Managing for Endowment Fund Portfolio Alpha

Understanding Non-Systematic Return on Investment

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[By Dr. David Edward Marcinko MBA]

According to Wayne Firebaugh CPA, CFP®, CMP™ alpha measures non-systematic return on investment [ROI], or the return that cannot be attributed to the market.

It shows the difference between a fund’s actual return and its expected performance given the level of systematic (or market) risk (as measured by beta).

Example

For example, a fund with a beta of 1.2 in a market that returns 10% would be expected to earn 12%. If, in fact, the fund earns a return of 14%, it then has an alpha of 2 which would suggest that the manager has added value. Conversely, a return below that expected given the fund’s beta would suggest that the manager diminished value.

In a truly efficient market, no manager should be able to consistently generate positive alpha. In such a market, the endowment manager would likely employ a passive strategy that seeks to replicate index returns. Although there is substantial evidence of efficient domestic markets, there is also evidence to suggest that certain managers do repeat their positive alpha performance.

In fact, a 2002 study by Roger Ibbotson and Amita Patel found that “the phenomenon of persistence does exist in domestic equity funds.” The same study suggested that 65% of mutual funds with the highest style-adjusted alpha repeated with positive alpha performances in the following year.

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More Research

Additional research suggests that active management can add value and achieve positive alpha in concentrated portfolios.

A pre 2008 crash study of actively managed mutual funds found that “on average, higher industry concentration improves the performance of the funds. The most concentrated funds generate, after adjusting for risk … the highest performance. They yield an average abnormal return [alpha] of 2.56% per year before deducting expenses and 1.12% per year after deducting expenses.”

FutureMetrics

FutureMetrics, a pension plan consulting firm, calculated that in 2006 the median pension fund achieved record alpha of 3.7% compared to a 60/40 benchmark portfolio, the best since the firm began calculating return data in 1988. Over longer periods of time, an endowment manager’s ability to achieve positive alpha for their entire portfolio is more hotly debated.  Dimensional Fund Advisors, a mutual fund firm specializing in a unique form of passive management, compiled FutureMetrics data on 192 pension funds for the period of 1988 through 2005.

Their research showed that over this period of time approximately 75% of the pension funds underperformed the 60/40 benchmark. The end result is that many endowments will use a combination of active and passive management approaches with respect to some portion of the domestic equity segment of their allocation.

Assessment

One approach is known as the “core and satellite” method in which a “core” investment into a passive index is used to capture the broader market’s performance while concentrated satellite positions are taken in an attempt to “capture” alpha. Since other asset classes such as private equity, foreign equity, and real assets are often viewed to be less efficient, the endowment manager will typically use active management to obtain positive alpha from these segments.

Notes:

  • Ibbotson, R.G. and Patel, A.K. Do Winners Repeat with Style? Summary of Findings – Ibbotson & Associates, Chicago (February 2002).
  • Kacperczyk, M.T., Sialm, C., and Lu Zheng. On Industry Concentration of Actively Managed Equity Mutual Funds. University of Michigan Business School. (November 2002).
  • 2007 Annual US Corporate Pension Plan Best and Worst Investment Performance Report.  FutureMetrics, April 20, 2007.

Conclusion

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Financial Monte Carlo Simulation’s FLAW and FIXES

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Physicians Must Understand Deus ex Machina

[By Wayne J. Firebaugh Jr; CPA, CFP®, CMP™]

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wayne-firebaughNamed after Monte Carlo, Monaco, which is famous for its games of chance, MCS is a software technique that randomly changes a variable over numerous iterations in order to simulate an outcome and develop a probability forecast of successfully achieving an outcome.

Endowment Fund Perspective

In private portfolio and fund endowment management, MCS is used to demonstrate the probability of “success” as defined by achieving the endowment’s asset growth and payout goals. In other words, MCS can provide the endowment manager with a comfort level that a given payout policy and asset allocation success will not deplete the real value of the endowment.

Divorce from Judgment

The problem with many quantitative software and other tools is the divorce of judgment from their use. Although useful, both mean variance optimization MVO and MCS have limitations that make it so they should not supplant the physician investor or endowment manager’s experience. MVO generates an efficient frontier by relying upon several inputs: expected return, expected volatility, and correlation coefficients. These variables are commonly input using historical measures as proxies for estimated future performance. This poses a variety of problems.

Problems with MCS 

First, the MVO will generally assume that returns are normally distributed and that this distribution is stationary. As such, asset classes with high historical returns are assumed to have high future returns.

Second, an MVO optimizer is not generally time sensitive. In other words, the optimizer may ignore current environmental conditions that would cause a secular shift in a given asset class returns.

Finally, an MVO optimizer may be subject to selection bias for certain asset classes. For example, private equity firms that fail will no longer report results and will be eliminated from the index used to provide the optimizer’s historical data [1].

Example:

As an example, David Loeper, CEO of Wealthcare Capital Management, made the following observation regarding optimization:

Take a small cap “bet” for our theoretical [endowment] with an S&P 500 investment policy. It is hard to imagine that someone in 1979, looking at a 9% small cap stock return premium and corresponding 14% higher standard deviation for the last twenty years, would forecast the relationship over the next twenty years to shift to small caps under-performing large caps by nearly 2% and their standard deviation being less than 2% higher than the 20-year standard deviation of large caps in 1979 [2].

Table: Compares the returns, standard deviations for large and small cap stocks for the 20-year periods ended in 1979 and 1999.  Twenty Year Risk & Return Small Cap vs. Large Cap (Ibbotson Data).

1979 1999
Risk Return Correlation Risk Return Correlation
Small Cap Stocks 30.8% 17.4% 78.0% 18.1% 16.9% 59.0%
Large Cap Stocks 16.5% 8.1% 13.1% 18.6%

Reproduced from “Asset Allocation Math, Methods and Mistakes.” Wealthcare Capital Management White Paper, David B. Loeper, CIMA, CIMC (June 2, 2001).

More Problems with MCS

David Nawrocki identified a number of problems with typical MCS as being that most optimizers assume “normal distributions and correlation coefficients of zero, neither of which are typical in the world of financial markets.”

Dr. Nawrocki subsequently describes a number of other issues with MCS including nonstationary distributions and nonlinear correlations.

Finally, Dr. Nawrocki quotes Harold Evensky who eloquently notes that “[t]he problem is the confusion of risk with uncertainty.

Risk assumes knowledge of the distribution of future outcomes (i.e., the input to the Monte Carlo simulation).

Uncertainty or ambiguity describes a world (our world) in which the shape and location of the distribution is open to question.

Contrary to academic orthodoxy, the distribution of U.S. stock market returns is far from “normal” [3]. Other critics have noted that many MCS simulators do not run enough iterations to provide a meaningful probability analysis.

Assessment

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Some of these criticisms have been addressed by using MCS simulators with more robust correlation assumptions and with a greater number of iterative trials. In addition, some simulators now combine MVO and MCS to determine probabilities along the efficient frontier.

Conclusion

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References:

1. Clark, S.E. and Yates, T.T., Jr. “How Efficient is your Frontier?” Commonfund Institute White Paper (November 2003).

2. Loeper, D.B., CIMA, CIMC. “Asset Allocation Math, Methods, and Mistakes.” Wealthcare Capital Management White Paper (June 2001).

3. Nawrocki, D., Ph.D. “The Problems with Monte Carlo Simulation.” FPA Journal (November 2001).

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Pity the Poor Hospitals?

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A Historical Look-Back to the Future?

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By Wayne Firebaugh CPA, CFP® CMP™

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Dr. Malcolm T. MacEachern, Director of Hospital Activities for the American College of Surgeons, presciently observed that:

… our hospitals are now involved in the worst financial crisis they have ever experienced. It is absolutely necessary to all of us to put our heads together and try to find some solution. If we are to have effective results we must have concerted and coordinated immediate action. … Repeated adjustments of expenses to income have been made. Never before has there been such a careful analysis of hospital accounting and study of financial policies. It is entirely possible for us to inaugurate improvements in business methods which will lead to greater ways and means of financing hospitals in the future. … It is true that all hospitals have already trimmed their sales to better meet the financial conditions of their respective communities. This has been chiefly through economies of administration. There has been more or less universal reduction in personnel and salaries; many economies have been effected. Everything possible has been done to reduce expenditures but this has not been sufficient to bring about immediate relief in the majority of instances. The continuance of the present economic conditions will force hospitals generally to further action. The time has come when this problem must be given even greater thought, both from its community and from its national aspect. [1]

In Agreement

Many health administration and endowment managers would agree that Dr. MacEachern accurately describes today’s healthcare funding environment. Although they might be startled to learn that Dr. MacEachern made these observations in 1932, there is the old truism that there is nothing new under the sun.

Today

More current healthcare statistics after the November 7th 2012 presidential election and Patient Protection-Affordable Care Act confirmation, suggest that the financial crises are much the same for today’s hospitals as they were for hospitals during the Great Depression.  The American Hospital Association (AHA) recently reported a number of gloomy statistics for hospitals: [2]

  • Hospitals provided $39 billion in uncompensated care to patients in 2010 representing 5.8% of their expenses.
  • Technology costs are soaring as traditional technologies such as X-Ray machines, for $175,000, are being replaced by contemporary technologies such as CAT Scanners at $1 million, that are in turn being replaced by CT Functional Imaging with PET Scans costing $2.3 million. Even such a “simple” instrument as a scalpel that costs $20, is being replaced by equipment for electrocautery costing $12,000, that is then being replaced by harmonic scalpels costing $30,000.

More Metrics

A further review added more daunting numbers: [3]

  • In 2010, 22.4% of hospitals reported a negative total margin.
  • From 1997 through 2009, hospitals saw a small net surplus from government payments from sources such as Medicare and Medicaid deteriorate into a deficit approaching $35 billion.
  • Emergency departments in 47% of all hospitals report operating at, or over, capacity partially reflecting an approximate 10% decline in the number of emergency departments since 1991.
  • The average age of hospital plants has increased 22.5% from 8.0 years to 9.8 years in just fifteen years.
  • From 2003 through September 2007, hospital bond downgrades have outpaced hospital bond upgrades by 19%.

In a time when so much seems different yet so much seems the same, hospitals are increasingly viewing their endowments as a source of help. But what is an endowment?

Latin Roots

The same Latin words that give rise to the word “dowry” also give rise to the word endowment.[4] Interestingly, the concepts of a dowry and an endowment are in many ways similar. Both are typically viewed as gifts for continuing support or maintenance.

With respect to the healthcare entity, an endowment is generally used to smooth variations in operating results and to fund extra programs or plant purchases. Any entity that enjoys the support of an endowment also encounters the conflicting objectives between current income and future growth.

Hospital

Assessment

Dean William Inge, a 19th century cleric and author, aptly noted that: “Worry is interest paid on trouble before it is due.”

When managing an endowment, it is important that the institution focus its attention on those items that it can control rather than worrying about those it cannot control. Successful endowment managers seem to agree that there are at least two major areas subject to the endowment’s control: asset allocation (also known as investment policy) and payout policy.

More:

Conclusion

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[1]   MacEachern, M.T., MD. “Some Economic Problems Affecting Hospitals Today and Suggestions for Their Solution.” The Bulletin of the American Hospital Association. July 1932.

[2]   Steinberg, C. Overview of the U.S. Healthcare System.  American Hospital Association (2003). Carline Steinburg is Vice President, Health Trends Analysis, for AHA.

[3]   “Trends Affecting Hospitals and Health Systems.”  TrendWatch Chartbook 2010.  American Hospital Association (2010).

[4]   Merriam-Webster Online.

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The Danger of Groupthink with Endowment Fund Portfolio Managers

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A Historical Look-Back to the Future?

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By Wayne Firebaugh CPA CFP® CMP™

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It is not unusual for endowment fund managers to compare their endowment allocations to those of peer institutions and that as a result, endowment allocations are often similar to the “average” as reported by one or more survey/consulting firms.

One endowment fund manager expanded this thought by presciently noting that expecting materially different performance with substantially the same allocation is unreasonable [personal communication]. It is anecdotally interesting to wonder whether the seminal study “proving” the importance of asset allocation could have even had a substantially different conclusion. It seems likely that the pensions surveyed in the study had very similar allocations given the human tendency to measure one’s self against peers and to use peers for guidance.

Peer Comparison

Although peer comparisons can be useful in evaluating your institution’s own processes, groupthink can be highly contagious and dangerous.

For example, in the first quarter of 2000, net flows into equity mutual funds were $140.4 billion as compared to net inflows of $187.7 billion for all of 1999. February’s equity fund inflows were a staggering $55.6 billion, the record for single month investments. For all of 1999, total net mutual fund investments were $169.8 billion[1] meaning that investors “rebalanced” out of asset classes such as bonds just in time for the market’s March 24, 2000 peak (as measured by the S&P 500).

Of course, investors are not immune to poor decision making in upward trending markets. In 2001, investors withdrew a then-record amount of $30 billion[2] in September, presumably in response to the September 11th terrorist attacks. These investors managed to skillfully “rebalance” their ways out of markets that declined approximately 11.5% during the first several trading sessions after the market reopened, only to reach September 10th levels again after only 19 trading days. In 2002, investors revealed their relentless pursuit of self-destruction when they withdrew a net $27.7 billion from equity funds[3] just before the S&P 500’s 29.9% 2003 growth.

The Travails

Although it is easy to dismiss the travails of mutual fund investors as representing only the performance of amateurs, it is important to remember that institutions are not automatically immune by virtue of being managed by investment professionals.

For example, in the 1960s and early 1970s, common wisdom stipulated that portfolios include the Nifty Fifty stocks that were viewed to be complete companies.  These stocks were considered “one-decision” stocks for which the only decision was how much to buy. Even institutions got caught up in purchasing such current corporate stalwarts as Joe Schlitz Brewing, Simplicity Patterns, and Louisiana Home & Exploration.

Collective market groupthink pushed these stocks to such prices that Price Earnings ratios routinely exceeded 50. Subsequent disappointing performance of this strategy only revealed that common wisdom is often neither common nor wisdom.

Senate house conference committee meets wall street reform

[Wall Street Reform?]

More Current Examples

More recently, the New York Times reported on June 21, 2007, that Bear Stearns had managed to forestall the demise of the Bear Stearns High Grade Structured Credit Strategies and the related Enhanced Leveraged Fund.

The two funds held mortgage-backed debt securities of almost $2 billion many of which were in the sub-prime market.  To compound the problem, the funds borrowed much of the money used to purchase these securities.

The firms who had provided the loans to make these purchases represent some of the smartest names on Wall Street, including  JP Morgan, Goldman Sachs, Bank of America, Merrill Lynch, and Deutsche Bank.[4]

Assessment

Despite its efforts Bear Stearns had to inform investors less than a week later on June 27th that these two funds had collapsed.

Conclusion

Is this same Groupthink mentality happening on Wall Street, today? Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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[1]   2001 Fact Book, Investment Company Institute.

[2]   Id.

[3]   2003 Fact Book, Investment Company Institute.

[4]    Bajaj, Vikas and Creswell, Julie. “Bear Stearns Staves off Collapse of 2 Hedge Funds.”
New York Times, June 21, 2007.

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More on Modern Investment Portfolio Rebalancing

Understanding Risks and Benefits

By Dr. David Edward Marcinko MBA CMP™

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According to Wayne Firebaugh CPA, CFP®, CMP™ rebalancing a private physician’s portfolio or medical endowment contradicts conventional market “wisdom” that you allow your winners to run. Perhaps in speculation this is true, but for investing such a view can be deadly.

One Healthcare Case Example

Take, for example, the Cleveland Clinic’s experience with its endowment. In 1999, the Cleveland Clinic Foundation reported $1.2 billion in investments. Unfortunately, by the end of 2002, the Foundation’s investments were valued at $650 million, a loss of approximately 50%. Its losses reflected its substantial allocation into technology stocks during the technology boom of the late 1990s. As a result of these investment losses, the Clinic had to postpone a planned $300 million cardiology center and certain debt financing had to be restructured. In addition, both Moody’s and Standard & Poor lowered their ratings on the Clinic.

Definition

Since rebalancing by definition requires an endowment to take money from more successful investment classes and invest it into under-performing classes, it will always cause some measure of anguish. There will always be some reason why rebalancing should not take place. In 1987, the unprecedented single day decline in the market could have been presented as an argument against moving into equities. In 1998, the seemingly endless number of world financial crises could have provided a useful excuse to avoid rebalancing into emerging markets. So too; the flash crash of 2008!

Assessment

Current bond prices could provide similar reasons for not rebalancing into an appropriate fixed income position. However, since the whole reason for asset allocation policy decisions is to mitigate the negative impact that irrational behavior can have on a portfolio or an endowment’s investment performance, they should include a process for periodic rebalancing of its assets.

Conclusion

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Understanding Absolute Investment Returns

Exploiting Market Inefficiencies

By J. Wayne Firebaugh CPA, CFP® CMP™

By Dr. David E. Marcinko MBA, CMP™

Source: www.HealthcareFinancials.com

This class of investments seeks to exploit market inefficiencies and generate positive returns regardless of broader market performance. Often, investments in this class are made through the use of hedge funds. Hedge funds will often employ leverage, short-selling, and arbitrage to take advantage of pricing distortions in their targeted strategy area.

Relation to Healthcare Endowments

When investing an endowment’s assets in this category, the physician director or money manager should be aware of fee structures that commonly include performance-related incentive fees, hurdle rates, and claw-back clauses. The endowment managers should also remember that these types of investments generally have much less transparency than other asset classes with which they may be more familiar.

Assessment

Finally, since many of these investments are offered only to accredited investors, the physician or investment manager is often free to pursue much more aggressive strategies than would otherwise be pursued for retail or lay customers.

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Conclusion

But, can we [anyone] exploit market inefficiencies? Is the market efficient or inefficient? What about Modern Portfolio Theory [MPT] or the Arbitrage Pricing Model? Did we really learn anything from the market crash of 2008?

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Hospital Loses Twenty-Five Million Dollar Investment

Investment Losses Cited

By Staff Reportersho-journal8 

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According to Brian Bandell, of the South Florida Business Journal on May 20 2009, Baptist Health South Florida [BHSF] could not climb out of the red in the fiscal second quarter that ended March 31, 2009. Its investment losses wiped out operating income, according to a report the nonprofit issued to its bondholders.

Investment Losses Nix Operating Income

The Miami-based health care provider lost $24.8 million on operating revenue of $530.2 million in its second quarter. That’s improved from a loss of $26.8 million on operating revenues of $470.2 million in the same quarter of 2008.

Link: http://www.bizjournals.com/southflorida/stories/2009/05/18/daily47.html

Assessment

Perhaps the BHSF CFO and CEO should read Tab 8, Chapter 3 on: Hospital Endowment Fund Management, by J. Wayne Firebaugh, Jr; CPA, CFP® CMP™ in Healthcare Organizations [Financial Management Strategies]?

T.O.C. Link: toc_ho[1]

Conclusion

And so, your thoughts, post and comments on this Medical Executive-Post are appreciated; especially from hospital CEOs and major health institutional CFOs and CIOs, etc. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, be sure to subscribe to the ME-P. It is fast, free and secure.

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This Time the Hospital Financial Crisis is Different

Oh Really … No so Fast!

Submitted by J. Wayne Firebaugh, Jr; CPA, CFP®, CMP™ho-journal2

Dr. Malcolm T. MacEachern, Director of Hospital Activities for the American College of Surgeons, presciently observed that:

… Our hospitals are now involved in the worst financial crisis they have ever experienced. It is absolutely necessary to all of us to put our heads together and try to find some solution. If we are to have effective results we must have concerted and coordinated immediate action. … Repeated adjustments of expenses to income have been made. Never before has there been such a careful analysis of hospital accounting and study of financial policies. It is entirely possible for us to inaugurate improvements in business methods which will lead to greater ways and means of financing hospitals in the future … It is true that all hospitals have already trimmed their sales to better meet the financial conditions of their respective communities. This has been chiefly through economies of administration. There has been more or less universal reduction in personnel and salaries; many economies have been affected. Everything possible has been done to reduce expenditures but this has not been sufficient to bring about immediate relief in the majority of instances. The continuance of the present economic conditions will force hospitals generally to further action. The time has come when this problem must be given even greater thought, both from its community and from its national aspect…

Source:  Steinberg, C. Overview of the US Healthcare System; American Hospital Association 2003.

Many hospital CXOs, healthcare administrators and physician executives would agree that Dr. MacEachern accurately describes today’s healthcare funding environment. However, they might be startled to learn that Dr. MacEachern made these observations in 1932! There is the old truism that there is nothing new under the sun.

American Hospital Association Statistics

Healthcare statistics suggested that the financial crisis is much the same today as it was for hospitals during the Great Depression. The American Hospital Association’s (AHA) reported gloomy statistics for hospitals include:

  • In 2001, 29% of hospitals had negative total margins.
  • Approximately $101.3 billion of uncompensated care was provided between 1997 and 2001 with an average annual increase of 16% during that time period.
  • Emergency departments in 62% of all hospitals report operating at, or over, capacity.
  • Technology costs are soaring as traditional technologies such as X-Ray machines, for $175,000, are being replaced by contemporary technologies such as CAT Scanners at $1 million that are in turn being replaced by CT Functional Imaging with PET Scans costing $2.3 million. Even such a “simple” instrument as a scalpel that costs $20, is being replaced by equipment for electrocautery costing $12,000, that is then being replaced by harmonic scalpels costing $30,000.
  • Between 2000 and 2002, 33% of hospitals reported increases in liability premiums of more than 100%.
  • The average age of hospital plants has increased 21% from 7.9 years to 9.6 years in just one decade.
  • In the four years ending 2002, hospital bond downgrades have outpaced hospital bond upgrades by almost 5 to 1.

Editor’s Assessment

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