By LARRY SWEDROE
Of an estimated universe of more than 310,000 public non-profit organisations (NPOs), about 35,000 have endowment funds, with a total of $800 billion in assets under management (AUM). Outside of university endowments, there is no systematic evidence to date about how NPO endowment funds invest, or what returns they earn. Andrew Lo, Egor Matveyev, and Stefan Zeume contribute to the literature with their March 2020 study The Risk, Reward, and Asset Allocation of Nonprofit Endowment Funds.
Their goal was to study the asset allocation decisions and returns of endowment funds of the entire nonprofit sector in the United States. The data was collected directly from the tax forms filed by NPOs with the U.S. Internal Revenue Service and contained the universe of NPOs with established endowments over the years 2009 through 2017.
Findings
The following is a summary of their findings:
— The average endowment fund had $20.5 million in AUM, largely driven by a few very large funds, as the median AUM was under $1 million.
— Endowments in higher education accounted for a mere 3.7 percent of all endowment funds, but their assets accounted for almost 40 percent.
— About 60 percent of NPO assets were in public equities, about 20 percent in fixed income and cash, and the remaining 20 percent split among alternatives such as real estate, private equity, hedge funds and others.
— The average return on invested capital, net of administrative expenses, was 5.3 percent.
— Average administrative expenses were 1 percent of AUM annually.
— Large funds significantly outperformed small funds, both in terms of returns and risk-adjusted returns. In particular, funds with more than $100 million in AUM had average net returns of 7.6 percent per year, while funds with an AUM below $1 million had returns of only 3.8 percent per year. Some, but not all, of the difference is explained by asset allocation, as smaller endowment funds allocated a disproportionately large fraction of their portfolios in fixed income and cash instruments — on average, almost a third.
— Small endowments engage more in individual stock-picking than large endowments. They also typically do not invest in international equity, while large endowments allocate a larger fraction of their portfolios to international equity.
— Board independence has a strong positive relationship to investment returns.
— Organisations with higher administrative and travel expenses have lower investment returns on their endowments—while you always pay for what you get, you don’t always get what you pay for.
— Higher investment and advisory fees are negatively related to net investment returns.
— Organisations that manage their endowment funds on their own earn lower net investment returns (by 0.7 percent per year) compared to those using advisers. However, organisations that use advisors and pay higher fees as a percentage of AUM tend to earn lower net returns.
— Among organisations that used external advisors, annual investment management fees were, on average, 1.2 percent of AUM. However, this was largely driven by small funds reporting high fees. The median fund paid 69 basis points annually.
— There is no evidence that endowments with dedicated chief investment officers (CIOs) outperform endowments without dedicated CIOs despite their larger size. Conditional on having a CIO, a CIO’s compensation is unrelated to endowment return—more highly compensated CIOs do not deliver greater returns.
— In line with economic theory, organisations with higher volatility in their contributions tend to hedge by investing in assets with a lower market beta and by allocating a larger fraction of their assets to cash instruments and money market funds. This is important, as contributions to endowments are negatively correlated with stock returns — a 1 percent lower annual stock market return was associated with 3.9 percent lower annual contributions. In other words, contributions to nonprofits are strongly exposed to market risk.
Summary
Among the important findings by Lo, Matveyev and Zeume is that they demonstrated that advisory firms have added value to endowments — NPOs that hire advisory firms outperform those that do not. However, they also found that both advisory fees and other investment expenses are negatively correlated with performance. In other words, the cost of the advice does matter, and higher costs don’t necessarily translate into superior performance.
Another important finding was that board independence is positively correlated with performance. A likely explanation for this finding is that all too often boards are influenced by members who are donors and are also employed by actively managed fund sponsors. The higher costs of active management and expensive alternative investments has negatively impacted returns.
A third interesting finding was that hiring CIOs was uncorrelated with returns — there is no evidence they added value. Endowments can benefit from these findings, assuming they are willing to change behaviours in the face of the evidence.
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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