Unpacking Mohamed El-Erian's Investment Strategy

Almost immediately after posting my blog entry on Mohamed El-Erian earlier today I received two emails asking me if I could translate the final paragraph of his FT column into something a little easier to understand. Here it is:

Therefore, the basic challenge for investors is an outlook that is inherently fluid and potentially dualistic. The solution may well have three principal components: a strategic asset allocation that emphasises secular themes and a long-term destination; portfolio overlays that recognise the reality of an historically unusual journey; and a risk management process that is sensitive to the nature and evolution of the underlying market distortions.

What Mohamed's getting at here is actually reasonably simple, I think: he has a pretty good idea where markets are going over the long term, but he's also quite sure that they're not going to get there from here by moving in a straight line. If something is going to go up before it goes down, then you don't want to simply go short now, even if you're quite sure that eventually you'll make money on the trade. In fact, you might want to go long, to capture the short-term upside, even if your big-picture investment strategy is telling you to be short over the long term.

And so to Mohamed's approach to investing, which one might say rests on three pillars.*

The first pillar is "strategic asset allocation," which is a long-term view of where the world is headed. This might take the form of buying Indian equities, say, in the expectation that India is on track to become a global superpower eventually. The asset allocation will also reflect how the world will look after today's macroeconomic imbalances have shaken out. "If something cannot go on forever, it will stop," as Herb Stein used to say, and sooner or later the US will stop borrowing billions of dollars a day at very low interest rates from the rest of the world in general and from emerging-market central banks in particular. A long-term investor has to be prepared for that day, when it come, and position himself to benefit from the consequences.

The second pillar is more short term. We know where we're going (that's the first pillar), and we also know that we're not going to get there in a straight line. In fact, the journey to there from here is going to be "unusual" – which means that we have to be alert to where markets are moving now. So we put on trades which make money from short-term moves in the market (or "underlying market distortions") even if they point in the opposite direction to our long-term vision.

The third pillar is crucial: risk management. It's also the reason why Mohamed El-Erian can get away with this kind of strategy, but you, dear reader, really shouldn't be trying it at home. The problem with trying to come to some kind of synthesis out of contradictory short-term and long-term visions is that you come very close to being that most failure-prone of investors, a market timer. You don't want to be the kind of person who thinks he's smarter than everybody else and therefore can get out right at the top of the bubble. Rather, you want to have a deep understanding of exactly what's driving asset prices – and protections in place which will make sure that you neither panic when things aren't going wrong (for instance: the little swoon we saw in February), nor stay stubborn after things have genuinely turned. This is the hardest part of all, and requires a gut-level understanding not only of the global macroeconomic picture but also of capital flows and other drivers of markets.

So far, El-Erian's gut calls have been spectacular. In his old job, at Pimco, he made a big long-term bet in 2002 that Brazil would do very well when the rest of the market was extremely bearish on the country. He made a big medium-term bet in 1999 that Argentina would do very badly. And in his new job, he made a big short-term bet in January this year that there would be a correction in global stock markets. All of the bets paid off. Whether they were the logical result of a rigorous investment process, however, or whether El-Erian is simply finding a way to put an intellectual spin on smart investment decisions he would have made anyway, no one can really know for sure.

*This is a bit of an in-joke: both Mohamed and I have sat through one too many Powerpoint presentations from emerging-market finance ministry or central bank officials where they explain their economic policy by explaining the "three pillars" it's based on.