Foundations and endowments: How smart people make dumb choices
America’s foundations spend many millions of dollars every year on investment advice. In return, they get sub-par performance.
You read that right: Money that could be spent on charitable programs — to alleviate global poverty, help cure disease, improve education, support research or promote the arts — instead flows into the pockets of well-to-do investment advisors and asset managers who, as a group, generate returns that are below average.
This is redistribution in the wrong direction, and why it hasn’t attracted more attention is a mystery.
The latest evidence that foundation executives make dumb investment decisions arrived recently with the news that two energy funds managed by a Houston-based private equity firm called EnerVest are on the verge of going bust. Once worth $2 billion, the funds will leave investors “with, at most, pennies for every dollar they invested,” the Wall Street Journal reports [paywall]. To add insult to injury, the funds in question, which were invested in oil and natural gas, raised money in 2012 and 2013, just as Bill McKibben, 350.org and a handful of their allies were urging institutional investors to divest from fossil fuels.
Foundations that invested in the failing Enervest funds include the J. Paul Getty Trust, the John D. and Catherine T. MacArthur Foundation and the California-based Fletcher Jones Foundation, according to their most recent IRS filings. Enervest operates 33,000 U.S. oil and gas wells, more than any other company, according to Shale magazine. Stranded assets, anyone?
Of course, no investment strategy can prevent losses. But the collapse of the Enervest funds points to a broader and deeper problem–the fact that most foundations trust their endowment to investment offices and/or outside portfolio managers who pursue active and expensive investment strategies that, as a group, have underperformed the broader markets.
How costly has this underperformance been? That’s impossible to know because most foundations do not disclose their investment returns. This, by itself, is a troubling; it’s a reminder that endowed private foundations are unaccountable to anyone other than their own trustees.
On disclosure, there are signs of progress. The William and Flora Hewlett Foundation recently released data on its investment performance for the first time. The Ford Foundation says it intends to do so.
What’s more, as the IRS Form 990s filed by foundations become machine readable, it will become easier for analysts, activists, journalists and other foundations to see exactly how billions of dollars of foundations assets are deployed, and how they are performing. Advocates for so-called mission-based investment, or for hiring more women and people of color to manage foundation assets are likely to shine a light on foundations whose endowments that are underperforming.
Unhappily, all indications are that most foundations fall into that category by pursuing costly, active investment strategies. This month, what is believed to be the most comprehensive annual survey of foundation endowment performance once again delivered discouraging news for the sector.
The 2016 Council on Foundations–Commonfund Study of Investment of Endowments for Private and Community Foundations® reported on one-year, five-year and 10-year returns for private foundations, and they again trail passive benchmarks.
The 10-year annual average return for private foundations was 4.7 percent, the study found. The five-year return was 7.6 percent. Those returns are net of fees — meaning that outside investment fees are taken into account — but they do not take into account salaries for investment officers at staffed foundations, who frequently are paid more than foundation presidents or CEOs.
By comparison, Vanguard, the pioneering giant of passive investing, says a simple mix of index funds with 70 percent in stocks and 30 percent in fixed-income assets delivered an annualized return of 5.4 percent over the past 10 years. The five-year return was 9.1 percent.
These small differences add up in a hurry.
The underperformance of foundation endowments is not a surprise. In a Financial Times essay called The end of active investing? that should be read by every foundation trustee, Charles D. Ellis, who formerly chaired the investment committee at Yale, wrote:
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.
The performance of hedge funds, private-equity funds and venture capital has trended downwards as institutional investors flocked into those markets, chasing returns. Notable investors including Warren Buffett, Jack Bogle (who as Vanguard’s founder has a vested interest in passive investing), David Swensen, Yale’s longtime chief investment officer, and Charles Ellis have all argued for years that most investors–even institutional investors–should simply diversity their portfolios, pursue passive strategies and keep their investing costs low.
In his most recent letter to investors in Berkshire Hathaway, Buffett wrote:
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.
For more from Buffett about why passive investing makes sense, see my March blogpost, Warren Buffett has some excellent advice for foundations that they probably won’t take. Recently, Freakonomics did an excellent podcast on the topic, titled The Stupidest Thing You Can Do With Your Money.
That said, the debate between active and passive asset managers remains unsettled. While index funds have outperformed actively-managed portfolios over the last decade, Cambridge Associates, a big investment firm that builds customized portfolios for institutional investors and private clients, published a study last spring saying that this past decade is an anomaly. Cambridge Associates found that since 1990, fully diversified (i.e., actively managed) portfolios have underperformed a simple 70/30 stock/bond portfolio in only two periods: 1995–99 and 2009–2016. To no one’s surprise, Cambridge says: “We continue to find investments in private equity and hedge funds that we believe have an ability to add value to portfolios over the long term.” Portfolio managers are also sure to argue that their expertise and connections enable them to beat market indices.
But where is the evidence? To the best of my knowledge, seven of the U.S.’s 10 biggest foundations declined to disclose their investment returns. I emailed or called the Getty, MacArthur and Fletcher Jones foundations to ask about their investments in Enervest and was told that they do not discuss individual investments. A Getty spokesperson emailed me to say:
The Getty Trust was an investor in a private equity fund managed by Enervest. We do not discuss the specifics of our investments, but this investment was not material in terms of our overall portfolio which is highly diversified. We also do not release investment performance data, but our returns compare very favorably with benchmarks and peers.
To its credit, MacArthur is one of the few big foundations that does disclose its investment performance of its $6.3bn endowment. On the other hand, MacArthur has an extensive grant-making program supporting “conservation and sustainable development.” Why does it want to finance oil and gas assets?
The refusal of portfolio managers to adopt simpler strategies that deliver higher returns is ultimately the responsibility of foundation boards, which brings us back to the headline on this blog: How smart people make dumb choices.
Maybe it’s because so many foundation trustees — particularly those who oversee the investment committees — come out of Wall Street, private equity funds, hedge funds and venture capital. They are the so-called experts, and they have built successful careers by managing other people’s people. It’s hard for the other board members, who may be academics, activists, lawyers or politicians, to question their expertise. But that’s what they need to do.
At the very least, foundations ought to be open about how their endowments are performing so those who manage their billions of dollars can be held accountable.
Originally published at nonprofitchronicles.com on July 25, 2017.