Global guru

NEW YORK (Fortune) -- When you first meet Mohamed El-Erian, 48, who heads up Harvard University's $30 billion endowment, two things immediately strike you: First, he's incredibly sharp, particularly when it comes to highbrow things like geo-political economics; second, despite being one of the world's most respected money managers, he's the antithesis of a hubristic hedgie or swaggering Wall Streeter: the Oxford and Cambridge-educated Egyptian is enormously polite and charming.

El-Erian, who lived in various parts of the world growing up as the son of a diplomat, took the helm of Harvard's endowment in February 2006. He had just spent seven hugely successful years running PIMCO's Emerging Markets Bond Fund. Prior to that he worked at International Monetary Fund for fifteen years. Also, he's brought to Harvard a unique understanding of global markets - something crucial in today's investing world.

Mohamed El-Erian, 48, who heads up Harvard University's $30 billion endowment.

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The past year at Harvard would have been a tough job for anyone, including El-Erian. For starters, he followed in the steps of superstar manager Jack Meyer, who ran the endowment for almost 15 years and posted average annual returns of around 16 percent. Most of the talent left to join Meyer at his new hedge fund months before El-Erian came on board.

Yet El-Erian has showed his stuff. He's hired a number of respected investors and he's hammered out a compensation system for himself and his managers that seems to be much more palatable to the university. (A big criticism of Meyer was that he and his team were paid far too richly.) He's been building a bridge between the academic community and the endowment.

And as performance goes, so far, so good. In the most recent fiscal year (July 1, 2005 to June 30, 2006) the endowment posted a 16.7 percent return, trouncing the Standard & Poor's 500-stock index, which rose 8.6 percent during that time. (To be fair, a more true assessment of El-Erian's investment strategies will be after the current fiscal year ending this June, since he had to largely work with what he inherited last year.)

Fortune senior writer Marcia Vickers recently had a chat with El-Erian, to find out what he's thinking about investing, the market, the global economy... and how his three-year-old daughter helps him manage Harvard's portfolio (well, sort of).

Q: Mohamed, you run one of the largest endowments in the world, you have access to the best alternative asset managers, private equity investments, even experts in academia. Is there anything average investors can learn from what you do?

A: While we may have better access to investment managers, external and internal, our overall approach is relevant for a much broader set of investors. The key is for investors, for example, to focus on the long term. Otherwise the risk of being pulled in and pushed out of investments at the wrong times is particularly high.

Q: Could you give us some specific pointers as to how you do that?

A: Absolutely. We feel that there are four distinct, albeit inter-related, issues that long-term investors need to take into account - and they're what we think of when constructing and managing the Harvard portfolio. They're factors we believe will play out in the market for several years to come.

First, it's important to have a diversified and internationalized portfolio. For the average investor, this may mean shifting part of the domestic equity exposure into international equities and introducing some commodities. We believe that long-term global forces are in play. For example, we're looking for a growth slow-down in the United States. Yet emerging economies, as well as Japan and Europe, are experiencing higher growth.

Commodities also serve as great diversifiers, and they provide some downside protection against a geo-political shock emanating in the Middle East. A good idea is to purchase a diversified commodities mutual fund or an ETF (exchange-traded commodities fund).

Second, within domestic equity exposures, we're looking for a handoff from small-cap and mid-cap to larger-cap companies. This has to do with the growing influence of the private equity. We believe that large cap companies will be next to benefit from the large influx of private equity capital buying up companies. Private equity companies are now targeting larger capitalization companies. As an example, think of the recent news on Cerberus Capital Management, the private equity firm, buying Chrysler for some $7 billion.

Third, it's a good idea to have some inflation protection in the portfolio. The world has benefited in the last few years from two major dis-inflationary forces that will likely diminish in importance going forward: increased U.S. productivity and the entry of low cost workers in the global workforce, particularly in China and India.

As these forces diminish, inflationary pressures will pick up, making securities such as TIPs (Treasury Inflation-Protected securities) a good addition to portfolios. The fourth theme may distant to the average investor, but it's of enormous importance. Suddenly more central banks in the world will be reconsidering how to deploy their capital. The numbers are large. For example, China has over $1 trillion of reserves, Russia over $250 billion and Brazil over $120 billion. To date, most of these funds have been invested in U.S. bonds, and Treasurys in particular. Over time, they'll adjust the allocations to other parts of the world.

Q: Dwelling on private equity for a moment, perhaps smaller investors can benefit from the private-equity boom without directly participating in buyout funds, which are typically out-of-reach for average folks?

A: Right. Even if you can't invest in private equity funds directly, it's important to respect how consequential this boom is. It's a special circumstance that is repricing all sorts of markets. As more money gets devoted to private equity, and we're still probably in the fourth or fifth inning of that process, then the money comes back into public markets through the leveraged buyout vehicles. It comes back leveraged (accompanied by borrowed money). That means it has more buying power.

So private equity funds will increasingly target larger-cap companies. Another example of this is the consortium of private equity firms including Blackstone and the Carlyle Group currently bidding around $30 billion for Alltel (Charts, Fortune 500), a wireless telecom company which is part of the S&P 500 index.

Q: But how do you anticipate which large-cap companies are going to benefit from the private equity boom?

A: That's very difficult. The best thing for average investors is to buy large cap equity index funds to gain diversified exposure.

Q: And back to those international stocks, how do investors get into the game there?

A: For U.S. investors, the tendency for those that venture abroad has generally been to buy international equities denominated in U.S. dollars. But we can also see a long-term case for having nondollar exposures as part of these investments. Mutual funds which purchase international equities in the currency where the underlying companies are based are a good bet. Right now, we have a tilt toward Japanese equity funds. A case can be made for their favorable valuations and the cheap yen.

Q: The U.S. market has been doing well this year, the S&P is over 7 percent, the Dow has hit some new highs. Is there anything we need to be wary of?

A: Yes. There's the increasing risk of sudden, sharp pullbacks. This occurred in May-June of last year, and in late February of this year. The corrections were technical in nature. We're likely to see more of them going forward as a growing number of hedge funds and other "fast money" investors rely on what I call "just-in-time" risk management approaches.

Instead of taking chips off the table gradually as prices go up, there are now all these sophisticated derivative-based instruments that encourage investors to "wait for the market turn." That's why you get S&P falling 4 percent in one day when nothing has really happened.

And the declines are inevitably broad-based and seemingly indiscriminate. Individual investors need to try to remain calm in order to minimize the risk of selling at the wrong time - instead try to have the right mindset, assess the situation, and be able to weather it out as long as the underlying economics remain sound. Because going forward, these technical selloffs will likely be a more frequent fact of life in the market.

Q: What about bonds? Can they protect us a bit from those equity swings and anchor our portfolio?

A: Yes, investors should hold part of their portfolio in bonds. It is part of an appropriate diversification of portfolios. Given the shape of the yield curve and the likely outlook, investors may wish to consider short-term domestic bond funds. Remember, in this context, that the Federal Reserve faces a particularly difficult policy outlook.

On the one hand, the economy is slowing, which would call for an inclination to cut rates. On the other hand, inflation is running above the Fed's comfort zone, which suggests an inclination to hike. Our feeling is, absent some truly unambiguous data, the Fed Fund's rate may well stay at 5 ¼ percent for the remainder of this year. But you need to be prepared for anything and that's why a short-term bond fund makes sense for investors.

Q: What is the major challenge you have in terms of investing at Harvard right now?

A: More people are replicating what we do. The endowment model is very much in vogue. There have been many articles in the press trumpeting how well endowments like Harvard's and Yale's have performed. And David Swensen, who brilliantly heads up Yale's endowment with impressive long-term performance, has written a great book showing how endowment management is done. So now lots of central banks and pension funds are trying to become more like endowments. The space is becoming more crowded.

Accordingly, we are spending a lot of time thinking about the related challenges and how we would be able and willing to differentiate ourselves. We have to play the smarter game. And that's always complex, never easy.

Q: You have a three-year-old daughter. Has she taught you anything about running Harvard's portfolio?

A: Gosh, that's a great question. I can think of at least three things, and there are probably a lot more. First, and foremost, by adding a tremendous amount of joy to my life, she keeps me sane - an important pre-condition for any portfolio manager!

Second, and this reflects the fact that I am an older parent that tends to live in a risk paradigm: Parenting is a continuous reminder of the importance of managing risk and dealing with uncertainty.

Third, her tendency to ask the repeated "why" question reminds me of the importance in the investment world of looking at things from first principles, and us all being open to re-invention and re-tooling where necessary.