Partner Healthcare

How “Real Assets” Play in Portfolio?

Partner Healthcare System had established several centrally managed pools to invest their financial resources. Two main pools are short-term pool with average yield of 3.2% and long-term pool (LTP). The Investment Committee was considering the size and composition of the new “real assets”, which are mainly made up of REITs and commodities, to add to the $2.4 billion long-term pool.

To determine the benefit of adding new assets to the portfolio, we need to analyze if the new portfolio’s expected return will increase for a given amount of risk, or equivalently the overall risk will decrease for a given level of expected return. The Sharpe ratio, which measures the excess return (or risk premium) per unit of risk, is a good parameter to rank the performance of different portfolios. We have 3 alternatives here: 1) adding REITs only; 2) adding commodities only and 3) adding both REITs and commodities.

Let’s start with the baseline asset allocation in LTP with only three assets prior to the addition of the real assets: US Equity 55%, Foreign 30%, and Bonds 15%. Given the assumptions of different asset classes’ expected return and risks, the baseline LTP can generate 11.65% expected return with future risk of 12.02%. What will these numbers change if we add the “real assets” to the portfolio? Given the same level of expected return, 1) adding REITs only bears risk between 11.52% and 12.25%; 2) adding commodities only bears risk between 10.29% and 10.98%; 3) adding both REITs and commodities bears risk between 10.24% and 10.98%. From this comparison, we can tell that adding “real assets” diversified the portfolio and reduced the risk for the same level of expected return.

Then how should we allocate to these five assets to offer the better risk-return trade-off for investors? If the investors require 10% expected return but with the least amount of risk, the optimal portfolio would be 14.3% in US...