Non-Profits: Why Chasing Returns May Jeopardize Your Mission

Is your non-profit endowment overexposed?

In recent years, non-profit endowments have increasingly invested heavily in equities and other growth assets, favoring the possibility of high returns over mitigating their risk of loss. The reasoning makes sense on the surface: endowments are designed to exist in perpetuity, and the market has always gone up over time, so why worry about the short-term risk inherent in equities? The main problem with this approach is that endowments have short-term spending requirements that often remain constant regardless of market movements, and, secondly, the negative consequences of compounding can have far-reaching consequences for long-term investors.

Spending from a depressed portfolio is costly.

When the value of your portfolio decreases, you need to sell more of it in percentage terms to meet the same spending requirements. Selling off risk assets while their value is depressed can do serious damage to an endowment’s portfolio—especially if the market stays down for an extended period and spending continues to eat away at your portfolio. To guard against this risk, a portfolio should be not just robust but antifragile. This means including investments that are designed to increase in value as markets decline.

Market declines often trigger a cascade of challenges.

When endowment portfolios decline in value, it typically doesn’t happen in a vacuum. As a market downturn causes the value of your endowment’s portfolio to drop, it has a similar effect on the assets of donors, undermining their ability to give and support your institution. For educational institutions, this means tuition-paying families have less spending power, and the need for loans and scholarships rises. This places further stress on the endowment as it struggles to meet steady, or perhaps even steeply rising, costs with dwindling resources.

Endowments are intended to protect institutions from this type of perfect storm, but they can’t do so effectively if their spending is limited due to a depressed portfolio. Cutting spending too deeply will inevitably inhibit an institution’s ability to deliver a quality educational experience, which could then negatively impact enrollment.

To adequately protect your institution’s endowment, it’s critical to not only limit spending but also limit portfolio losses in adverse markets. Thus, endowments should carefully consider whether their current investment model can properly carry them through sustained economic turbulence or if they should pursue an alternate strategy. It may be prudent to build a portfolio with a greater concentration of uncorrelated, diversified assets designed to provide more stable and predictable return streams.

Endowments aren’t in competition with each other.

Non-profit boards and staff alike often compare their institution’s endowment performance to their peers, so it can be tempting to pursue an investment strategy that prioritizes out-earning their rivals. Unfortunately, this ignores the fact that even institutions that are considered peers differ greatly with regard to their needs and goals. Thus, peer competition may lead non-profits to pursue an endowment strategy that incorporates larger, and potentially unnecessary, allocations to risk assets that can jeopardize the health and even the existence of these institutions.

Prudent investment management is essential.

Recent market behavior has illustrated for many endowments the real risk that an excessive reliance on equities and other highly correlated risk assets poses to their institutions. In this harsh light, it’s become clear that prudent investment management is imperative. An outsourced chief investment officer (OCIO) can help non-profit institutions create healthy, robust, and all-weather portfolios that support their missions. Working as fiduciaries dedicated to the success of their client entities, OCIOs allocate assets, manage risk, develop long-term strategies, and generally serve the functions that a CIO would perform. To learn more, check out Verger’s approach to non-profit investment management or browse our blog.