(Marc Gunther writes about nonprofits, foundations, business and sustainability. He also writes for NonprofitChronicles.com. This post also appears in Nonprofit Chronicles.)
This post is part of a new Transparency Talk series devoted to putting the spotlight on the importance of the 990PF, the informational tax form that foundations must annually file. The series will explore the implications of the open 990; how journalists and researchers use the 990PF to understand philanthropy; and its role, limitations, and potential as a communications tool.
With a collective $800 billion in assets under management, America’s big foundations spend vast sums of money to buy investment advice. They’re getting little, if anything, of value in return.
Their own investment offices, and the Wall Street banks, hedge funds, private equity firms and consultants they hire, when taken together, deliver investment returns that lag behind market indexes, all evidence indicates.
These foundations would do better to call an 800 number at Vanguard or Schwab and buy a diversified set of low-cost index funds.
So, at least, argues Warren Buffett, one of the great investors of our time. In his latest letter to investors in Berkshire Hathaway, Buffett writes:
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.
The limited data available about foundation endowments bears him out.
It’s not possible to prove that Buffett’s advice would enable foundations to improve their returns–and thus have more money to devote to their grant-making. Most foundations don’t disclose the financial performance of their endowments.
Of the 10 largest grant-making foundations in the US, only two — the MacArthur Foundation and the W.K. Kellogg Foundation — publish investment returns on their websites. MacArthur’s disclosure is exemplary. (So is its performance, perhaps not coincidentally.) I emailed all ten and got nowhere with the rest.
The best evidence about how foundations are managing their endowments comes from an annual study published by the Council on Foundations and Commonfund, a nonprofit asset management fund that serves foundations, colleges and nonprofits. Their most recent survey, which covers the 10-year period from 2006 through 2015, found that returns averaged 5.5 percent per year for 130 private foundations and 5.2 percent per year for 98 community foundations.
Further insight can be gleaned from Cambridge Associates, an investment firm whose clients include foundations, universities and wealthy families. Cambridge tracked the performance of 445 of its endowment and foundation clients and found they generated average annualized returns of 4.97 percent for the 10-year period ending June 30, 2016. (These returns should not be considered Cambridge’s performance track record, a spokesman told me.)
“High pay for money managers does not necessarily translate into superior returns for foundations.”
By contrast, Vanguard’s model portfolio for institutional investors, a mix of passively invested index funds, with 70 percent invested in stocks and the rest in fixed income securities, delivered 5.81 percent over the 10-year-period through 2015, and 6.1 percent for the 10-year period ending on June 30, 2016, according to Chris Philips, head of institutional advisory services at Vanguard. (All figures for investment returns are net of fees, meaning fees are taken into account.)
That may appear to be a small edge for Vanguard. But when institutions are investing hundreds of millions, or billions of dollars, small gains compounded over time add up to big money. Money, again, that could be better spent on programs.
Actually, it’s worse, because the figures reported by the Council on Foundations and CommonFund do not include the salaries that foundations pay to their in-house investment offices. The chief investment officers are often the highest-paid executives at foundations, and their deputies do well, too.
Why, then, do foundations continue to pay high salaries and high fees in the pursuit of market-beating returns, when so many fail?
They should know better. It’s no secret that passive approaches to investing outperform most active money managers, once fees and trading costs are taking into account. In 2005, Buffett wrote that “active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still.”
Taking aim at hedge funds, with their high expenses, Buffett then offered to bet $500,000 that no investment professional “could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees.”
Only one — one! — investment pro took the bet. Not surprisingly, Buffett will win the bet, by a very comfortable margin. And yet foundations and those who advise them are pouring more, not less, money into hedge funds.
Everyone Wants to Be Special
Buffett has a theory about why those in charge of foundations entrust their endowments to active money managers and hedge funds:
The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket, you name it. Their money, they feel, should buy them something superior compared to what the masses receive.
In many aspects of life, indeed, wealth does command top-grade products or services. For that reason, the financial “elites” – wealthy individuals, pension funds, college endowments and the like – have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars.
Vanguard’s Chris Philips has a similar theory:
There is this perception that by going index you are ceding that you do not have any skill and you are going to be average in the marketplace. That doesn’t feel good. As humans, we want to be good. We don’t want to be average.
Foundation executives may be especially prone to believe that they deserve better than “average” investment advice. By dint of their position, they are often told that they are wiser, funnier and better-looking than average.
Jeffrey Hooke, a senior lecturer at the Johns Hopkins Carey Business School and a former investment banker, says the trustees of foundations who serve on their investment committees are likely to favor active asset management.
The people on the boards tend to be in the business. They’re private equity executives, they’re stockbrokers or they’re in hedge funds. They’re totally biased in favor of active managing because that’s how they’ve made their living.
Hooke has researched public pension funds and found that they, too, underperform the markets by choosing active managers. Investment officers don’t want to talk themselves out of a job, he says:
They are never going to walk into the boardroom and say, ‘Hey, it just isn’t working.’ They’ve got wives, they’ve got mortgages they’ve got kids.
These investment officers aspire to be the rare bird who can consistently outperform the market, like David Swensen, the storied portfolio manager at Yale. (I profiled Swensen in 2005 for the Yale Alumni Magazine.) But Swensen, like Buffett, says that identifying the best asset managers is exceedingly difficult. In a 2009 interview, Swensen told me that investors who rely on “low-cost, passively managed index funds” and rebalance regularly will “end up beating the overwhelming majority of participants in the financial markets.” Buffett has said that in the course of his lifetime he has identified only about 10 investment professionals who can beat the markets over time; there are about 87,000 foundations in the US.
Pay for Performance?
In fairness, the foundation trustees and investment officers labor under a peculiar burden. They are obligated by law to give away five percent of their assets every year. So if they want to exist in perpetuity, they must earn in excess of five percent on their investments, which is a tall order. Of course, no foundation is entitled to live forever. If some spend down their assets, well, new foundations come along all the time.
Most foundations, though, aim to survive in perpetuity, and chase superior returns, at a cost. Consider, for example, the Ford Foundation, which, with assets of $12.2 billion (as of 12-31-2015), is the second-biggest foundation in the US, behind the behemoth Bill & Melinda Gates Foundation.
In 2015, the Ford Foundation’s highest-paid employee was vice president and chief investment officer Eric Doppstadt, who was paid $2.1 million. He was followed by director of public investment Michael Walden at $1,017,061, director of private equity Sherif Nahas at $972,362 and director of hedge funds William Artemenko at $955,479. All were paid more than Darren Walker, Ford’s president, whose compensation was $788,542, according to Ford’s Form 990-PF filing,
Then there were Ford’s outside asset managers. In 2015, they included Silchester International Equity Management which was paid $2.2 million, Wellington Energy Investment Advisor, which collected just under $2 million and Eagle Capital Management, which got $1 million.
How did they perform? “Sharing the investment returns is outside of our policy,” says Joshua Cinelli, Ford’s chief of media relations, by e-mail.
In this, Ford is typical. At the David and Lucille Packard Foundation, chief investment officer John Moehling was paid $2.3 million, and three other investment professionals earned more than $1 million. All were better paid than Packard’s chief executive, Carol Larson. Packard, too, will not disclose its returns.
The Robert Wood Johnson Foundation, William and Flora Hewlett Foundation, Gordon and Betty Moore Foundation and MacArthur Foundation all pay their chief investment officer more than their top executives. The argument for doing so, presumably, is that these investment professionals could make as much money or more in the private sector.
But, again, with the exception of MacArthur and Kellogg, the foundations won’t say whether their investment officers and their outside asset managers are delivering market-beating performance.
What we do know is that high pay for money managers does not necessarily translate into superior returns. Interestingly, when pension-fund critic Jeff Hooke analyzed data from 33 state pension systems, he found that the 10 states with the highest fee ratios achieved lower return rates than those that spent the least.
Transparency and Accountability
Foundation endowment returns could probably be calculated by going through years of IRS filings. Unfortunately, the Form 990-PF tax form for foundations is “seriously flawed,” “unwieldy” and “unintelligible to the many lay readers, including trustees and journalists,” according to longtime foundation executive John Craig.
In a 2011 blog post for the Foundation Center, Craig lamented the fact that investment performance is not solicited on the Form 990:
Since their endowments are the only source of income for most foundations and effective endowment management is a challenge for many foundations, this is an egregious omission—equivalent to not requiring for-profit corporations to report their earnings on tax returns and financial statements.
I asked Brad Smith, president of the Foundation Center, which promotes transparency through its laudable Glasspockets initiative, why foundations won’t disclose their investment returns. “They don’t report it because it’s not required,” he said, “to state the obvious.”
Smith went on to say that foundations may be “worried about perverse incentives that could be created by a ranking.” If foundations compete to generate the best investment returns, he explained, they could feel pressured to take on risky investments. During the Great Recession, some foundations that pursued aggressive investment strategies had to sell highly-leveraged, illiquid investments at a loss.
Still, I wonder if there’s a simpler explanation for the lack of disclosure: Foundation staff and trustees don’t want to be held accountable for mediocre results.
If MacArthur and Kellogg are exemplary in their disclosure — Kellogg kindly arranged a phone interview with Joel Wittenberg, its chief investment officer — the Gates and Bloomberg foundations are unusually opaque. Gates Foundation money is housed in a separate trust and is reportedly managed by Cascade Investments, which also manages Gates’ personal fortune. (Buffett is a trustee of the Gates Foundation, and presumably keeps an eye on the endowment.) Bloomberg’s philanthropic and personal wealth are reported to be managed by Willett Advisors. Cascade and Willett have access to some of the world’s top money managers, and may have a shot at outperforming the averages.
This isn’t a new issue. Testifying before Congress in 1952, Russell Leffingwell, the chairman of the board of the Carnegie Foundation, famously said:
We publish our investments. We have to be very careful about our investments because we know that others, some others, take investment advice from our list of investments. Well, that is all right. We think the foundation should have glass pockets.
The bottom line: America’s foundations, as a group, are taking money that could be devoted to their programs – to alleviate global poverty, to improve education, to support medical research or promote the arts — and transferring it to wealthy asset managers. They should know better, and they do.