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Investments – the unbelievable underperformance of endowments

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People may call economics a dismal science, but it is nowhere near as dreary as the investment returns generated by the US non-profit endowments in the years that followed the 2008 financial crisis.

An academic survey of tax returns for 28,000 endowments suggests their annual mean returns were 6.7%, between 2009 and 2016. These compare to 13.7% from equity indices and 8.0% from long-term US Treasuries.

This implies that the endowments would have lagged a traditional 60/40 US equity/bond balanced fund popular with cautious investors by 4.75 percentage points.

There has always been scepticism concerning the value of financial advice, where clients pay large sums to gain access to funds of uncertain prospects

To be fair to endowments, this was a period of massive liquidity in money markets created by central banks to dig economies out of the 2008 crisis, during which bonds and equity indices performed exceptionally well. Separate reports show that their portfolios performed better in 2017, and a few Ivy League universities excelled in several years, after putting capital at the disposal of their investment departments

The report is called Investment Returns and Distribution Policies of Non-Profit Endowment Funds. Its authors – Sandeep Dahiya of Georgetown University and David Yermack of the Stern School of Business – are staggered at the paucity of returns they have discovered.

They say: “The average endowment fund would have earned substantially higher returns during our sample period if its trustees had followed a simplistic investment strategy of holding 100% Treasuries and taken no equity market risk whatsoever.”

Dahiya and Yermack point out the largest endowments, with the greatest resources, lagged smaller organisations during the period, possibly illustrating that big organisations find it harder to move with the investment times. They also discovered the worst performers tended to be large endowments near New York, San Francisco, Chicago or Boston, where third-party advice is readily available.

There has always been scepticism concerning the value of financial advice, where clients pay large sums to gain access to funds of uncertain prospects.

In 2016, the renowned investor Warren Buffett said: “Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something ‘extra’ in investment advice. Those advisors who cleverly play to this expectation will get very rich.”

Clients are less enriched. Buffett recalls an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”  It goes without saying that the Bill & Melinda Gates Foundation, to which Buffett is a donor, does not lack expertise in this department.

Advisers, in effect, are paid for their intuition on future direction of the stock market. Since there are so many variables, it is hard to see why they can be confident. A survey of wealth advisers by behaviour economist Daniel Kahneman not only showed the inability to outperform, but a collective lack of regret at falling short, probably because they were so used to the experience.

But the problem runs deeper than poor advice. It concerns the way in which nonprofit endowments are run, and the nature of their core beliefs.

A 2013 paper on nonprofit investment returns by Garth Heutel of the University of North Carolina and Richard Zeckhauser of the Harvard Kennedy School took a less critical view of their performance, which they saw as mixed.

But they expressed concern over a general lack of accountability: “ Nonprofit executives, like any executives, are agents for other parties. An intriguing question is: who is the principal for whom these executives serve as agents? Is it the board, the recipients of charitable services, or some ill-defined future entity?”

In so many ways, of course, endowments are devoted to their charities. Their websites are dedicated to their excellence in helping humanity, plus their passion for diversity and the environment. A lot of risk-averse behaviour stems from a determination to never let their charity down. The view is enhanced by a reliance on third-party donations, as opposed to a regular stream of profits. It can lead to reckless conservatism.\

Hautel and Zeckhauser agree endowments tend to be reluctant to put their money into motion: “Looking across all the years in our data, it seems clear that many charities consider building their endowment to be a critical end unto itself. Foundations produce even more Midas-like behaviour.”

Investment performance is not openly discussed – and it is pretty hard to get behind the way in which charities have been putting their money to work via US tax returns. And the absence of detailed peer group comparisons means trustees are not shamed into taking action.

The latest performance data would suggest the thoughts of (most) endowments have been dedicated to their own survival while allowing third-party advisers to make investment (in)decisions to achieve this end.

This flies in the face of sensible investment management defined in 1990 by Roger Urwin of Willis Towers Watson, the godfather of UK pension scheme investment consulting.

In a speech that year, he made it clear the most important factor in successful asset management involved a sound investment process and the selection of the right people to run it. The third key driver, he said, involved a passion to succeed. With these three factors in place, investors develop the confidence to take an appropriate level of risk.

They have certainly been adopted by global family offices, forward-thinking endowments and larger pension schemes. But many nonprofits need to update their thinking, and wealthy individuals would do well to ensure they are travelling in the right direction before they make donations. Throwing money at a problem isn’t necessarily the right way to solve things.

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