Capital Finance

Sarah Vigneron

An investment approach that originated in the academic community has won widespread use in the management of institutional investment pools-and it remains as relevant as ever in the aftermath of the market and economic shocks of the past two years.

The causes and effects of the global financial crisis and recession continue to be the subjects of in-depth analysis. Rightfully, the risky practices of some major financial institutions have been much discussed. Unfortunately, however, some fundamental principles of long-term institutional investing have also been called into question.

Among these principles are those embodying what is commonly called the endowment model-i.e., the set of principles guiding the management of long-term institutional pools of capital. The endowment model originated in the halls of academia as leading thinkers sought better ways to manage large investment pools in the form of college and university endowments. Over the years, this investment model has expanded well beyond the educational community and has been widely adopted by healthcare institutions. As of this time, institutional investors have adhered to it for several decades. Its underlying tenets remain intact and very much relevant to the task of investing in today's market environment.

A Look at the Endowment Model

The endowment model has three basic principles.

Own more than loan. According to this principle, equity ownership of assets is the best way to benefit from fundamental economic growth that is the source of real, long-term, investment returns. Often referred to as "risk assets," equity positions derive their return from the productivity of the capital invested-that is, growth in earnings and appreciation in the value of the asset owned due to economic activity or growth in rents. Debt securities, or loans, are wasting assets in that investors are paid a current return for the use of financial capital, while the principal, in nominal terms, may or may not be repaid, depending on an assessment of credit risk. Consequently, equity ownership should offer higher real returns than lending against those same assets. Nonetheless, equity investments will entail greater risk.

Time horizon matters. This principle refers to the expected period over which capital is committed and the time value of the invested capital. The future is uncertain and the longer the time horizon, the greater the uncertainty. The longer an investor is willing to commit capital, the greater should be the expected return to compensate for the greater uncertainty and consequent greater "riskiness" of the investment associated with the longer time frame. Investors are likely to have greater conviction or confidence (i.e., less uncertainty) in what will happen tomorrow or in the near future-say, one to five years-than in what will happen in 10 to 20 years-or longer. This principle acknowledges the advantage of being able to stay the course and not be driven by, or be forced to react to, relatively short-term market gyrations.

A corollary to the idea of capitalizing on the time value of invested capital that has emerged over time is the notion of exploiting market inefficiencies. Some sectors of the capital markets suffer from a scarcity of capital owing to their illiquid nature and long-term uncertainty. It is in these sectors that risk is often (but not always) mispriced and, consequently, the risk premium to be earned from supplying capital to these less efficient sectors can be significant.

Diversification matters. Some types of investment risk can be diversified away, and some types are immune to diversification. Long-term investors want to diversify away as much risk as possible to ensure that they own "efficient portfolios." In particular, investors-regardless of their time horizon-want to own assets or invest in strategies that not only diversify capital market risk, but also mitigate, protect against, or hedge some fundamental risks, the most important of which are inflation and deflation.

Recent events have validated one essential and enduring investment principle: There is no return without risk. There is a risk-return trade-off. However, the inverse is not true: Taking risk does not guarantee a return. Some investments have a greater risk of principal loss, are unsecured or lower in the capital structure (common stock versus secured debt), or are in sectors of the capital markets with longer pay-off periods or fewer participants. They are, therefore, subject to greater mispricings and market inefficiencies and should have higher expected returns to compensate for their greater risks. The first corollary to this principle is as follows: For long-term investors and perpetual pools of assets, the only returns that matter are real returns that preserve purchasing power and/or fund obligations or liabilities in real terms.

How do these points relate to the principle of "diversification matters"? We have long known that, in the capital markets, in times of great stress and in times of great euphoria, "correlations go to one"-that is, investors assume a herd mentality. Globalization of the capital markets, financial innovation, and abundant and nearly instantaneous market information have increased correlations. In times of stress, risk aversion abounds and we see a "flight to quality" (or, in extreme circumstances, to the mattresses). Similarly, in times of great euphoria, a rising tide lifts all boats; correlations increase, risk is ignored, and there is a tendency to chase returns. But these periods do not invalidate the long-term value of diversification of risk. Nor do they invalidate the other principles that form the basis of the endowment model. Instead, they affirm the importance of carefully considered investment policies and objectives. In short, an institution should invest its long-term investment pool in a way that will support the unique mission of the institution over specific time horizons.

Still a Tried and True Approach

The recent financial crisis has caused many long-term investors to revisit an older approach to asset allocation consistent with the endowment model and address, from a policy perspective, the realities of the current capital market environment. Thoughtful investors have refocused on equity ownership of assets and are reassessing the need for liquidity consistent with their institutions' operating needs. There also is a need to consider hedges against deflation, protection against inflation, and diversification against secular and cyclical economic downturns. In this environment, institutional investors are well served when they factor into their thinking the proven principles of the endowment model.

What is the bottom line for those responsible for investing long-term funds for healthcare organizations? Return data from the two most recent Commonfund Benchmarks Study® Healthcare Reports go a long way toward answering this question. In the study of participating healthcare organizations' returns for 2008, the average return was 221.2 percent. This year's study, reporting returns for the year ended Dec. 31, 2009, found that participating healthcare organizations realized a return of 118.8 percent. Although these two years may represent extremes, returns inevitably will vary from year to year. A very poor-even traumatic-year such as 2008 does not mean that the time-proven principles of the endowment model no longer apply. To be certain, healthcare investors-indeed, all investors-should remain vigilant with respect to key elements of their investment policy. That said, draconian changes or knee-jerk reactions should not be mistaken for effective risk management.

Sarah Vigneron is associate director, Commonfund Group, Wilton, Conn., and a member of HFMA's Connecticut Chapter (

Publication Date: Wednesday, September 01, 2010

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