January 7, 2009
The events of 2008 have exacerbated the financial challenges that healthcare organizations were already facing. As we start a new year, now is a good time to consider whether your organization's allocation of operating assets is still appropriate.
How should you go about establishing an asset allocation? Have there been fundamental changes in the capital markets that warrant a review of an existing asset allocation? And how can a healthcare system have some assurance that its operating asset allocation is compatible with its investment objectives? These are some of the questions addressed in "Making Sure Your Operating Asset Allocation Is on Target," an article by Thomas H. Dodd, president of the Stratford Advisory Group, in the Winter 2009 issue of HFMA's Strategic Financial Planning newsletter.
Seven Key Steps
An asset allocation study is fairly straightforward, and involves seven key steps.
Obtain Financial Statement Projections. Projected healthcare system financial statements--including balance sheet, income sheet, and cash flow statement--are the critical inputs to the asset allocation study. Health systems that have projections completed for a three- to five-year period can fairly simply extend important elements of the statements for a model period of up to 10 years.
Determine Capital Market Assumptions. As the study involves modeling the future investment returns of operating assets, assumptions for expected return, standard deviation, and correlation coefficient are needed for each asset class included in the model. Historical results, rationalized with a forward-looking view of capital market expectations, form the basis for these assumptions.
Determine Asset Classes to Include. Include asset classes that are currently being used by your hospital system, as well as additional asset classes that you are considering adding to the mix. The decision as to which asset classes to include should be based on your system's comfort with the risk, reward, and liquidity characteristics of each class. You should develop different sets of capital market assumptions for separate asset classes (for example, large-cap equities, hedge funds, and fixed-income allocations with different maturities).
Complete Asset Allocation Scenarios. There are an infinite number of asset allocation scenarios. You should choose to model those that meet your healthcare system's return and risk objectives, aiming for a total of three to 10 scenarios in addition to your current allocation.
Determine Financial Metrics to Model. For most healthcare systems, the most commonly used metrics are operating fund balance, total investment return, days cash on hand, debt service coverage, and debt to capitalization.
Run Asset Allocation Model. At this point, all of the inputs are available to run the model for each asset allocation scenario you have selected. Using a Monte Carlo method, the allocation model simulates portfolio investment returns for each year during the projection period.
Report and Review Findings. Summarize the study results in a report, which should also present observations and recommendations. Often, after an initial review, a hospital system will decide to model additional asset allocation scenarios as it seeks the optimal asset allocation.
Making a Decision
As you sift through the data resulting from your study, here are some points to consider as you work toward an asset allocation decision.
- How comfortable are you with the asset classes included in the allocation? This is a "gut-check" decision, not something that can be quantified.
- Focus on the unfavorable investment percentiles. The good times will take care of themselves; the purpose of the study is to see you through the bad times.
- Look for allocations that not only improve returns at the 50th percentile, but also at the 95th percentile. Adding asset classes with low correlations to equities and bonds will improve returns at the 75th and 95th percentiles.
- Add a real-world element to your decision by using a predetermined set of return assumptions during the projection period. You might use actual market returns over the past 10 years, or during the bear market of the 1970s.
- Rerun the model using negative operating results, or using different capital expenditure or bond issuance/repayment schedules.
Finally, remember that in the end, an allocation needs to be appropriate during both good times and bad, fit within your system's risk parameters, and complement the mission of your system.
If properly designed, an asset allocation study can also model the impact of adverse market environments on key financial metrics and serve as a budgeting tool for your organization. The study can also be used during a rating agency review. Current healthcare rating trends are the subject of "Healthcare Bond Ratings: Current Healthcare Rating Trends and Related Developments," an upcoming HFMA audio webcast on January 28, 2009.
Strategic Financial Planning -- which is sponsored by Kaufman, Hall & Associates, Inc. -- advises healthcare executives on top-level decisions, and is packed with specifics on how to prioritize, implement, and finance capital decisions. A copy of Thomas Dodd's article on operating asset allocation is available free of charge to HFMA Wants You To Know readers on the newsletter's web site.