s economy. This is where the “markets collide”. Throw in complicated structured investments like derivatives which nobody perfectly understands, and we are only in the beginning of a very bumpy road ahead.

Model Asset Allocation
So what is a U.S.-based individual investor to do? El-Erian states the three basic steps of portfolio management are: “choosing the right asset allocation, finding the best implementation vehicles, and conducting risk management.” Accordingly, here is his model asset allocation, with midrange percentages.

Equities (49% total)
15% United States
15% Other advanced economies
12% Emerging economies
7% Private

Bonds (14% total)
5% U.S.
9% International

Real Assets (27% total)
6% Real estate
11% Commodities
5% Inflation protected bonds
5% Infrastructure

Special Opportunities

This adds up to 98%, but the way I read the book, the rest should be in cash. As a comparison, here is the asset allocation from Unconventional Success.

El-Erian doesn’t like home-bias and is believes strongly in being “globally-diversified”. You can see that only about 1/3rd of the equity allocation is to U.S. stocks. If an investor does have access to private equity, then you can redistribute that back into the other equities. In my opinion, he cops out in the active manager vs. passive index debate. He simply states that it’s really hard to find a good active manager, but if you can you should go with them. Of course, no further hints are given. 😛

As for bonds, he believes that bonds are overall a good portfolio diversifier to manage volatility. He also advocates a big portion of international bonds, which he believes are mature enough to be considered right beside domestic bonds. (He was also was an emerging bonds analyst for many years.)

Inflation is another big concern due to huge global growth, and thus there is a sizable allocation to real assets – commodities, real estate, inflation-protected bonds, and infrastructure (publicly traded equity and debt securities of utilities, airports, ports, roads, hospitals, etc.). Special Opportunities could mean speculative plays such as distressed debt or long-term environmental gambles like carbon credits.

In general, this is pretty different mix from many other model asset allocations I’ve read about.

When Markets Collide is mainly a macro-economics book as opposed to a how-to-invest book, but it does give some interesting insights about the future that might influence my personal investing strategies. For example, I agree that activities from non-U.S. countries will be increasingly important and their equities should be a significant part of one’s portfolio. I am not so sure (or educated) about the rest. I could only give a very superficial review here, so if this perspective sounds interesting and you want more details than I have given, I would read the book. If futuristic projections aren’t your thing, then I’d probably skip it.

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  1. I wonder what the heck you’d use for “special opportunities.”

    I’ve yet to find a commodities ETF I really like. I hadn’t really liked ETNs from the beginning, and that now looks like a decent decision.

  2. felt that he came off as one of those guys who is just “too smart” and can’t simplify things for the rest of us.

    The sample sentence is just poorly edited. It should be two sentences, possibly three. He also throws around a lot of terminology: how to deal with consequential and volatile endogenous liquidity…

    I’m sorry, “average investors” simply cannot understand this type of terminology without a footnote and some examples. It looks like someone on amazon references the same sentence.

  3. can you suggest related vanguard (or other) funds or ETFs along with the suggested allocation?

  4. Stephen – I agree. Special opportunities is very vague. In general, I think it means some “longshot” investments, a la Taleb.

    Infrastructure is another ??

    Examples for the rest:

    US: VTI
    Int’l: VEU
    Emerging: VWO

    US Bonds: BND
    Int’l Bond: BWX

    Real Estate: VNQ
    Inflation-protected bonds: TIP, IPE

    I personally like GSG for commodities, although it it heavy in oil due to the passive index it tracks. Over at Bogleheads they like PCRIX a lot.

    After a quick google for private equity ETF, I found PowerShares Listed Private Equity Portfolio (PSP), and I think Barclays had one coming out too.

    Gates – Yeah, I stole that sentence choice from the Amazon review. There are plenty of other confusing phrases to choose from, though!

  5. A good example of infrastructure is BAM. It is a stock I own, but don’t really consider it a stock so much as an asset class. They own things like toll roads, dams, public utilities, etc. Infrastructure is big right now among the endowment managers I talk to.

    In substitute for special opportunities and private equity I own BRK.B and LUK as proxies. Again, stocks that are sufficiently well diversified that they act almost like a mutual fund.

    Other than those mentioned, I get exposure to the other classes via index funds. I don’t own commodities, but that is in great part because I haven’t found an efficient means of owning them. If I did, they would be 5% max. I’m not a big fan of commodities.

  6. Random curiosity. Has anybody had an experience with either taking a withdrawal out from a Vanguard 401K (and just paying the taxes on it, I guess) or changing the dividend election to get the dividends in cash?

    If anyone has done either of these things and wouldn’t mind me picking their brains a bit, I’d love to know.

    Basically, I’m just wondering how doing either of those things works, if it’s as simple as it sounds, if it’s just a matter of taking the money out and paying taxes on it like it was a paycheck, and in the case of the dividends, do they just send you a check for all your dividends, or is it just some of them, does it cost anything (fees) to do either of those, etc.

    Also, has anyone had any luck getting anyone on the phone at Vanguard to answer questions about that stuff?

    Huge thanks if somebody can spare a clue for me!

  7. Amanda – your best bet is to call Vanguard. Their phone reps are excellent in my experience, and will answer your questions.

  8. This does sound convoluted. Investing doesn’t need to be. This is why people get scared of investing on their own. I believe in keeping it simple.

    1 – Use ETFs as the primary investment driver, since they can cover the entire investment range.
    2 – You can diversify with a few ETFs (but this guy has gone hog wild). You can hurt your returns with too much diverisfication
    3 – Use a stop program
    4 – Know when to get into and get out of the markets by using volatility and other indicators

    Investing doesn’t have to be hard or complicated. You just need to develop an investment plan that covers these points.

  9. Sheesh.

    I guess this is not an El-Erian crowd.

    First, the man has a Ph.D. in Economics. Now, that doesn’t *mean* he has to explain things at that level, but I think it shows a predisposition to doing so.

    Second, he’s really good. He was more than an emerging markets bond analyst. The funds he managed had the best return in their peer group for years. He headed the practice at PIMCO before moving to Harvard Management. Technically, he was only there a year and change, but if you look at the numbers the way most people do, it looks like 2 years. He then returned to PIMCO as co-CIO (alongside Bill Gross, who most people consider the best bond fund manager on the planet) and co-CEO (now only CEO).

    That said, many of the things El-Erian is going to suggest are going to be foreign to even the best PF bloggers. He’s on a different level, conceptually. Its not bad advice at all, but in order to replicate his model portfolio well, you probably need to be investing $500,000 or more. To do it perfectly, you’re looking at $5M – $10M investable. Easy.

    That said, if you’re open minded, his advice is good. But again, Jonathan, I think you might just be in over your head (from a PF perspective) with this book. Swensen’s book along with Teresa Lo’s model portfolios are probably a better bet for the average PF blogger and their readers.

  10. As a follow up to my last post…

    Pimco’s El-Erian Wins $52,000 FT/Goldman Business Book Award


  11. I have seen El-Erian on CNBC several times he is a sharp guy, no doubt. But he is sometimes hard to understand. If you are interested in investing with his theories in mind PIMCO started a mutual fund with the principles laid in the book as its goal. El-Erian is the co-manager of the fund. Long term his points make a lot of sense as emerging markets become developed markets and the middle class grows in these countries.

  12. My short list: FAZ, SRS
    Stocks: NOK, MTA
    ETF: IGD

    Buy Europeans stocks in Frankfurt using Interactive Brokers or E*Trade Global

    Buy into Desertec Project

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