Given the ever-changing crosscurrents of market and economic forces, institutional investors of all kinds can be clever to contemplate an entrepreneurial approach to managing their investments. From liquidity-oriented and income-oriented portfolios to liability-oriented insurance pools, a holistic investment management framework can profit any institutional investor.
Corporate approach vs. return-only strategy
Put simply, a company approach to investment management considers the impact of investment risk on the general financial health of a company, versus an approach that addresses the expected return of a portfolio in isolation. To illustrate this idea, imagine a healthcare provider monitoring days of money available (Figure 1) to tell its investment strategy. With a returns-focused approach, the provider may only consider the numerator (unrestricted money and investments) where investment market returns have a major impact. In contrast, astute capital managers typically find it useful to contemplate the interplay between the numerator and denominator (cash-based operating costs), as many providers’ money holdings have come under significant pressure in recent times resulting from financial market volatility and rising supply and labor costs.
Figure 1.
In this instance, operating costs are influenced by many aspects, similar to the fee of medicines and other supplies and naturally labor markets. Days of money available may decrease resulting from a decrease in liquidity (the flexibility to convert resources into money, the numerator), a rise in costs (the denominator), or each. A hospital system focused solely on return on investment could also be tempted to make significant allocations to illiquid alternative investment strategies – an asset class known to supply high return potential in exchange for lower liquidity.
But what happens when investment markets pull back in a difficult business environment? One possible final result is that the money supply shrinks in days on either side of the fraction – the numerator decreases when returns are negative and the denominator increases resulting from rising costs (Figure 2).
This “double whammy” scenario could prove particularly difficult for a provider that has over-invested in illiquid alternatives, as these strategies often include higher volatility. A possible negative final result is larger investment losses coupled with increasing operating costs, leading to a breach of the liquidity debt agreement, as shown by the road “With Illiquids – Negative Returns and Rising Costs” in Figure 2.
However, a provider adopting an enterprise approach might make a more measured allocation to illiquid alternatives, bearing in mind the necessity to take care of liquidity in a difficult operating environment. This provider should still experience a decline in money available, but not a lot as to cause a breach similar to that shown within the “Cash Only – Negative Returns and Rising Costs” line.
Investment strategies with illiquid alternatives may offer greater return potential, but in addition involve greater downside risk – a very important consideration for maintaining liquidity as operating costs rise.
Figure 2.
The hallmarks of a successful business approach
Analyzing a company’s current investment strategy requires several documents, including the investment policy statement, expenditure policy, and current investment statements. These documents provide details on how current asset allocation may differ from investment policy objectives and what opportunities may arise from the mixing of economic statements and investment objectives.
Core financial statements – the balance sheet, income statement and money flow statement – can provide insight into how investment risk has historically affected an establishment’s overall financial condition. On the opposite hand, a budget, multi-year forecasts, and other operational assumptions may also help develop and implement a longer-term strategic vision.
Consider a university that forecasts gifts or other contributions to its endowment and assumes that a portion of its endowment spending will go toward the upkeep and construction of campus facilities. A holistic approach can make clear how investment performance can support or hinder projects that impact other key sources of revenue, similar to tuition and charges.
For example, what if funds from the endowment were insufficient to support the timely completion of a critical capital project? Would the university have the option to fulfill its enrollment goals and what impact would this have on tuition revenue? Or, if borrowing from the muse is feasible, from a strategic, maintenance and engagement perspective, what are the longer-term costs of reduced foundation net assets within the short term? A purely returns-focused approach could provide advice on maximizing net price, while a business approach has the potential to give attention to goal achievement by examining how each factor influences a spread of potential outcomes.
In order for a company to measure its investment success, a tailored benchmark that reflects long-term asset allocation objectives is useful in almost any investment policy statement. However, I might caution against tying the definition of success solely to performance against a benchmark, as this does not all the time capture the total picture.
Consider a property and casualty insurer that, within the low rate of interest environment following the 2008 financial crisis, increased the duration – a measure of rate of interest sensitivity – of its fixed income portfolio to enhance returns. While many insurers can have felt compelled to increase duration to extend investment returns and keep pace with a benchmark, the market value of this fixed income portfolio would have fallen dramatically when the Federal Reserve began aggressively raising rates of interest within the spring of 2022, as shown in Figure 3.
Longer-dated bond portfolios would have lost more value in comparison with shorter-dated bond portfolios through the Fed’s 2022-2023 rate hike cycle, all other things being equal.
Figure 3. Market yield of U.S. Treasury bonds with a relentless maturity of 10 years, quoted on an investment basis
That yr, a “fire sale” scenario became a reality for a lot of as inflation and catastrophe-related losses wreaked havoc on the industry’s financials and triggered a downward spiral. A holistic approach to investment management could consider these elements in an integrated model: the worth of investment income, the potential for increased losses, the good thing about aligning asset duration with that of liabilities and – perhaps most significantly – the style wherein investment performance and operating activities At the identical time, they influence the policyholders’ profit participation.
By understanding how investment decisions play a task in commonly used metrics, similar to the ratio of premiums written to policyholder surplus, operational risk becomes a key a part of the investment strategy. In my view, it is a win for organizations that value corporate governance.
Harvest the fruits
For me, an entrepreneurial approach to investment management is timeless and an integral a part of every institutional investor’s to-do list. Organizations that implement investment programs within the context of their broader financial performance measures have the potential to profit from sound investment discipline for a few years into the longer term.
