An El-Erian Fund for the Masses Using ETFs

The investment guru has distinct ideas about diversification, which anybody can copy.
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Mohamed El-Erian has quickly become an investment guru.

El-Erian, the CEO of Pimco, the world's largest bond-fund manager, has interesting ideas about portfolio construction and the evolution of diversification. He devotes a large portion of his latest book, "When Markets Collide," to a new type of portfolio. I will now explore some simple choices that fit in with El-Erian's concept.

Here's the breakdown:

For the domestic equity allocation, 10% goes to

PowerShares S&P 500 Buy Write Portfolio

(PBP) - Get Report

. The track record of the buy write index has been to outperform the S&P 500 over the entire stock-market cycle, only lagging when the market rallies, as it did in 2003.

iShares S&P 600 Small Cap ETF

(IJR) - Get Report

would take the other 5% in domestic equities. In the early stage of a stock-market cycle, small-cap stocks tend to outperform large caps. IJR helps capture that effect.

Many investors use

iShares MSCI EAFE ETF

(EFA) - Get Report

for developed country equities, but it is heavy in Japan, at 25%, so I prefer 10% be allocated to

WisdomTree International Large Cap Dividend ETF

(DOL) - Get Report

, which only puts 9.7% in Japan. There is now a choice among foreign small caps. The

SPDR S&P International Small Cap Index Fund

(GWX) - Get Report

is lighter in financials than similar funds and gets the other 5% in this category.

In emerging markets, I use the

PowerShares BLDRS Emerging Market 50 Index Fund

(ADRE) - Get Report

. Interestingly, small-cap emerging markets ETFs don't do any better than large-caps.

El-Erian likes private equity. Because no ETF can mimic that category adequately, I omitted it from the portfolio. El-Erian recently said this might be the most difficult part of the market for do-it-yourselfers to access.

The ETF industry has been creating more fixed-income choices, which is a boon for investors. For domestic bonds, I would suggest 6% to

iShares Barclays 1-3 Year Treasury Bond ETF

(SHY) - Get Report

and 3% to

iShares Barclays Agency Fund

(AGZ) - Get Report

. The yields are lousy (about 2% and 2.5%, respectively) but if yields rise, longer-dated bonds and bond funds will tumble. Anyone so inclined could buy individual fixed-income issues. The 15% target for foreign bonds could be easily captured with

iShares S&P Citigroup International Treasury

(IGOV) - Get Report

. SPDR has a similar product, but it has emerging market exposure, whereas IGOV does not.

Real estate is also difficult to capture. During the financial crisis, REITs offered no diversification benefits. I have not had real estate exposure for clients since late 2007, but for investors who believe in the asset class, the

WisdomTree International Real Estate ETF

(DRW) - Get Report

offers a mix of property operators and owners in real-estate markets that are less mature than ours. These less-mature markets have a better chance of capturing a cyclical upswing than do U.S. REITs.

In the past few years, most investors have come to learn a lot more about commodities than they previously knew. El-Erian advocates 11% in commodities, which is more than I prefer. Being true to El-Erian's portfolio, I would allocate 6% to

SPDR Gold Trust

(GLD) - Get Report

and 5% to

PowerShares Agriculture Portfolio

(DBA) - Get Report

. I am not a fan of the broader commodity funds because of their exposure to crude oil.

El-Erian considers TIPS to be separate from fixed income. The

iShares Barclays TIPS Fund

(TIP) - Get Report

or

SPDR Barclays Capital TIPS Fund

(IPE)

are the easiest ways to access the space.

Infrastructure is a compelling theme, and there are several ETFs in existence. The truest ETF exposure might be the

iShares S&P Global Infrastructure Fund

(IGF) - Get Report

because it is heavy in industrial companies that will build roads, airports and the like.

Thus far, the portfolio takes no single-stock risk, but that is not ideal for building a diversified portfolio. There are plenty of examples of foreign stocks that stand to be important to the building up and out of infrastructure in emerging markets.

China Railway and Construction

(CWYCY)

would seem to have its finger on the pulse of all things infrastructure in China including railroads, highways, commuter rails, airports and hydroelectricity. A combination of IGF and a stock like CWYCY could be an effective way to capture the effect El-Erian is looking for.

Special opportunities can be anything you understand and are willing to pay close attention to. Some examples of this could include small emerging market countries. I just wrote an

article

on the

GlobalX Colombia ETF

(GXG) - Get Report

. There will be more ETFs that focus on small countries in the future. One special opportunity now is volatility. A couple of weeks ago, iPath listed the

S&P 500 VIX Short Term Futures ETN

(VXX) - Get Report

. VXX is not the VIX, but it is close. Something like water via the

PowerShares Water Portfolio

(PHO) - Get Report

could be another example.

The bigger context is recognizing how we get the return our financial plans require may be changing, and we need to change with it.PBP, ADRE, GLD, IGF, DBA

At the time of publication, PBP, ADRE, GLD, IGF and DBA were client and personal holdings, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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