Q. What are some of the best ways in which hospitals and health systems can take advantage of time-frame arbitrage?

A. Hospitals and health systems have the inherent advantage of a longer time horizon than most market participants, and thus they have opportunity to exploit market opportunities by simply committing capital for long periods of time. It is the excess return-or "alpha" -from investing in, and thereby providing liquidity to, the less liquid, less efficient sectors of the capital markets where there is the greatest opportunity for assets to be temporarily mispriced. It is "staying power" or "long-horizon" investing. Some refer to time-frame arbitrage as an "allocation alpha" or "structural alpha."

Q. What are some steps to ensuring diversification is achieved? Is it common now for hospitals to have significant foreign investments? And do you think the experiences of recent months will lead to sweeping changes in philosophy and investment management?

A. Diversification can best be achieved by a thoughtful discussion among experienced members of the investment committee, and their commitment to constructing and maintaining a diversified portfolio. In other words, it is a philosophical commitment to begin. The principles of modern portfolio theory (MPT) are useful guides throughout the process, and investment decision-makers should certainly be familiar with them.

In terms of implementation, there are many ways to model different portfolios as to expected risk and return, leading to an allocation with optimum potential returns given the risk tolerance of the organization. Many hospitals do have reasonable exposure to foreign markets. A study we conducted in 2007 disclosed that the average allocation to international equities among participating hospitals and healthcare organizations was 14 percent. This is commendable, but below the levels found in other not-for-profit sectors. For example, our 2007 study of educational endowments found that colleges and universities had an average international equity allocation of 20 percent.

With regard to turmoil in the market in recent months, I don't believe there will be significant shifts in the investment management philosophy of not-for-profit organizations. Back to the point about diversification: It is times like these that underscore the need for a well-diversified portfolio-not to mention the value of time-frame arbitrage. I do, however, believe that there will be more emphasis on risk management.

Q. You mentioned that "In rising markets, one would want correlation between the U.S. and foreign markets." Why is correlation important?

A. It's important because an investor cannot construct the diversified portfolio I spoke of earlier with assets that are correlated-in other words, assets whose risk and return characteristics are similar. Only by adding assets that are relatively uncorrelated will diversification be achieved. Of course, in rising markets one, is less concerned about correlation-it's a happy occasion when "a rising tide lifts all boats," as the old saying goes. But that's a false sense of security-because when markets fall that same lack of correlation will prove costly. It's during times of duress that one wants to hold some assets that will "zig" when others "zag."

Q. Once investment managers have made the assessments of where they are within the four dimensions, are there rules of thumb that identify danger signs?

A. Considering assets, currency, liquidity, and risk holistically is a newer way of thinking about asset allocation-not just how the assets are divided among the various classes and strategies. In response to the question, I would say the best defense is a good offense. Assets: hire the best managers and don't constrain them. Currency: Look at the currencies your portfolio represents. Is it just the U.S. dollar? Or the euro, yen, loonie, yuan, peso? Liquidity: Most not-for-profit investors are too liquid, meaning they give up return because less liquid assets generally have higher returns. Risk: Actively stress test the portfolio and use methodologies such as VaR (value at risk).

Q. Hospital financial managers must cope not only with their own amygdalas, but those of their Board (particularly the finance committee). Can you suggest an approach to keeping the Board members' amygdalas in check?

A. Asking them to read Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich by Jason Zweig is a great way to start! A close working relationship with the chair of the finance (or investment) committee is essential. If there is timely, open communication between senior financial staff and the finance committee chair, an air of calm, confidence, and control should prevail. In addition, if the committee has been engaged in and understands the investment policy and objectives-that is, they understand the decisions they have made and why they were made-then reason and rationality should prevail.


Dennis Doody, CPA, is managing director, Healthcare, for Commonfund, Wilton, Conn., and a member of HFMA's New Jersey Chapter (ddoody@cfund.org).

Publication Date: Tuesday, April 01, 2008

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