It’s been a good few years for the investment portfolios at U.S. health systems. Equity markets have been strong, while interest rates have been declining. As a result, the rates of return on many long-term capital pools have exceeded borrowing costs by a comfortable margin.
Unfortunately, the comfortable ride is probably about to end. If interest rates go up in the near future – and it seems increasingly likely that they will – many healthcare organizations could face significant challenges. In anticipation of this change, it’s a good idea for healthcare CFOs and investment committees to review their investment strategies and take a closer look at some areas that may require adjustment.
Focus on fixed income
To start, some portfolios may rely too heavily on core fixed income. Over the past decade, this has proved to be a good choice – delivering a steady, modest return at a reasonable risk level. But the status quo could soon be changing.
In its March Federal Open Market Committee announcement, the Federal Reserve dropped its pledge to be ‘patient’ before raising interest rates. While it says it wants to be confident that inflation is headed to two percent, a recent article in the Financial Times notes that interest rates could start to rise as soon as June.
As interest rates rise, fixed income portfolios may not perform as well as they have in the past, leaving healthcare organizations with the challenge of finding alternate sources of return at a level of risk with which they’re comfortable. Currencies, non-U.S. investments and absolute return strategies could all be areas worth exploring, depending on each healthcare system’s specific goals.
Emerging downside risks
The Affordable Care Act, new technologies, and the shift from a fee-for-service to a value-based model are driving change. At the same time, volatility could be increasing in the financial markets as a result of oil shocks, quantitative easing (QE) in Europe and potential QE in Japan, along with potential regulatory changes coming out of Washington, D.C.
As a further complication, Russell Investments’ second quarter update to its 2015 Global Outlook notes that bull markets generally get riskier as they stretch on – and the current bull market is six years old. In practical terms, this means that investors will probably need to look harder for returns in the coming years.
All of this signals challenges for CFOs, but they should not be discouraged. They can construct and manage portfolios that help them hedge the probable financial risks stemming from known market risks and operational risks.
Currency challenges
Diverging monetary policies at some of the world’s major central banks have significantly increased volatility in currency markets. Recent events include the Swiss National Bank’s decision to remove their peg from the euro and QE in the European Union. While the euro and the British pound have plummeted, the U.S. dollar has seen substantial gains in recent months.
Currency markets are unpredictable by nature, and healthcare organizations need to understand their currency exposure as well as how it might impact their portfolios. One positive is that hedging currency risk is not necessarily difficult. For example, when foreign currencies drop, it cuts into earnings from foreign equities. Investors can prepare for this risk by selling foreign currencies and buying local ones instead.
Likewise, while volatility can lead to losses and underperformance, it also presents an opportunity for investors. As global currencies strengthen and weaken against each other, currency exposures offer diversification and a potential source of return.
What’s next?
Clearly, healthcare CFOs have their work cut out for them. The first step is gaining a thorough understanding of the risks their investment portfolios currently face. Diminished yield and rising volatility are two major considerations.
To address this, they can work to diversify into a variety of global assets with different risk levels and return drivers. Options abound, including loans, absolute return funds, active currency, hedge funds and other alternatives. Interest rate risk is another important consideration, especially for healthcare systems with significant fixed income allocations.
Broadly, CFOs should endeavor to understand the role that each asset they own plays in their overall portfolio, because it’s better to manage portfolio risk holistically and address potential issues as they arise.
Given the changes sweeping across healthcare, however, many CFOs need to focus on other goals. That is understandable, but we are in the last days of the comfortable fixed income strategy that largely takes care of itself.
Whatever route they choose to pursue, well-managed portfolios that take into account the changing market environment will be key to success – not only for the pools of capital, but for the healthcare system as a whole.
Lisa Schneider is managing director, non-profits and healthcare systems, at Russell Investments. Mike Ruff is director and senior portfolio manager at Russell Investments.