The credit crisis and how to survive it

When Markets Collide: Investment Strategies for the Age of Global Economic Change
By Mohamed El-Erian
McGraw Hill, $27.95 (£15.99)

Few people are as well positioned to understand markets as Mohamed El-Erian. He is almost unique in being able to attack the credit crisis from the perspectives of academic economist, policy official, investment banker and fund manager. He has the global perspective of an Egyptian long resident in the US whose area of greatest expertise is Latin America. And his success, as an academic who came relatively late in life to fund management, gives him credibility – after a brief stint running the Harvard Management Company, the biggest university endowment, he finds himself joint chief executive of Pimco, the giant fixed-income manager.

So When Markets Collide, his attempt at explaining the forces that created the credit crisis, and making some prescriptions on how to survive it, has understandably created much interest. Mr El-Erian avoids the polemical tone that permeates many of the books that have so far covered the crisis and avoids over-simplification. From where he is sitting, the world looks complicated and he attempts to put the tectonic shifts into perspective. He also makes a distinction between the perilous journey on which the markets have embarked and the final destination. Thanks to secular growth in the emerging markets, he believes this will not be such a bad place.

His title refers to several different “collisions”. The greatest is between the market of yesterday (centred around the US and based on an assumption that credit can continue to expand) and the markets of tomorrow, in which the centre of gravity has shifted to emerging markets – where sovereign wealth funds are important actors – and where many contradictions in the way the financial services industry works have been painfully resolved. Presciently, as this book went to press before a renewed inflation scare this summer, he also warns that the pressures that emerging market growth puts on resources will lead to higher global inflation.

He identifies the long-term disintermediation of the financial system and the waning power of the big “sell-side” investment banks as a critical problem. At one point they were a monopoly provider of price discovery in the markets and also analysis and research. That monopoly has been eroded by the new technology and the rise of independent participants. “By putting pressure on revenues and profits, it has also encouraged sell-side firms to extend their activities to new areas” and “abandon their comfort – and expertise – zones”. In the process, Mr El-Erian says, they increase the risk of market accidents.

Perhaps surprisingly, he emerges as a sceptic on the alternative investment industry. He took over at Harvard when many internal managers had defected to set up their own hedge funds. He rejected the natural solution, which would have been to do what many others do and “outsource” management to hedge funds. This would “solve” the controversy “not by lowering the cost of managing the endowment but rather by obfuscating it”. He says the costs of external managers would have been double but would not have shown up clearly on Harvard’s accounts. More subtly, Harvard operates with the equivalent of a triple-A balance sheet, while hedge funds have a much higher cost of borrowing. Also, he complains that hedge funds’ secrecy over their holdings would have made it impossible for the endowment to manage its overall risk. He has other complaints: hedge funds’ pricing structure means that investors start in “negative territory” and also gives the funds’ managers perverse incentives to take on excessive short-term risks.

As for private equity, he points out that returns are crucially dependent on the manager you choose, and it is difficult to get access to the best managers.

For investors, key recommendations for surviving the next year involve allocating assets on the assumption that you will not be able to make any changes for the next three years. This forces a conservative mindset. He also calls for a new approach to choosing assets that starts with assessing the risks involved with each asset class, rather than the returns. He strongly recommends buying “tail insurance” – contracts that protect against the extreme market events now generally known as “black swans”.

The book has its flaws. It is not an easy read and could have been condensed into fewer pages. It is also unclear whether it is aimed at the general reader or at specialists – the language can be rather technical for the former, while there may not be enough numbers for the latter.

It is difficult to quench the suspicion that it was rushed into publication with the onset of the credit crisis. But even though When Markets Collide has imperfections, Mr El-Erian’s insights are as valuable as ever.

The writer is the FT’s investment editor