As donations to nonprofits have decreased during the Covid-19 pandemic, those with endowments are turning to these funds to help them survive the crisis. But not all endowments are created equal. Factors such as size, management, and investment allocation significantly affect how much revenue endowments generate.
Until now, research on nonprofit endowments has focused solely on higher education, leaving many organizations in the dark about how to effectively manage their funds. To better understand which organizations have endowments, how assets are invested, and how much revenue they’re producing, we analyzed more than 300,000 tax returns of nonprofits from 2009 to 2017. We found that one in nine, or 11.2 percent, have endowments and that the most significant factor affecting investment returns is the size of the fund.
The data shows that bigger funds consistently outperform smaller funds in every type of nonprofit organization, according to our study, “The Risk, Reward, and Asset Allocation of Nonprofit Endowment Funds.” Funds worth more than $100 million earn average returns of 7.6 percent a year compared with just 3.8 percent for endowments under $1 million.
Portfolio investment decisions drive much of this difference. Nonprofits with larger endowments make riskier investments and generate higher returns, while the investments of those with smaller endowments are more often low risk and yield lower returns. For example, small endowments on average hold 20 percent of their assets in cash and 11 percent in bonds while larger endowments on average hold just 2 percent of their assets in cash and bonds.
Small Groups Avoid Risk
The relationship between fund size and investment allocation and returns is pervasive for all types of nonprofits, but it’s unclear why organizations with small endowments choose such a conservative investing approach. One possibility is that smaller organizations simply need more cash on hand and that management is less inclined as a result to make riskier investments. But the other possibility is that these investments are just managed poorly. In particular, it is unclear why such large cash balances are a part of the endowment and not simply kept on organizations’ balance sheets.
What is clear is that investment-management decisions at organizations with small endowments are less rigorous and would benefit from a more integrated approach, including less cash and more higher-returning but liquid assets, such as stocks.
The research also uncovered some surprises. For instance, while higher education endowments are on average among the top performers, this performance is explained primarily by their larger size. Endowments for nonprofits devoted to areas such as civil rights, the environment, and the arts actually perform better than higher education endowments and may have better investment practices than large universities with their huge endowments.
CEO Pay Influences Returns
The overall management of nonprofits has a significant impact on endowment investment returns. Organizations with more independent boards have higher returns on their endowments, as do those that pay officers and directors well. The same is true for CEOs—nonprofits that paid them more reaped rewards when it came to endowment returns. On the other hand, spending on administrative and travel expenses produces the opposite outcome: The more organizations spend in those areas, the worse their endowments perform.
These results highlight the need for more oversight of not only how nonprofits are run, but also how their endowment funds are managed. For corporations, this role is typically performed by shareholders. For many large nonprofits, such as universities, it is performed by stakeholders, including alumni and prominent donors. But most other nonprofits do not enjoy the benefit of such oversight. As a result, the need is acute for more public scrutiny of how these organizations manage their funds.
Hiring investment advisers can help. Most nonprofits (60 percent) manage endowment investments on their own, while 40 percent hire investment advisers. Organizations that hire advisers outperform those that do not by almost 1 percent annually. The cost of the adviser also matters. A 1 percent increase in investment adviser fees resulted in a 0.17 percent decline in net returns.
Nonprofits relying on endowments to survive the pandemic should take a close look at whether their funds are performing as well as they could be and whether they need to put smarter financial strategies in place. That could include something as simple as hiring a low-fee investment adviser. But it might also require taking a close look at management practices that could be contributing to an underperforming investment portfolio. During this crisis and the next one, keeping many nonprofits healthy means keeping their endowments growing.