Institutional investing often elicits images of ivy-clad walls, multi-billion-dollar endowments, and investment committees comprised of professionals from the largest and most well-known firms. That is certainly one component of the institutional market. However, there is a much larger segment that garners less attention. There are almost two million nonprofit organizations in the United States, many of which have endowments or board-designated funds, often with balances that are far smaller than those of the largest institutions. While these two market segments differ in many ways, they usually share a similar investment goal.
Most nonprofit portfolios are in place to balance the current and future needs of the parent organization. Spending policies of around 4% to 5% are common across the spectrum of institutional investors.
Yet despite shared goals and broadly similar mandates, nonprofit investment portfolios consistently underperform. This blog explores the drivers of that underperformance — manager selection, committee behavior, and structural inefficiencies — and proposes a remedy: the adoption of a clearly articulated investment philosophy statement.
Institutional Investment Performance
There are many studies showing systemic underperformance across the institutional investment market, but perhaps the broadest was written by Sandeep Dahiya and David Yermack in 2019.
The study gathered data on 28,000 institutional investment portfolios and their returns. What it found was that:
Endowments badly underperform market benchmarks, with median annual returns 5.53 percentage points below a 60-40 mix of US equity and Treasury bond indexes, and statistically significant alphas of -1.01% per year. Smaller endowments have less negative alphas than larger endowments, but all size classes significantly underperform. Higher education endowments, most of the $0.7 trillion asset class, do significantly worse than funds in other sectors.
Why have larger institutions performed worse? Most likely because of their allocations to alternative investments. Smaller organizations may not have access to the biggest and best hedge funds and private equity deals, but studies suggest that may be a good thing.
Richard Ennis recently observed:
Alternative investments, or alts, cost too much to be a fixture of institutional investing…Alts bring extraordinary costs but ordinary returns — namely, those of the underlying equity and fixed income assets. Alts have had a significantly adverse impact on the performance of institutional investors since the Global Financial Crisis of 2008 (GFC). Private market real estate and hedge funds have been standout under-performers.
Ennis shows that the largest investors don’t necessarily have an advantage over smaller portfolios and haven’t benefited from their size.
Who is to Blame?
It is no secret that the investment industry has generally failed to generate benchmark-beating alpha. The biannual SPIVA (SPIVA U.S. Scorecard Year-End 2024) study shows that active managers across asset classes largely fail to add value above their passive benchmarks. Clearly, the investment industry bears some responsibility for the nonprofit performance shortfall.
Still, there is plenty of blame to share for the systemic failure of institutional investors. Investment committees also need to reexamine their behavior and composition. While it may be easy for Harvard University to fill the seats of its investment committee with some of the smartest, best resourced, and most experienced investors, that is not universally true. Often committees for smaller organizations are staffed with savvy businesspeople, attorneys, accountants, and stockbrokers (who generally are sales professionals rather than investment professionals), but how many of them truly understand the nuances of how to build or assess efficient portfolios for the long term?
Additionally, I have noted the cycle of hiring an outside investment manager through an RFP process where past performance is the primary consideration. In such instances, the manager with the best recent track record is hired, then underperforms, prompting yet another RFP. This effectively locks in the process of selling low (at least on a relative basis) and buying high. Not the best approach.
More formal evidence of this has been shown in studies, including a CFA monograph by Scott Stewart back in 2013 (rf-v2013-n4-1-pdf.pdf) and “The Selection and Termination of Investment Management Firms by Plan Sponsors” written by Amit Goyal and Sunil Wahal.
Worse still, there may be perverse incentives at some organizations that lock in long-term underperformance. The aforementioned Ennis blog notes:
CIOs and consultant-advisors, who develop and implement investment strategy, have an incentive to favor complex investment programs. They also design the benchmarks used to evaluate performance. Compounding the incentive problem, trustees often pay bonuses based on performance relative to these benchmarks. This is an obvious governance failure.
Even if an organization is fortunate enough to have a qualified committee that implements a robust long-term investment program, membership turnover hurts consistency. It is not unusual for committee members to rotate in and out every year or so. Without some documented philosophy to adhere to, committees can rush from one shiny object to the next in search of investment outperformance, even if the academic literature largely suggests that is a fool’s errand unlikely to yield positive excess returns.
A Way Forward: Establishing an Investment Philosophy
What’s to be done? How do organizations break out of the cycle of systematic underperformance? It can’t be through better committee selection since in most communities there simply aren’t enough qualified volunteer committee members. It is also unlikely to come from a change in the investment industry, as its conflicts and problems have been well documented for over a century. Organizations must instead adopt a deliberate, long-term investment philosophy.
Almost all nonprofit organizations have investment policy statements. These layout investment considerations and the basics of the portfolio including time horizon, liquidity needs, asset allocation targets and ranges, and benchmarks. However, most investment policy statements I’ve seen still leave a lot of discretion to outsourced investment managers. While flexibility may benefit a skilled manager, evidence suggests that most underperform, especially when given broad tactical discretion. That suggests committees should have more formality and constraints in how they run their investment portfolios.
But there is a lot missing in most investment policy statements. Most investment policy statements lack a robust articulation of long-term philosophy, something that could help committees commit to a consistent strategy over time.
From Policy to Practice
Next to asset allocation, investment philosophy will largely drive the long-term return characteristics of an investment portfolio. And the key to a successful long-term experience is the commitment to a “proven” philosophy. Understanding the pros and cons of a particular philosophy may be helpful in sticking with it over the long haul, particularly during times of market duress when emotional reactions are most tempting.
A good starting point would be to consider the revenue sources and characteristics of the organization. For example, are grant revenue and donations likely to hold up during a recession or bear market for stocks? If not, a component of the portfolio may need to be counter-cyclical. That may include low-correlation alternatives, though not necessarily the types criticized by Ennis.
While asset allocation would cover how much to include in alternatives, a philosophy statement would discuss what types of alternatives are appropriate. Trading in and out of various alternatives opportunistically is unlikely to add to returns, just like market timing in the stock market has been shown to destroy value, so the return characteristics of various long-term alternatives should be examined. For example, do the returns have low correlation to traditional stock and bond strategies? Do they hold up in stock market downturns?
All investment philosophies will have pros and cons, so a careful examination of each and how they interact with the organization’s needs is critical.
A brief overview of a few potential philosophies includes:
Active management is generally more expensive than indexing and is therefore unlikely to generate above-benchmark returns. It is also unlikely to be a specific enough philosophy to be useful.
Active value (or some other factor) would be more specific and could outperform over the long-term but will likely still have a large expense headwind and will suffer long periods of underperformance.
Passive/indexation addresses the cost and underperformance issues, but there could be long periods of time when performance is not enough to meet the required returns to keep up with the spending policy. This occurred during the 2000s, a lost decade in which equities delivered flat returns, underscoring indexing’s limitations over shorter horizons.
Factor investing can benefit from some of the best aspects of indexing, such as lower costs and broad diversification. It may also keep up with required returns better during flat or down markets but comes with significant tracking error.
Alternative investments (hedge funds, private equity, and liquid alts) carry significantly higher costs than traditional assets. Committees must rigorously assess whether those costs are justified by return potential.
What often happens is that investment committees rush from one philosophy to the next at the most inopportune times, locking in underperformance. For example, a good factor-based manager may have underperformed lately during the Magnificent 7 boom. Should that manager be fired for underperforming or should the committee stick with them for the long run? If there is no guiding long-term philosophy, then short-term performance is likely to be the deciding characteristic when making that choice, often just as the cycle turns.
While investment committees want to meet their required returns and outperform their benchmarks all the time, it is important to remember that this just isn’t possible. Even Warren Buffet has had long stretches of significantly lagging the market. The challenge for committees is to determine if their manager is bad or whether their strategy is just out of favor. For investment committees seeking consistency in an inconsistent world, philosophy may be the most underused tool they have.
