Running a Foundation in a Low Return World
The perpetuity challenge of small foundations
The current environment of low investment return expectations challenges the future relevance of foundations that do not have an on-going fundraising program. Many smaller foundations were established from one-time bequests, with the benefactors’ hoping that their “good works” would endure perpetually. It is often impractical or unsuitable for the investment committees of these foundations to assume more risk in hope of higher returns. On the other hand, academic research supports that “high-quality” equity investment strategies provide superior returns with lower volatility, and that implementing such a “high-quality” strategy is a practical, cost-effective solution to the problem of lower future investment returns.
In late 2013, the CD Howe Institute published a report that projected long-term returns of just 4.7% for a conventionally constructed portfolio split 50:50 between bonds and stocks. The report assumed long-term returns of 6.9% for equities and 2.5% for bonds. While lower future equity returns are part of the problem, it is the prospect of low bond returns that is most problematic. Lower future returns are troublesome for foundations that are obliged to distribute capital. It is made more acute when these foundations are small and oriented to donating money, rather than fundraising. In many cases, when running a foundation, trustees are more committed to the disbursement of funds to worthy causes than they are experienced in sophisticated investment strategies, or are able to properly assess the value and/or risks of the many complex solutions available to them.
The math is straightforward. Given the assumption of a 4.7% return, and allowing for the CRA disbursement quota, inflation and management fees, trustees that don’t address the challenge of lower future returns, in some fashion, risk losing the perpetual nature of their endowment and are tacitly accepting a future of reduced charitable impact.
A Future of Low Returns
A Monte Carlo simulation is a computerized, mathematical technique designed to assess the probabilities of otherwise uncertain outcomes. For any given set of variables, such as equity returns and interest rates, it runs thousands of calculations using random inputs to produce a likely distribution of possible outcomes. Here’s the result of Monte Carlo forecast that Nexus ran for a hypothetical $1 million portfolio split 50:50 between bonds and stocks, and that endures the CD Howe forecast for 10 years ( 2.5% for bonds and 6.9% for stocks) before returns revert to more normal levels. (4% for bonds and 8% for equities – both expressed nominally.)
We’ve drawn 2 vertical lines on the graph. The first is at $1 million dollars in inflation-adjusted terms. Anything more than that and capital has grown in real terms even while it has been paying out an assumed distribution rate of 3.5%. This is the “ideal” that we all aspire to.
Unfortunately, the distributions of the portfolio values after 50 years suggests that in ¾ of the scenarios, the foundation winds up with less than $1 million of capital in inflation-adjusted terms, and only a 24% chance of maintaining or growing its capital in real terms.
We’ve drawn a second line at the $500 thousand level to show the chance of ending up with less than 50% of the starting capital (in real terms). If you care about the longevity of your foundation, it’s the area to the left of this line that’s most critical.
On these return and volatility assumptions, there is a 1/3rd chance that the foundation ends up with less than 50% of the inflation-adjusted capital it started with. This is a condition that we describe as “irrelevance”.
In response, foundations that are aware of the gravity of a future world with lower investment returns may be encouraged to take more risk. It is becoming common to see the introduction of lower-quality bond strategies or the use of alternative investments that investment committees may not fully understand. In particular, due to the non-discretionary nature of the disbursements and their inability to offset capital losses with recurring donations, smaller foundations need to be particularly wary of trading off liquidity for the prospect of higher returns.
“Investing is simple, but not easy” – Warren Buffett
These days, the investment management industry loves complex solutions. But it may be that investment success doesn’t require as much complexity as is sometimes recommended. Rather than pursue less liquid and higher risk approaches, an emphasis on “high-quality” equity selection actually produces superior results without the higher fees that are common to other strategies chosen in the quest for higher returns.
In fact, there is a wide body of academic and street research to support the out-performance of “high-quality” stock selection over alternative approaches. “High-quality” strategies have proven to be less volatile, be more liquid and generate higher long-term returns than other approaches. “High-quality” is not the same as “blue chip” or “large cap”. Experienced “high-quality” managers consider quantitative as well as qualitative criteria when analyzing potential investments. Many factors such as leverage, business cyclicality, management capability, the ability to pay dividends and profitability must be considered in conjunction with traditional valuation techniques. In a 2013 paper from the Review of Financial Economics, the author screened across 22 different developed markets using both cash flow variability and profit margin stability as proxies for quality. Companies that ranked high by these measures generated significant excess returns – more than 8% per year over low-quality companies.
Importantly, an investment committee that selects a manager that emphasizes quality in its equity selection process makes room for the responsible substitution of a larger equity content in portfolios at the expense of low-return fixed income.
Scenario forecasting using Monte Carlo simulations confirms the benefits. Adopting a “high-quality” approach and making an incremental increase in the equity allocation to 65:35 dramatically increases the probability that a foundation can maintain its charitable impact and relevance in the future.
Thankfully, a modest additional allocation to equities has a pronounced effect on expected longevity. Charities and foundations that adapt to the more difficult return environment and select a “high-quality” approach more than double their chances of growing the real value of their capital and dramatically decrease the likelihood that their capital is eroded by either inflation or market declines.
For many smaller charities and foundations, pursuing the status quo will bind them to a smaller and less influential future. Assuming more risk or adopting alternative strategies is not always workable or desirable – especially for smaller foundations. A simple alternative exists to dramatically reduce the risk of irrelevance. “High-quality” investment approaches offer a practical, reasonable and affordable solution to more “sophisticated“ methods. Using a “high-quality” approach can have a dramatic positive effect on longevity and thus a charity’s or foundation’s future charitable impact.
If you are a foundation board member or trustee, and are wondering how to adapt your investment approach to an era of lower and less certain returns, we encourage you to contact us.
This is an executive summary of a presentation made in 2014 to the Foundation, Endowment & Not For Profit Investment Summit by Nexus Investment Management.
1. Canada Revenue Agency