Failing grades: Investment wisdom attributed to university endowments proves a myth
- December 1, 2020: Vol. 7, Number 11

Failing grades: Investment wisdom attributed to university endowments proves a myth

by Michelle Mathieu

In one of the most exhaustive studies of the investment performance of U.S. nonprofit endowment funds, Sandeep Dahiya of Georgetown University’s McDonough School of Business and David Yermack of New York University’s Stern School of Business found that “nonprofit endowments badly underperform market benchmarks.”

True, that is not very surprising. What is surprising is that, despite all their advantages of size and access, larger endowments underperformed smaller ones, and colleges and universities underperformed other nonprofits.

The report, titled Investment Returns and Distribution Policies of Non-Profit Endowment Funds, analyzes returns, distribution rates and governance characteristics of nearly 30,000 nonprofits for the years 2009 through 2017. Over that period, the median annual net investment return for endowments was 4.84 percent. The authors found that the mean annual risk-adjusted return of endowments was 1.12 percent below their benchmarks over the time period studied, and 61 percent of endowments displayed negative alpha.


The larger the endowment, the worse the relative performance. Endowments with more than $100 million in assets had negative alpha estimates of 1.67 percent — more than 50 basis points worse than small ($1 million to $10 million) and tiny (less than $1 million) endowments. Seventy-four percent of large endowments — which account for 4 percent of the observations and 78 percent of the assets in the universe — had negative alphas over the time period studied. The authors estimated that only about 0.6 percent of the endowments studied have chief investment officers, implying endowments outsource investment management to professional firms in the vast majority of cases studied.


During the period studied, college and university endowments underperformed their benchmarks by 1.5 percent annually, versus 1.1 percent for non-higher-educational institutions. Colleges and universities account for 6 percent of the observations and 54 percent of the assets in the universe of nearly 200,000 nonprofits that filed with the IRS during the period studied.


The study also found that endowments’ returns appear to be influenced by their internal governance in several ways. First, the study identified a negative relationship between investment returns and board size. This is consistent with numerous other studies that find smaller boards generate superior investment results. The negative effect of board size strengthens as the endowment size grows. “Some of the benefits of small board size include a propensity to take greater risk and less temptation for individual members to engage in free-rider behavior.”

Second, there is a positive association between board accountability and investment performance. Accountable boards are either elected by the organization’s members or must submit certain decisions to the organization’s membership for ratification. A nonaccountable board has the power to choose its own successors, and trustees are not vulnerable to removal or reversal by stakeholders. Related studies show the presence of state officials on the board negatively impacts the performance of pension funds’ private equity investments, and when trustees have expertise in alternative investments and larger professional networks, their universities allocate more to alternatives and earn higher returns.

Third, there is a modest but significant correlation between investment performance and the willingness of donors to contribute in future periods. The analysis found that an endowment that outperforms the equity benchmark by 10 percent, for instance, would experience 1.7 percent growth in donations in the following year, all else equal. “This implies that the constituent donors of a nonprofit … are aware of how well the organization performs as an investor and adjust their donations in a pattern that rewards stock market profits with a supply of new capital, much as one sees the inflows to a mutual fund increase when the fund outperforms the market.”


The authors concluded with their opinion that “the investment wisdom of top universities today amounts to little more than a myth, as one could expect to earn these types of returns simply by chance. Frequent mentions in the media of the outperformance of top schools may be due to the publicity about the success of just one university, Yale.”

Understanding this will help avoid one of the most common biases, the representativeness heuristic. Just because an endowment resembles Yale doesn’t mean it will perform like Yale. Quite the contrary.


Michelle Mathieu is a managing partner and CIO at Fulcrum Capital.

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