Dennis Doody

A precipitous decline in asset values has left many investment portfolios in intensive care, waiting for the recovery to finally take hold. In the interim, there are lasting lessons to be learned from the financial crisis.

In an autopsy, the patient has died. The issue is confirming the cause of death. In a biopsy, a tissue, cell, or fluid sample helps diagnose a potential problem so that an effective treatment protocol can be developed and patient returned to health.

Think of this article as a kind of biopsy of your investment portfolio-a sample of ideas that are worth a closer look as you consider the future. After all, there will be a next time-another bull market (and another bear market in the ongoing cycle). Many of those responsible for not-for-profit investment funds have been frozen into inaction by the financial crisis. But the patient has not expired, so the goal should be to develop a robust regimen that will be beneficial in the future. Here are some thoughts to consider.

The Endowment Model

Some believe that steep portfolio losses point to the death of the "endowment model." I believe it is alive and well-but, admittedly, a bit bruised. Consider the three fundamental tenets upon which the "endowment model" is based:

  • An equity bias ("own more than loan")
  • Diversification (to mitigate inflation risk as well as market risk)
  • A long-term horizon (to manage risk and take advantage of time frame arbitrage, which is a truly long-term view of investing when other investors are constrained by short-term needs).

Equity investments should continue to deliver superior long-term returns compared with debt under most market conditions. As to diversification, questions about its value have arisen only under the most extreme conditions of the past 70 years. And as to time frame arbitrage, it is likely that the return premium for providing long-term capital to illiquid markets will remain attractive.

Consider this: Do you believe that in the future, you will choose to manage a concentrated, short-term portfolio that is largely fixed-income oriented? I doubt it. The principles underlying the endowment model have not been invalidated. Instead, we should use this crisis to improve our execution of those principles.


Traditionally, one equates liquidity with the short term. But there are longer-term implications associated with liquidity for a "going concern" that intends to be in business in perpetuity. Of course, institutions such as hospitals and healthcare systems have paid particular attention to liquidity, for instance, by focusing on days cash on hand and a strong current ratio. In the financial crisis, liquidity became the central issue for all mission-based organizations.

As conditions in credit markets improve, you may want to adopt a new perspective on liquidity, namely, by adding a complementary liquidity policy to your long-term asset allocation policy. Although asset allocation and liquidity are related, they should be evaluated separately.

A central question is, how does an institution develop a policy portfolio for liquidity? The answer is key to managing effectively through crises such as the one we have just experienced. In essence, liquidity allocation is the same as asset allocation. In an asset allocation, you think about the long term. If investors thought only about investing for the worst-case environment, they would not have captured the returns they have enjoyed for the past 25 years. They would have been protected from the current downdraft, but net-net they would not be as well off over the long term.

If an institution should be rewarded for accepting illiquidity, the key question is, how much illiquidity can the institution accept? A liquidity policy allocation can be broken down into four allocations: very liquid (daily), somewhat liquid (monthly), somewhat illiquid (quarterly), and very illiquid (more than one year).

As with asset allocation policies, there is no one-size-fits-all for liquidity. Each institution is unique. To develop this portfolio, each of these liquidity levels should be considered under four scenarios:

  • A normal environment
  • A stressed environment
  • Liquidity tolerances associated with major market moves
  • The need for "dry powder" (i.e., reserve funds either for an unforeseen circumstance or to take advantage of an investment opportunity)

This approach also requires looking at liquidity on an enterprise basis, not the more limited portfolio basis, and focusing on outflows and inflows as well as the probability of changes to those cash flows under various scenarios.

The Future of Hedge Funds

Perhaps no investment strategy has been vilified in the wake of the credit crisis more than hedge funds. The massive deleveraging of the capital markets, freezing of credit markets, and repricing of risk over the past 24 months has stressed a number of hedge funds and led some to liquidate their funds or impose gates or other restrictions on liquidity.

It's true that most hedge fund managers posted negative returns in 2008, but it's also true that hedge funds, in aggregate, outperformed virtually every category of long-only financial assets last year except for sovereign and investment-grade debt.

As confirmed by industry data, hedge funds have done quite well on a risk/return basis relative to virtually every group of risk-based assets since the credit crisis began in June 2007. This relative outperformance has become more pronounced recently, as hedge funds dramatically scaled back their leverage between October 2008 and March 2009, two of the worst quarters in history for risk-based assets. The only major asset group to provide better returns and lower drawdowns than the HFRI Composite (a measure of hedge fund performance) during the heart of the credit crisis (June 2007-March 2009) was the Barclays Aggregate Index-a primarily investment-grade index with a heavy dose of U.S. government and agency debt, which was an obvious beneficiary of the flight to quality.

The point is simply this: During one of the worst periods in the history of the financial markets, the ability of most marketable alternative strategies to provide superior downside protection and better risk-adjusted returns than a portfolio of traditional long-only assets did not depend upon leverage, as many have assumed.

I believe that fundamental strategies that trade in liquid securities like hedged equity, global macro, and commodity trading adviser managers-especially those that use little or low degrees of leverage-will continue to generate superior risk-adjusted returns when compared with the broad markets.

Hedge funds are not for everyone, and the credit crisis certainly hasn't made hedge fund selection or portfolio construction any easier. But with careful assessment of the risks, rigorous portfolio analysis, and due diligence, hedge funds will likely continue to provide value to investors long after this crisis has dissipated.

Defining Performance

Not long ago, it was hard not to get caught up in the pursuit of outsized returns. We have seen the impact of this phenomenon time and again, most recently in Wall Street firms' rush to use leverage to multiply earnings. But remember, we should put performance in the context of the specific objectives of each institution.

What do you do when facing extreme volatility? Risk models have helped us understand the sources of volatility and their potential performance. But it is how investors use these models and incorporate them into their decision-making process that has become so important. In this environment, it is clear that due diligence is not a "one and done" event, but rather an ongoing analysis. And free lunches don't exist. If performance is too good to be true, it probably is, as witnessed by the Madoff fraud.

We need to understand our sources of performance, and that demands transparency. We can all agree that models have their limitations, and we should not use their output in a vacuum. Instead, we should continue to apply qualitative judgment to our quantitative analysis. It's not that Value at Risk (VaR) failed to identify true value at risk, but that it didn't quantify a negative 10-standard-deviation event. Risk models help us understand and manage left tail, or downside, risk while showing us the right tail or upside opportunity.

Risk Management

A primary tenet of investment management is no risk, no return. The understandable reaction to the meltdown is to question the effectiveness of risk management overall and, as a consequence, to dramatically reduce risk profiles. Yet risk management is more likely to be flawed not so much in design, but in execution. Understanding that risk management is inseparable from policy design and management is the first step toward effective execution to mitigate risks from unexpected volatility and to find opportunities where one is, in fact, paid to take risk.

Determining How to Achieve Your Objectives

So where do we go from here? What opportunities are right for you, but may not be right for another institution? To what degree can you take advantage of illiquid opportunities versus more liquid opportunities?

At issue is what's best for your institution. Many institutional investors are leaning toward more conservative, liquid investing. Others that are not dependent on their investment pool to support day-to-day operations are taking advantage of more opportunistic investing. During these volatile times, each institution must determine where it is on the continuum and how best to achieve its objectives. As stated earlier, this prospect begins with a reassessment of your policy portfolio and whether it is consistent with the time horizon and risk tolerance that enable you to support your mission.

This brings us back to earlier questions: Does the endowment model still work? Does an equity bias still make sense? Is there value in diversification? Can investment talent still take advantage of mispriced assets without misplaced risk?

The metaphor of autopsy versus biopsy is particularly apt, in this case. If we are performing an autopsy, we might as well declare defeat and go home. Of course, we in the healthcare industry don't have that option, nor do we want it. Yes, the wounds are deep-but not fatal. If we use this time to perform a biopsy, which means to take a hard look at what we are doing and how we are doing it, we have the opportunity to position ourselves much better for whatever future markets hold.

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

Publication Date: Tuesday, September 01, 2009

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