Nonprofit Chronicles

We’re gradually learning more about the investment performance of foundation endowments.

The news is not good.

The Chronicle of Philanthropy yesterday published my story about foundation endowments. [Paywall] The peg was the Ford Foundation’s decision to publish the investment returns of its $12.1bn endowment for the first time in several years. Ford has done well–its endowment generated 9.2 percent in annual returns for the five-year period ending December 31, 2016.

Most others who manage foundation endowments were not as smart, or as fortunate.

A new analysis of more than 5,700 foundations finds that they generated a median return of 7.72 percent over that same five year period. Most of those foundations employ active asset managers–that is, investment advisors who engage in stock-picking and market-timing, or look to hedge funds, private equity funds or real assets like land, buildings or timber to improve their returns.

Most would have done better to buy a simple mix of low-cost index funds, with 70 percent of their portfolio invested in stocks and 30 percent in bonds. A sample portfolio put together by Vanguard, the index-investing giant, found that the 70-30 mix returned 9.1 percent over that same five years, just a notch behind Ford but well ahead of the median foundation.

The analysis of endowments–which is the most comprehensive ever performed–was done by a startup company called Foundation Financial Research, which can be found at FoundationMark. The company will soon release comparative data about endowments to foundation trustees; if all goes according to plan, that should bring more transparency to the sector, spur competition and improve returns. You can read more about Foundation Financial Research and its founder, John Seitz, in the Chronicle story.

What does this new data tell us? Nothing less than the fact that foundations collectively waste hundreds of millions of dollars, and probably billions of dollars, on investment fees every year. That’s money that, instead of flowing to Wall Street, could and should be given to worthy causes.

To be fair, some foundation are probably not trying to maximize their returns. Their managers may choose safer investments, and give up on bigger gains. (Foundations that are spending down their assets might choose this path.) What’s more, while passive investors have outperformed active investors in the last 5 or 10 years, their returns have been driven in large part by the long bull market in U.S. stocks. When the market falls, active managers or hedge funds could outperform the indexes.

But they probably won’t. There are fundamental reasons to believe that passive investing will outperform active management over the long term, for all but a handful of the best money managers.

The trouble with active portfolio management

For one thing, it’s hard for any asset manager to consistently outsmart the collective wisdom of the many thousands of investing experts who have arrived at a consensus about what any given asset is worth, which is then reflected in its market price. In other words, it’s harder than it has ever been to discover mispriced assets, which is what active managers must do to succeed.

It’s equally hard, if not harder, for foundations to identify the very best active investors, in advance.

Finally, the higher costs of active portfolio managements mean that active managers always will be at a disadvantage when competing with low-cost passive approaches.

In a must-read opinion piece in The Financial Times titled The end of active investing?, veteran asset manager Charles Ellis noted:

Over 10 years, 83 per cent of active funds in the US fail to match their chosen benchmarks; 40 per cent stumble so badly that they are terminated before the 10-year period is completed and 64 per cent of funds drift away from their originally declared style of investing. These seriously disappointing records would not be at all acceptable if produced by any other industry.

About the fees charged by active managers, Ellis writes:

The fees conventionally described as “only 1 per cent” of assets are better seen for what they really are in a 7 per cent return market — 15 per cent of returns.

For foundations, it’s perhaps even worse: The typical foundation that gives away 5 percent of its endowment and spends 1 percent on fees is sending $1 to Wall Street for every $5 that it spends on its operations and gives to nonprofits. Every foundation trustee should ask: Why give up that 1 percent, in advance, to buy advice that will likely prove worthless? Why not settle for being average?

As investment guru Warren Buffett wrote in his latest letter to Berkshire Hathaway investors:

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.

This is the fourth time I’ve blogged about foundation endowments this year. (See this, this and this for the previous posts.) I’m grateful to The Chronicle for publishing my story. It’s my hope that this reporting will deliver a wake-up call to foundation trustees and CEOs.

I’m interested in hearing from foundations that, like the Central Carolina Community Foundation, have switched from active to passive investing, as well as hearing from proponents of active portfolio management who want to challenge my thinking. There’s more to come on this topic. John Seitz of Foundation Financial Research has promised to release select data on individual foundations and their performance, as their tax returns for 2016 trickle in. I’ll publish some of his findings here on Nonprofit Chronicles and, I hope, in The Chronicle as well.

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Photo credit: Matthew Knott, via flickr,