News and analysis
June 06, 2017

Getting Squeezed

With endowments struggling to generate robust returns, experts wonder if charities and foundations should tighten their belts — or lower their expectations.

The American Technion Society earned nearly 9 percent on its endowment last year, a sign of robust recovery for an organization that suffered more than most during the financial crisis of nearly a decade ago.

The society, which raises money for the Technion-Israel Institute of Technology and ends its fiscal year in September, did so well largely because nearly half of its endowment is invested in the stock market, which has been roaring for months.

But its return on investment outpaced that of most nonprofit endowments last year, according to a new Chronicle survey of 137 such funds. And the mediocre or even negative investment results nonprofits have reported in recent years could be a sign of a deeper problem for many organizations.

While endowment managers are optimistic about the markets in 2017 and confident about long-term investment prospects, they are raising some alarms: that U.S. stocks may be overvalued; that the hedge-fund field, in which many nonprofits have sought bigger returns, is contracting; that global unrest and the policies (and unpredictability) of the Trump administration could roil markets and trigger trade fights, potentially dragging down returns.

For those reasons and others, experts say the ambitious returns most nonprofit endowments seek — usually 7 to 8.5 percent may be difficult to sustain. If so, organizations might need to trim what they pay out in investment fees, reduce how much they give away or spend on programs each year, or even intensify their fundraising.

‘We Are Spoiled’

Returns ranged from tepid to dismal last year for most endowment endowments, according to The Chronicle’s data.

Organizations with fiscal years that end in December — 32 institutions, mostly foundations — chalked up a median return of 6.5 percent.

By contrast, most of the 82 groups in the Chronicle study that close out their fiscal year in June saw their investments lose value, at a median rate of minus 1.9 percent.

Other data also shows muted investment returns for nonprofits. The most recent annual study of endowments by the Council on Foundations and Commonfund, released in August, found that private grant makers’ returns were flat in 2015, while community foundations averaged minus 1.8 percent.

The 10-year average for both types of organizations hovered just above 5 percent, creating a challenge for grant makers that are required by law to to distribute at least 5 percent of their assets and need to exceed 5 percent returns to keep up with inflation.

Other nonprofits feel similar pain.

"We are spoiled," says Michael Waxman-Lenz, chief financial officer at the American Technion Society. He believes that median returns in the mid-single digits will be common in the years ahead.

Robert DiMeo, managing director of DiMeo Schneider & Associates, which invests assets for nonprofit clients, asks, "How realistic are 8, 8 1/2, or even 7 percent returns?"

Taking the risks necessary to achieve big returns year after year "will necessitate a strong punch in the gut from time to time," Mr. DiMeo says. "And I think some institutions aren’t prepared for that."

David Villa, board treasurer of the Marguerite Casey Foundation and chief investment office for the sate of Wisconsin, says he is worried about long-term demographic trends.

The population in developed countries is aging, and with that comes a decline in the percentage of people who remain in the labor force, hampering productivity and potentially cutting into companies’ value. As a result, he says, institutional investors like nonprofits may need to lower their expectations about returns.

"If you try to fight that, you’re likely to wind up doing things that are too risky and you’ll be unlikely to be compensated," says Mr. Villa.

"You can look for other strategies, but there’s only so far you can stretch."

Top Performers

The stock market’s performance proved decisive for groups in The Chronicle’s survey: Organizations that put a lot of their money into equities earned higher returns overall in 2016, though the opposite was true in the 2015 fiscal year. Last year, the S&P 500 saw returns of 9.5 percent; in 2015, returns declined by 0.73 percent. As of mid-May this year, the figure was 6.5 percent.

Charities with returns above the survey’s median had just under 45 percent of their assets in stocks. Foundations that performed above the median allocated 55 percent to stocks.

Among the top performers in the survey:

  • The W.K. Kellogg Foundation, with a fiscal year ending in August, earned the highest returns among all 137 organizations — 17.8 percent. Joel Wittenberg, Kellogg’s chief investment officer, attributed the grant maker’s performance to its holdings in Kellogg Company stock, which has been on a winning streak. Half of the foundation’s $9.2 billion endowment is invested in the namesake food giant; nearly 20 percent is in other publicly traded equities.
  • The Kalamazoo Community Foundation, with a fiscal year ending in December, saw the highest return on investment among the charitable organizations in the survey, at 12.3 percent. It invested nearly 72 percent of its $350 million endowment in equities. The organization said in its annual report that it is careful not to react to "near-term market pressures or new investment fads" but declined a request for further comment on its strategy.
  • The JPB Foundation had the highest return among foundations with fiscal years ending in December. Its nearly $3.9 billion endowment reaped a return of 8.7 percent, with 55 percent of its assets invested in stocks. The organization declined an interview with The Chronicle.
  • Among charities, the 10 largest endowments were all at colleges, with Harvard University’s $35.7 billion at No. 1. The endowment’s value declined 2.2 percent in 2016; the university did not provide return-on-investment or asset-allocation information.

Hot Markets

The stock market’s showing of late is reinforcing for many charities the value of putting a big share of funds there.

At the American Technion Society, where nearly half of assets are in equities, returns for this year’s first quarter are outpacing fiscal 2016 performance. In March, the group’s endowment had a 12 percent return compared to March 2016, Mr. Waxman-Lenz says.

The stock market is going gangbusters and unemployment is down, but charities and foundations face many risks in deciding how to invest.
The organization had moved away from stocks in 2009, putting 70 percent of its assets into bonds. With good reason: In addition to the specter of the 2008 financial crisis, there were "a lot of memories of Madoff," Mr. Waxman-Lenz says. The Technion Society lost $72 million in Bernard Madoff’s massive investment fraud, which unraveled in late 2008.

But when Mr. Waxman-Lenz joined the organization in January and analyzed its investment performance over the long term, he realized that strategy of avoiding risk "hurt us more than Madoff."

"We’re in year eight, nine of an amazing run of financial markets," he says. Reducing the share of endowment money invested in stocks during that period "was a huge opportunity cost."

The Marion and Henry Bloch Family Foundation, created in 2012 by the co-founder of tax-preparation firm H&R Block and his wife, achieved a 7.9 percent return in 2016. The grant maker put 60 percent of its $254.7 million in assets into stocks, with only 11 percent in bonds.

The allocation is essential for an organization that intends to last into perpetuity, says David Miles, president of both the family foundation and H&R Block’s corporate philanthropic arm. Still, he warns, "We want to be cautious in our commitments for grant disbursements for future years, to make sure we’re not overcommitted, in case of a down market."

Taking Risks

While the stock market is currently going gangbusters and unemployment is down, charities and foundations face many risks in deciding how to invest. For starters, the economy is experiencing not a boom but a "long, drawn-out recovery," says Kristofer Kwait, managing director and head of investments at Commonfund. And he and other experts cannot predict when the next downturn will arrive.

The biggest potential risk, Mr. Kwait says, "is that we fall to recession because we don’t get enough growth, and we don’t see it on the horizon."

The Charles F. Kettering Foundation rode a stock-market wave to an 8.6 percent return on investment when its fiscal year ended in December. Seventy-six percent of its $330 million in assets are in stocks.

Some of President Trump’s goals could be favorable to businesses, notes Brian Cobb, vice president and treasurer of Kettering. "I think the market is pricing that in," he says. "But I think there will be disappointment."

If the president’s promised lower taxes and loosened regulation do come to pass, Mr. Cobb expects more capital spending by companies. "There’s a lot of pent-up demand," he says, and that spending and improved productivity could drive up returns.

With concerns that stock markets may be due for a correction, alternative investments can look enticing to nonprofits eager for sustainable returns, say many endowment experts.

"There’s a fear that by investing in the stock market today, they are relegating themselves to lower returns going forward," when the market drops, says Christopher Philips, head of Vanguard’s Institutional Advisory Services. "So there’s a perceived need to look elsewhere."

Mr. Philips says that he sees nonprofit clients drawn to private equity, real estate, hedge funds, and private-debt funds, but those alternatives simply trade one type of risk for another.

"They are taking on liquidity risks, transparency risks, leverage risks by going into private alternatives." he says.

In addition, worthwhile investments can be tough to find, he and other endowment experts say.

"You kind of have this environment where everyone wants to give private-equity managers more money, and the private-equity managers are saying, ‘Well, I have nowhere to put the cash,’ " Mr. Philips says. According to some estimates, more than a $1 trillion in what he calls "dry powder" — money earmarked for investment that’s not being put to work — is currently clogging the private-equity market.

In The Chronicle’s data, foundations with returns that beat the survey’s median in 2016 were less heavily invested in private equity and hedge funds. The most successful investors reserved a median of 7 percent to private equity and 14 percent to hedge funds, compared to 9.5 percent and 20 percent, respectively, at foundations that were below the median.

New Opportunities

Given how expensive many U.S. stocks are these days, some experts believe charities and foundations are putting too small a share of their money into international and emerging-market stocks.

Many investors suffer from "recency bias," focusing on wealthy U.S. companies that have been doing well lately, says Joe Curtin, head of global portfolio solutions and institutional investments at U.S. Trust and Bank of America Merrill Lynch.

"It’s a lot easier to be invested where the markets are doing well or have done well recently," he says.

Stan Ra, investment director at Seattle Children’s Healthcare System, is also bullish on international equities. His nonprofit has seen strong results with investments in Asian stocks.

The Kalamazoo Community Foundation saw the highest return on investment in the survey, at 12.3 percent.

Seattle Children’s $839.3 million endowment earned an overall 9.4 percent return for its 2016 fiscal year, which ended in September. Fifty-one percent of its assets were in stocks; 29 percent was committed to hedge funds, a higher share than at most organizations in The Chronicle’s survey.

‘Weaker Hands’ Folding

Hedge funds, investment partnerships that use a variety of strategies to eliminate risk, are disappearing at a rapid rate; in 2016, for the second year in a row, closures outnumbered launches, according to Hedge Fund Research. Hedge funds overall earned a 5.5 percent return last year, according to Fortune, well below the 9.5 percent the S&P 500 returned.

In light of the industry’s current upheaval, "everyone’s looking at their hedge-fund portfolio," Mr. Ra says. "Everyone’s asking, ‘Am I getting good value for the fees that I’m paying?’ "

The closure of many hedge funds "is good for the industry," he says. "It forces out weaker hands. There is a place for hedge funds in a portfolio but you have to be a little bit smarter about who you’re allocating to, to make sure they make sense for your portfolio. and to better align the incentives for the managers, to the extent that you can."

For example, Mr. Ra says, some hedge-fund managers will reduce their management fees as assets grow, or will only collect incentive fees when the assets reach a certain benchmark. "The proposition can’t be that the hedge-fund manager wins in every scenario."

The hedge-fund market is cooling, says Sharon Liebowitz, CEO of Meritam Investments, which manages assets for nonprofit clients. "The dirty secret is that a lot of these hedge funds are underperforming, and people are paying a lot of money for the privilege."

Several state pension funds have pulled their money out of those investment vehicles, she notes, and "you’re likely to see that trend continue."

Property Values

More nonprofits should be looking at real estate as a place to increase the value of their endowments, says Mr. Curtin. The tangible asset generates a "decent yield, which is inflation-adjusted and helps you meet [your] spending policy. You have stored value in the land itself. It’s not impossible, but it’s very hard to lose all of your money in real estate."

Charities in the Chronicle survey that had above-average returns put a median of 5 percent of their endowment assets in real estate; the top-performing foundations allocated 2.5 percent of their portfolios to property. Both figures were higher than those at peer groups that performed less well.

Loma Linda University earned the highest return on investment — 3.6 percent — of charities with June fiscal-year ends that provided investment data. About 28 percent of its $784.2 million in assets is invested in real estate.

The Southern California institution depends on endowment income to support scholarships and research and thus takes a largely low-risk approach, focusing on yield, says Greg Nelson, investment manager at the Loma Linda University Foundation.

Six years ago, the university began investing, with a partner, in apartment houses and complexes. It now has property in 10 states, putting in up to 50 percent of equity. "We save about 2 percent on fees, over the long term, because we negotiate directly," Mr. Nelson says.

Loma Linda also invests in a portfolio of mortgage loans, largely for properties such as offices and nursing homes. Since it began making such investments six years ago, the university has seen a 10 percent return on the real estate and 6.5 percent on the mortgages.

Cutting Costs

Endowment experts urge charities and foundations to take a hard look at what they can control with regard to their investments. One of the biggest factors: the fees organizations pay to the managers of their assets.

Nonprofits pay, on average, about 90 basis points, units that equal one-hundredth of 1 percent of their endowments, in expenses to asset managers, Mr. Philips of Vanguard says. "Trimming that down to, even, say, 30 basis points, that’s a 6 percent difference over 10 years. That’s real money. It goes for spending, it goes for growth. Those are donations that you don’t have to seek."

Yet many charities and foundations, in their quest for higher returns, are turning to actively managed funds with high fees, Mr. Philips says — moving in the opposite direction of individual investors, who are embracing index and balanced funds that cost less and see returns that often equal or beat more expensive options.

The Marguerite Casey Foundation is among those organizations seeking to shave fund-manager costs. "Our mission is alleviate poverty," Mr. Villa says — not to spend money "to manage assets."

The grant maker brought management of its endowment in-house more than 10 years ago. Today, Mr. Villa says, "our investments are lower-cost and simpler than the typical foundation’s." The group pays a mere 40 basis points in fees.

It does not allocate money to hedge funds. It’s been slowly rebuilding its investments in private equity and real estate, which currently stand at 9.4 percent and 8.5 percent, respectively. The organization allocated 59 percent of its assets to stocks in 2016.

Marguerite Casey earned a return of 7.7 percent on its $695.8 endowment for its 2016 fiscal year, which ended in December.

As part of its efforts to tie its mission to its investments, the foundation opted in 2015 to start offering low-interest loans, known as program-related investments. This year, it made its first loan, to a community-development financial institution called Self Help. The money, $1 million over 10 years, will help the group expand its banking and financial-education program in Florida, with the intention of serving more low-income families in the state.

Of the 137 organizations in The Chronicle’s survey that provided data on their investments, 32 reported they had put some money into so-called impact investments that align with their missions.

Under Pressure

Nonprofits struggling to make that "5 percent plus inflation" return should look carefully at their spending policy and make adjustments, says Ms. Liebowitz of Meritam Investments.

"Organizations can choose to not spend so much in years when the market is bad," she says. "They have that flexibility."

Trying to guess when the next bear market or the next recession will hit is a "fool’s errand," Vanguard’s Mr. Philips says. Rather, he advises organizations to diversify allocations to prepare for any possible scenario — and "don’t weight your portfolio to reflect something you see or read."

Nonprofits should focus "on what they can control," he adds. "Look at how they can increase donations, look at how to maximize the effect of their spend. Those are things they can control."

Foundations and charities are also being buffeted by growing pressure from regulators, donors, and the public to show that they’re using assets wisely, and at the same time undergoing generational change on boards and in leadership posts that can change financial expectations, notes Mr. Curtin, of Bank of America Merrill Lynch.

The arrival of new board members, he says, could put the focus "on driving more short-term results. That keeps me up at night. You don’t want to change abruptly. You don’t want to try to time markets."

The message in the tea leaves, say endowment experts, is the same as it ever was: Set a course for the long term, seize opportunities, and hold on tight.

"Am I nervous?" asks the Kellogg Foundation’s Mr. Wittenberg. "I’ve been in this business since 1983. I’ve been nervous since 1983."