Why do foundation endowments underperform?

Culture trumps strategy, it’s often said in business. At companies and nonprofits alike, culture can be defined as “the way we do things around here.” It’s tough to change culture.

Culture helps explain the way that most foundations invest their endowments. The way they do things -- the way they've always done things -- is to turn to investment consultants, stock pickers and, more recently, venture capitalists, hedge funds and private equity funds, all in an effort to outperform the markets as a whole. It’s an approach that has been failing for about a decade, and yet they go on, shipping large sums of dollars off to Wall Street money managers that could be devoted to curing disease, fighting poverty, improving education, supporting the arts and the like.

The disappointing performance of foundations endowments has been a frequent topic of this blog, here and here and here. My story in the new issue of the Chronicle of Philanthropy, headlined Billions Squandered, has more to say. The key takeaway:

Nearly three out of four U.S. foundations underperformed the global markets for stocks and bonds during the five-year period ending in 2016, according to Foundation Financial Research [a company that has compiled a database of foundation endowment returns].Foundations manage about $850 billion in assets. Those that fail to match market returns are missing the opportunity to earn billions of dollars each year.

Of all the activities foundations engage in, the investment performance of their endowments may be the least scrutinized--in part because most foundations decline to disclose their returns. But it’s one of the most important things that foundations do, and lately they have not been doing it well.

It’s possible that this underperformance is temporary, and that active managers and so-called alternative investments will outperform the market indexes in the future, particularly when the current boom in stock prices comes to an end. Cambridge Associates, which manages endowments for numerous foundations, reminded its clients in a study published last year that a fully diversified portfolios that includes hedge funds and private equity funds outperformed a simple portfolio of 70% developed market equities and 30% US government bonds both in the decade leading up to the 2008 financial meltdown and during the full 25-year period between 1990 and 2016. Of course, past performance -- neither the last decade of subpar returns, not the prior years of superior results -- do not predict future returns.

But the theory of efficient markets holds that it's impossible for most active money managers to consistently beat the market averages. Markets are a zero-sum game: If one investor’s dollars outperform over a particular time period, another investor’s dollars must underperform. This isn’t to say that skilled active managers can’t outperform the markets; they can and do. But identifying, in advance, the rare manager with the ability to outperform over long periods of time is incredibly hard.

So, many prominent investors say, small and large investors alike ought to invest in a diverse portfolio of low-cost, tax-efficient, diversified index funds and settle for average returns.

Among the advocates for low-cost index investing are Warren Buffett, the Yale University endowment manager David Swensen and Charles Ellis, who began his career at the Rockefeller Foundation and later founded Greenwich Associates. Buffett put it best:

When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

Remember, too, that when compared with index funds, actively-managed investments have higher management fees and transaction costs. Hedge funds, for example, often charge a flat fee of 2% of assets under management and an additional 20 percent of any profits earned.

So why aren’t foundations adapting? In a word, culture.Most foundations are conservative. It’s sometimes said that philanthropy is society’s “risk capital” but foundations tend to be risk averse. If most rely on active managers, few will turn to index funds. (One community foundation did.) The investment committees at bigger foundations are typically staffed by people who have spent their careers in the financial services industry. They come with a lifelong belief in active portfolio management.

A community foundation won't settle for "average"

Here's a case in point: The New Hampshire Charitable Foundation, a community foundation with $755m in assets. The single largest institutional grant-maker in the Granite State, the NHCF made $46m in grants and scholarships to nearly 1,800 nonprofits and 1,600 students last year.

The vast majority of the money managed by the NHCF sits in donor-advised funds, or DAFs. Donors can ask the foundation to make grants on their behalf, but the foundation manages the assets, and cites its expertise as a selling point.

“We are committed to responsible investment to grow your fund and maximize charitable impact,” it says.

But, like most of its peers, it has lagged the broader markets for close to a decade.

To its credit, the NHCF is transparent about its performance and Michael Wilson, its CFO and vice president of finance, kindly agreed to speak with me.

Its typical in another way, too: The NHCF wants to do better than average. “In the end,” Wilson told me, “we want to achieve a return that’s superior to the passive indexes.”

In its pursuit of superior returns, the NHCF says it turns to outside managers and that its investment management fees average 1.1 percent That adds up to more than $6 million a year. Put another way, for every $8 spent on charitable purposes, the foundation spends $1 on investment fees.

In 2016, the last year for which it has published its Form 990 tax return, it paid $485,000 to Forester Capital, a Greenwich, CT, hedge fund; $389, 537 to Elliott Management Co., a so-called activist investment fund recently profiled in The New Yorker; $341,730 to Lyxor Asset Management, a French-owned asset manager in New York; $267,846 to Adage Capital Management, a hedge fund in Boston; and $257,906 to the aforementioned Cambridge Associates, which advises the foundation but does not directly manage its money.

Any one of those managers may have done perfectly well, but, as a group, the NHCF’s advisors and managers have delivered below average performance, at least lately. Returns on the core investment fund in NHCF’s endowment have lagged the broader markets, year in and year out, since 2009. For the five year period ending in 2017, the NHCF’s Combined Investment Fund generated average annual returns of 7.7 percent, compared with average annual returns of 8.2 percent for a 70/30 mixed of global stocks and bonds. That half a percentage point is a significant gap, representing about $3 million in 2017 alone.

Predictably, the foundation’s investment committee is staffed by people from the financial services industry. The board chair, Roy Ballentine, is the founder of Ballentine Partners, a wealth management firm that employs a mix of active managers and index strategies, and the committee chair, Laurie Gabriel, is a retired managing partner of Wellington Management Co., an investment firm that touts its stock-picking savvy. Cambridge Associates, meantime, has managed the NHCF endowment since 2002.

By email, after our interview, Michael Wilson explained:

The New Hampshire Charitable Foundation believes that actively managed, globally diversified portfolios have the capacity to provide additional return compared to diversified sets of index funds over the long term. Research shows that investors with access to the top tier of managers in the public and private markets have exhibited returns in excess of passively managed index funds. However, since the financial crisis ended, a combination of rebounding market returns and the dominance of the largest technology stocks in the indexes have created an unusually challenging environment for active managers. The Foundation’s Investment Committee periodically evaluates its investment strategies - including when and where to use index funds - and incorporates them into its portfolios, as it deems appropriate, alongside active management.

Fair enough. But it's fair to ask whether the NHCF and, by extension, Cambridge have the scale, the savvy and the network to identify and access “top tier managers.” The Ford, Gates or Bloomberg Foundations, arguably, have billions to invest and the cachet and connections to access the best managers and obtain favorable terms. Smaller foundations or advisories like Cambridge aren’t as likely to get first crack at the best ideas of proven money managers.

It's also worth asking whether the disappointing performance of the past decade is cyclical, or something more lasting. Early investors in venture capital, hedge funds and private equity did extremely well, but as those markets matured, they attracted new funds and more investors chasing deals. Performance declined.

All that said, it’s possible, and perhaps even likely, that active portfolio managers will do a superior job of protecting endowments against a downturn, when the next one comes.

As Wilson put it when we talked: “At a high level, you could say that our approach has been to win by not losing.”

What’s unknown is whether endowments, including the one at the NHCF, will do well enough going forward to make up for years of lagging returns during the boom--not to mention all those investment costs. For nonprofits everywhere, the stakes are high.

AN UPDATE: Michael Wilson emailed today [Sept 10] with some further thoughts:

You raise a number of good questions surrounding the passive versus active debate. We had discussed our performance in more challenging markets on our phone call, so I thought I would share a couple of data points for context.This chart shows our 10-year annualized performance of 5.1% compared to a passively invested, or simple, benchmark for the period to June 30, 2018. You correctly point out that our recent performance has lagged the simple benchmark return of 5.5% annualized. However, we generated this return with a lower risk profile than the simple benchmark. This lower risk profile was an intentional choice. The other chart also touches on what we discussed on the call, which is the 10-year performance up to the end of 2008. As you will see from that chart, we achieved a 4.0% annualized return compared to the simple benchmark return of 1.9%, with outperformance being largely driven by superior downside protection in market corrections. I hope these are helpful illustrations. We believe the Foundation’s portfolio will outperform simple benchmarks in the long-run, but continuously evaluate the merits of active vs. passive investing.