Endowments and Foundations Also Carry Unrealistic Return Expectations

New data from CAPTRUST shows there is a continued misalignment between foundations’ and endowments’ expected returns, risk preferences and asset allocations.

CAPTRUST has published the results of its second annual Endowments & Foundations Survey, compiling the responses of more than 130 organizations that focus on a broad variety of religious, educational and charitable missions.

Of respondents, 64% identified as private, while 36% were public.

Discussing the findings with PLANADVISER, James Stenstrom, senior manager of asset and liability at CAPTRUST, and Eric Bailey, principal and financial adviser at CAPTRUST, say the data shows a clear disconnect surrounding risk appetites and return expectations. Case in point, 72% of respondents indicate their organization’s expected return on assets falls within the 5% to 8% range—which is higher than investment managers were projecting even before the outbreak of the coronavirus pandemic—with 13% expecting returns over 8%.

As endowments and foundations look to increase their returns, it would be reasonable to anticipate an increased tolerance for risk, Stenstrom and Bailey explain. However, the survey shows no significant differences in levels of equity exposure between respondents with moderate and high return expectations. In this sense, endowments and foundations appear to be subject to many of the same misconceptions and challenges hampering individual investors.

In the survey results, the vast majority (91%) of nonprofits indicate an annual loss tolerance of 15% or lower. However, when simulating their asset allocations through the 2008 market crash, each group saw declines in excess of 20%. More troubling, Stenstrom and Bailey observe, nearly half of respondents indicate an annual loss tolerance of only 5% or less, which was far exceeded when run through simulations of both the 2002 and 2008 market downturns.

“These misalignments put endowments and foundations at risk to sustain permanent damage in the event of a major downturn, like the one we are currently experiencing,” Stenstrom warns. “To mitigate any long-term effects, endowments and foundations should develop a playbook for making necessary shifts in asset allocation to limit losses.”

“The first thing about building a playbook like this is to understand the cash flow needs,” Bailey explains. “If you know what the year ahead is going to look like in terms of outflows, and you have that amount in cash or cash equivalents, this will mean you don’t need to tap other assets in a severe downturn.”

It’s also important to look at the donor funding streams and to understand the timing on that side of the balance sheet. Is it state funding? Mostly grants? Are these sources stable or variable? Are they seasonal?

“Finally, with an organization that is responding to natural disasters, there is no correlation to the current state of the economy,” Bailey says. “On the other hand, for an organization that is funding housing and addressing food insecurity, when there is an economic slump, their needs go up dramatically. Those two types or organizations need very different plans.”

Overall, those organizations willing to tolerate larger annual losses allocate measurably more to equity and other assets, such as alternatives. As the survey shows, 56% of organizations indicate their current portfolio includes an allocation to alternative asset classes. The most common alternatives include real estate (61%), hedge funds (39%) and private investments (35%).

While each organization’s portfolio allocation may not match the potential magnitude of loss, taken as a group, more conservative nonprofits do invest larger proportions of their portfolios in fixed income and cash.

Another enlightening portion of the survey focuses on the perception and use of investments with environmental, social and governance (ESG) themes. While most organizations surveyed (70%) do not currently leverage ESG investing themes, the survey shows that foundations with less than $100 million in assets are much more likely to use ESG funds when compared with larger organizations.

Looking forward, only 2% of respondents plan to reduce their allocation in ESG funds. Half of respondents (51%) are undecided when considering ESG funds, while more than a third of respondents plan to maintain their investments and another 9% plan to increase allocation into the funds.

With half of respondents remaining undecided about their participation in ESG investments for the next year, Stenstrom and Baily observe, it is important to note that many donors have been embracing these funds. Further, a number of national grants are only awarded to foundations that invest in ESG funds, and by not investing in those funds, foundations could be inadvertently restricting which grants they can access.

Beyond the challenges brought about by volatility and lower returns, additional issues respondents point to that could inhibit their organizations in the future include difficulty expanding the donor base, government policies restricting fundraising, competition from other organizations and staffing shortages.

CAPTRUST finds the bulk of organizations exhibit strong governance practices, but room for improvement still exists. For example, fewer than half (43%) of organizations conduct fiduciary training for board or investment committee members, and even fewer (21%) include training on investment-related topics as part of new board member orientation.