Dennis Doody

Has the financial crisis shown time-tested investment management practices-asset allocation, in particular-to be flawed? Not at all.

We have been in one of those "no-place-to-hide" markets for the past 18 months. Following a collapse of mortgage-backed securities as the real estate bubble burst, domestic equities tumbled first, followed by international equities. Spreads reached historic levels in credit sectors of the bond market as money poured into treasuries, whose yields actually went negative. Commodities, stellar performers for the past few years, declined sharply as economic growth screeched to a halt, with emerging market equities following in short order. Forced selling devastated many hedge funds. Further write-downs occurred when the portfolio holdings of long-term private capital partnerships were marked to market.

As the saying goes, in a crisis, all correlations go to one.

In the minds of some, this environment calls into question the value of long-held practices and policies, one of the chief ones being asset allocation. Yet the reality is that thoughtful asset allocation and a well-diversified portfolio are still the underpinnings of a sound investment policy, especially for long-term investors. What is required is simply a different way of looking at the approach to asset allocation that has become increasingly prevalent over the past 30 years.

First, a Look at Liquidity

Any discussion of asset allocation should address the issue of liquidity first, because it's on everyone's mind these days, especially in the healthcare industry. The famous British economist John Maynard Keynes-a very shrewd investor himself-once commented that investors tend to make a "fetish of liquidity," meaning they worship it. But he also noted that it is during times when liquidity is most dear-during a crisis, for instance-that it also is most likely to dry up.

Implicit within Keynes' comments is an important message regarding investment strategy: Despite a short-term liquidity squeeze, such as that caused by the credit crisis, institutions with long-term horizons, such as hospitals and health systems, can continue to benefit from engaging in what is called "timeframe arbitrage," or the ability to take a long-term view of investing at a time when retail, pension, high net worth, and other types of investors are constrained by liquidity needs.

It therefore may well be that to effectively meet their charge of securing the future financial well-being of their institutions, healthcare financial officers and trustees should consider a relatively high level of illiquidity in their long-term portfolios. It's true that the crisis has caused correlations to increase, but this effect may be the result of markets having stopped their normal functioning. As more normalized markets return, alternative strategies-such as private capital, real estate, natural resources, and hedge funds-will once again offer good opportunities to diversify portfolios.

Evolving Views of Asset Allocation

The diversification movement of the past few decades was based on the premise, established in the late 1960s, that by building portfolios of uncorrelated asset, investors would likely secure both a higher return and lower volatility. But in viewing how the basic concepts of diversification have been borne out over the past 30 years, there are three broad considerations that need to be addressed:

  • Have the basic concepts of diversification changed? Have asset classes that have been diversifiers historically in fact become more correlated, thereby reducing the diversification benefit?
  • Are investment committee members or senior financial managers of healthcare institutions devoting the appropriate amount of time to asset allocation?
  • Has asset allocation actually been changed into risk management? Have we put so much emphasis on asset allocation and policy portfolio concepts that they obfuscate important portfolio risk factors?

In the 1970s and 1980s, asset allocation was as simple as 65 percent stocks, 35 percent bonds. Over the past 30 years, however, we have increasingly sliced and diced asset allocation into many small buckets thought to be independent of one another. Thus, a typical asset allocation now might be 4 percent invested in small cap, 12 percent in growth, 8 percent in value, 5 percent venture capital, 8 percent international, and so on. As we parse our asset allocation into smaller and smaller buckets, we are spending more time thinking about considerations such as how we allocate between mid-cap growth and mid-cap value, or how we allocate between small cap and large cap.

The question is, Does spending a lot of time thinking about asset allocation across highly correlated asset classes really make a long-term difference? And that question applies even as we get into newer alternatives-that is, the massively diversifying concepts of hedge funds, private capital, and commodities.

The original premise was that diversification works if the portfolio is built on assets that are uncorrelated to one another. But we're seeing asset classes converge. Capital markets have become increasingly integrated around the world. The speed and velocity with which global markets react to one another has been truly astounding. Things are no longer fitting into neat and tidy buckets. For instance, what do you call investments in infrastructure? Are they private equity or real estate? What do you call investments in distressed debt? Should they be classified as fixed income or equity? Or do we create wholly new asset classes?

Convergence of Managers' Strategies

Similarly, look at what is happening with managers, particularly hedge fund managers. Once again, we are seeing a convergence-for instance, activist hedge funds that may invest in public stocks but look to make material changes in the way portfolio companies are managed, thus acting like private equity managers. We see hedge funds that invest in private capital and distressed debt.

As an industry, we need to think about whether we are limiting managers by putting tighter and tighter constraints around each of these asset classes and in the process limiting investment managers' ability to make money. It's an important question. In the days of 65/35, you could focus on the areas where you were going to add value. Now, as we parse our managers into smaller and smaller categories, we have to wonder if we are limiting their flexibility and, hence, their ability to take advantage of opportunities as they present themselves.

Thinking Differently About Asset Allocation

Over the years, we have used the concept of asset allocation to address several additional concepts that go beyond mere asset classes. For instance, do we create separate asset classes for public and private equities-not because they are correlated but because one is liquid and one is illiquid?

Perhaps we really do have to think about asset allocation differently. Instead of thinking about one master asset allocation that covers everything from cash to private equity and venture capital, perhaps we should think about multiple allocations associated with evaluating our portfolios and make independent decisions relative to four layers: assets, liquidity, currency, and risk.

Assets. Looking at the asset layer is a matter of thinking about how to allocate to create a diversified portfolio. We expend significant effort to evaluate allocations to "asset classes" that are correlated-for instance, public versus private equity, U.S. versus developed market equities, or U.S. Treasury bonds versus non-U.S. government bonds (ex-currency). As we examine today's environment, many of those so-called asset classes have become more correlated. Asset allocation efforts should focus on those asset classes that are truly unrelated:

  • Equity
  • Fixed income
  • Absolute return strategies
  • Real assets

In this new way of thinking about asset allocation, each of the current asset classes would fit within one of these four "super asset classes."

Liquidity. The second layer is thinking about how you allocate your assets to take advantage of your ability to invest in illiquid instruments. This approach to liquidity spans the asset classes and should be specifically broken down by asset class. In each of the "super asset classes" there will be liquid assets, such as U.S. and developed markets equities, and illiquid assets, such as distressed debt and natural resources.

Currency. It's easy to become confused about currency. We say we want to allocate to international equities. In reality, there are two components involved: international equity and currency. With today's instruments, you can manage those two components independently because, for example, when you invest in euro-based equities you don't have to take euro risk. You can hedge that risk or, vice versa, you can invest in U.S. equities and create euro risk. 

Risk.As it relates to risk, investors can determine the profiles of their assets on a number of levels. One method is value at risk (VaR). Others are stress testing and examining the total potential loss under various scenarios. These data can then be accumulated to show total risk as well as risk by various components based on differing asset allocations. Execution decisions relate to policy and will generate new types of risk that should be identified and quantified.

Thinking about asset allocation in this way, rather than the traditional bucketed approach,  yields a comprehensive view of your portfolio and allows you to focus on factors that are likely to make a long-term difference-and to avoid getting buried in the 17 asset classes that you call your equity portfolio.

Certainly, healthcare organizations have fund flows and investment pools that are distinct from those of most other institutional investors. Like most social enterprises, hospitals and healthcare organizations are pinched in this poor economic environment. Days' cash on hand is critically important to them (and to the agencies that rate their debt), making any claim on cash-for instance, investments in illiquid programs-something to be considered very carefully. But rating agencies today want to see well-diversified portfolios, including illiquid investments, in healthcare organizations' primary pools of capital. That's where rethinking asset allocation comes in, and why asset allocation is still a bedrock principle of investment management-and a place of refuge in a world that is anything but normal.


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

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