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By Todd Cohen

Nonprofit hospitals in the United States enjoyed average returns of 14.1 percent on their investments in 2003 after losing 4.9 percent in 2002, a new study says.

Driving the turnaround was an overall improvement in the securities markets, along with greater use of sophisticated financial and benchmark practices, says the Commonfund Benchmarks Study Healthcare Report 2004.

Those practices include rebalancing and diversification of portfolios, and in particular an increase in allocations to alternative investments such as hedge funds.

Hospital returns also benefited from non-trustees with more financial experience serving on their investment committees, and from continued heavy reliance on consultants, the study says

Still, sustaining their growth will require greater attention by nonprofit hospitals to their long-term funds, more complex portfolios and private fundraising, says John Griswold, executive director of the Commonfund Institute in Wilton, Conn.

The study, which looks at the management, investment and operational practices of 204 nonprofit healthcare organizations with $129 billion in total assets, says three-year and five-year average returns totaled 0.9 percent and 2.9 percent, respectively.

Average investment-pool assets totaled $632 million, with 54 percent in operating funds, 24 percent in defined-benefit pension plans and 3 percent in insurance reserves, with the remainder spread among other funds.

While the average total return on operating funds was 14.1 percent, organizations with over $1 billion in total assets posted 17.2 percent returns, compared to 12.1 percent for those with $50 million to $100 million.

Hospitals reported an average annual return of 18.1 percent for defined-benefit pension funds, compared with a loss of 6.4 percent the previous year, and three-year and five-year returns of 0.9 percent and 2.9 percent, respectively.

Those longer-term returns create a significant shortfall for pension funds, nearly all of which set actuarial-return assumptions of 8 percent, the study says.

Eighty-four percent of the hospitals rebalanced their operating-fund portfolios, including nearly 90 percent of the largest organizations, a relatively large proportion, the study says.

Within total operating-fund assets, allocations totaled 39 percent to fixed-income investments, 37 percent to domestic equities, 9 percent to international equities, 8 percent to alternative strategies and 7 percent to cash, short-term and other investments.

Within domestic equity, allocations totaled 54 percent to large-cap funds, 17 percent to index funds, 15 percent to small-cap funds and 14 percent to mid-cap.

Domestic bonds accounted for 96 percent of fixed-income, which lost its share of allocations at 21 percent of hospitals, while fixed-income allocations to global bonds, international bonds or high-yield bonds were 2 percent or less each.

Among alternative strategies, 67 percent were allocated to hedge funds, with 29 percent of hospitals overall, and 51 percent of the largest hospitals, saying they expect to increase their operating-fund allocations to alternative strategies.

The move to alternative investments likely benefited nonprofit hospitals, particularly at a time when equity and fixed-income markets have not performed well, the study says.

But it says increased investments in alternatives also “have created a growing concern that returns will decline and whether investment committees have sufficient expertise to conduct due diligence, monitoring, risk management, manager selection and hiring.”

Hospitals are not applying enough resources “to overseeing much more complex portfolios,” Griswold says.

As the share of assets allocated to alternatives grows, particularly to hedge funds, many hospitals lack the staff and expertise to oversee portfolios that are becoming increasingly sophisticated, he says.

“Hedge funds don’t give you too much information,” he says. “You’re investing in areas where there’s a lack of transparency, the strategies are complex and difficult to understand, and there is lack of reporting from the managers.”

Successful hedge-fund managers tend to attract money quickly, and to close their funds before they get too big, leaving investors to look for managers who “may be less scrupulous about how much money they take,” Griswold says.

If investment committees at nonprofit hospitals lack expertise, he says, “they may invest with lower-quality managers whose returns will be disappointing or, worse, whose funds may go out of business.”

Hedge-fund managers also tend to “leverage” their portfolios by borrowing money to buy more securities, a strategy that can magnify the return, whether it is a gain or a loss, Griswold says.

“So he can go up faster or down faster than he would if he was not leveraged,” he says, adding that hospitals may not be prepared to scrutinize hedge-fund leveraging strategies.

“The average committee person on a nonprofit investment committee is not equipped to deal with complex hedge funds and they should not try to get into them if they don’t understand them,” he says.

Professional staffing of the investment function at nonprofit hospitals was “extremely lean,” with 0.7 full-time employees at hospitals overall for that function, and 1.6 full-time employees at the largest hospitals, or those with over $1 billion in assets, the study says. Hospitals have been increasing both their use of outside consultants and the sophistication and number of investment committee members with specific experience in alternative strategies.

Faced with the expense and difficulty of overseeing direct investments, the study says, most small hospitals and even some larger ones have opted to invest in alternatives through “funds-of-funds” consisting of commingled funds of individual portfolios managed by different investment managers, and in multi-strategy, multi-manager firms.

By doing that, the hospitals in effect are outsourcing the selection of investment managers and even strategies to outside experts, Griswold says.

That can incur additional fees that still may be more efficient that hiring staff, he says.

And with limited staff devoted to investment work and available to manage outside investment managers, staffing that is significantly lower than that of comparable educational endowments, the study says, the investment function often is a part-time activity in the finance department.

That pattern is “not consistent” with concerns that hospitals express about the fiduciary duty of investment committees, the increasing complexity of alternative investments and the need for more education of investment committees, the study says.

As a result, it says, hospitals are adding non-trustees with financial expertise to their investment committees.

Eighty-five percent of hospitals reported using consultants, both to “extend” the understaffed investment function, and to provide guidance to investment committees.

“A lot of the health-care industry relies on outside consultants, and that’s good, they’re buying the expertise outside,” Griswold says. “The fiduciary duty is still on the shoulders of the committee, and they will be responsible for any gain or loss ultimately.”

A larger issue for hospitals is easing the overall operating strain they have experienced for several years, he says.

“The concern is that the health-care industry is under such siege because of the all the financial and regulatory and other pressures,” he says.

Hospitals need to find ways to “ramp up their development efforts to counterbalance the drain on the operating side,” he says.

Another key challenge is to better oversee long-term funds, he says.

“A number of institutions have not fully identified the portion of their asset
s available for long-term investment,” he says.

Because long-term investments generally produce higher returns than do short-term investments, he says, “leaving long-term money in a short-term pool implies lower returns.”

While the market overall has improved, rates on short-term investments have been at historical lows, he says, “so you’re not getting much return from short-term investing.”

The failure to identify long-term assets that could produce greater returns if moved from short-term to long-term investments may be a result of the limitations of hospitals’ investment staff and committees, Griswold says.

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