Is Rochester missing out on $65 million annually?

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Of the top 20 employers in Monroe County, nine are nonprofit organizations employing 61,700 people in 2017. Compare that to the 38,200 jobs at the largest for-profit employers rounding out the top 20, and it is easy to see how important nonprofits are to our community.

We’ve enjoyed a rich legacy of philanthropy in Monroe County that has improved the lives of countless citizens. It is because of taxpayer dollars and generous donations that the nonprofit community has been able to do so much good. Yet, despite the good being done, there is evidence that even more could be accomplished.

Mark Armbruster

A recent paper by professors Sandeep Dahiya of Georgetown University and David Yermack of the NYU Stern School of Business shows that most nonprofit organizations nationally have not been great stewards of their investment assets. Specifically, the paper shows that across the country, “endowments badly underperform market benchmarks, with median annual returns 5.53 percentage points below a 60/40 mix of U.S. equity and Treasury bond indexes.”

This result is perhaps surprising, given how much positive press is devoted to the largest university endowments’ investment returns. For example, Yale University, under Chief Investment Officer David Swensen, is routinely cited for the strength of its investment program. However, Dahiya and Yermack found that higher education endowments perform the worst among all the nonprofit sectors when it comes to investment performance. 

Their paper relies on information from Form 990 that is filed with the IRS by each nonprofit. The authors downloaded bulk data using Amazon Web Services to conduct their analysis. In Part V of Schedule D in Form 990, nonprofits must disclose endowment fund balances at the beginning of the year, contributions, distributions, administrative expenses, and net investment earnings. This data then can be used to calculate annual rates of return. 

The authors note that industry-standard time-weighted rates of return and asset allocation are not available, but they believe their methodology, using data self-reported by each nonprofit, is a fair assessment of actual investment returns. The paper also conducts regression analysis using an industry-standard Fama-French-Carhart factor model to determine whether these nonprofits are generating true investment “alpha” or excess return compared with a benchmark. The conclusion, unfortunately, is that as a group those managing money for nonprofit organizations are significantly underperforming, and the results are statistically robust. 

The Rochester picture

So, what about the Rochester community? Do we differ from the national averages? After all, there are a lot of investment management firms in our area. Many of them are highly skilled and credentialed. Has that helped to generate better investment results? We set out to answer that question. 

My colleague Craig Julien and I followed the same methodology as the original paper. We downloaded Forms 990 for all the nonprofit organizations that file electronically in Monroe County. We then screened for organizations that have investment assets in excess of $500,000. We reviewed Part V of Schedule D, just like in the original study, and calculated investment performance the same way. To include more data points, we also searched for organizations that do not file electronically, but that have disclosed the requisite information. Finally, we conducted regression analysis using the same model as the original paper. 

We were able to get data going back to 2011. Not all of these organizations with investment assets over $500,000 filled out Part V of Schedule D, but each year between 25 and 73 did report this information, and we were able to analyze their investment performance. The results: not good.

The average nonprofit endowment underperformed a simple benchmark consisting of 60 percent S&P 500 stock market index and 40 percent Bloomberg Barclays Aggregate bond index by 3.2 percentage points annually. On an asset-weighted basis, the results were slightly better, with an annual performance deficit of 1.9 percentage points. This implies that the largest organizations outperformed the smallest, but even the largest organizations generally failed to meet the returns of the benchmark. The total investment assets of all the organizations we studied totaled $3.4 billion in 2017. The lion’s share of these assets was held by Rochester’s two large educational institutions: the University of Rochester and Rochester Institute of Technology. Excluding these two, the assets totaled $920 million. The average underperformance is effectively the same whether these two organizations are included or not.

As noted in the original study, this performance calculation methodology is different than an industry-standard time-weighted rate of return. However, we compared calculated performance versus actual, time-weighed performance for organizations that are clients of ours, and found the numbers to be very close, suggesting the approach used in the original study is indeed valid. 

Over longer periods, the numbers do not improve. In any one year, the success rate of a nonprofit meeting or exceeding its benchmark return was 25 percent. However, when we reviewed rolling three-year periods, the odds declined to 5 percent. No organization outperformed over the entire period studied. Our regression analysis confirmed negative alpha that was statistically significant over all periods.

While Rochester’s nonprofits did perform better than the national average, they still left significant sums on the table. Applying the asset-weighted underperformance to the total asset base, we find that by merely meeting benchmark returns, the Rochester community could see an additional $65 million of nonprofit asset gains annually. This just includes the organizations that we have data for, so the actual number is probably even greater. 

If you assume the average spending policy of Rochester’s nonprofit organizations is 5 percent, up to 38 percent more could be spent annually in support of charitable causes if money was not lost to subpar investment performance.

Why is this occurring?  

One valid reason is that U.S. large-capitalization stocks have generally outperformed smaller-cap and international stocks over the period studied. The S&P 500 rose 13.8 percent annualized from 2011 to 2017, while a more diversified portfolio with 25 percent each in small-cap and international stocks gained only 11.9 percent. Most nonprofit organizations have more diversified investment portfolios, which have allocations to small-cap and international stocks. 

However, the performance difference between a large-cap and a more diversified stock portfolio accounts for only about a third of the average underperformance by nonprofit organizations. 

The rest is likely because of avoidable actions taken by investment committees and investment managers. Unfortunately, these issues are not unique to Rochester. A study by professors Tim Jenkinson, Howard Jones and Jose Vicente Martinez, published in the Journal of Finance in 2015 found “no evidence that (institutional investment consultants’) recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless.” A research monograph written by Rochester native Scott Stewart for the Research Foundation of the CFA Institute in 2013 noted data that investment managers hired by investment committees tend to subsequently underperform investment managers fired by investment committees. 

Thus, decisions made by investment committees can act counter to long-term value creation. One reason might be that investment committees, particularly for smaller organizations, often are not filled with investment professionals. It is tough to attract and retain enough skilled investors to fill out committee and/or management roles. Thus, the nuances of how to optimally build and manage a long-term, institutional investment portfolio may be missed. 

Another reason might be that investment committees feel compelled to take action. When even a very good investment manager is underperforming over a relatively short time period, investment committees often feel compelled to address the situation in order to uphold their fiduciary obligations. However, they need to be very careful that they aren’t making a change at the wrong time, as Stewart’s research warns against. 

That isn’t to say that investment committees are solely responsible for the underperformance of local institutional portfolios. There is a mountain of academic and empirical evidence that investment managers generally underperform their benchmarks. From stock pickers and mutual funds to separate accounts, study after study shows that only a small minority of professionals are able to outperform “the market.” It is certainly likely that manager underperformance accounts for a good deal of the lost opportunity in Rochester. 

Breaking the cycle of underperformance

How do we, as a community, break out of this cycle of underperformance? Rochester could certainly use an additional $65 million of annual spending on charitable causes. 

One approach would be to index the portfolios so that they have no real chance of underperformance. The benefits of low-cost, index-based investing have been well known for decades. It certainly seems that meeting a basic, naïve benchmark such as 60 percent stocks and 40 percent bonds should be achievable, and perhaps even a default option. Implementing such a strategy with two mutual funds from Vanguard would be simple. It also wouldn’t require the use of an investment manager that charges excessive fees that detract from returns.  

Perhaps doing away with both investment managers and investment committees would help, since both entities are complicit in the loss of performance. The Carver Model of board governance advocates for the board to set policy and let management and staff carry out the mandates. This eliminates the board or a committee of the board overstepping into operational roles. With respect to investment portfolios, this might mean that the board writes the investment policy statement that stipulates spending, asset allocation, performance objectives, and risk constraints. This document would be delivered to management, and the CEO, chief financial officer, and finance staff would be responsible for implementation. 

Recognizing that these are fairly drastic and, in many cases, unreasonable steps to take, a more moderate approach would be for management and investment committees to focus less on historical performance and more on the long-term drivers of investment returns. 

Periodically testing asset allocation scenarios to ensure the organization is on track to earn returns that will allow it to meet its spending objectives and maintain purchasing power is an important step that is often overlooked. Considering the impact and expected returns of not just stocks and bonds, but also alternative investments, could help increase average returns and reduce annualized volatility. 

Investment costs are the largest detractor of returns. Examining not just management costs, but also implicit costs in the investment process, could help identify areas for improvement. Are you paying more than it would cost for a simple indexed portfolio? Are you likely to generate additional performance because of that? History suggests otherwise, so fiduciaries should consider this in great depth and demand evidence that their manager’s approach is likely to meet expectations. 

Maintaining a long-term focus and not chasing performance are critical. Too often investors of all stripes, including investment committees, react to short-term market fluctuations or historical performance (both good and bad). Remember, the investment horizon for most nonprofits is infinite, so short-term considerations shouldn’t upend a solid long-term plan. 

The usual approach of meeting periodically to review performance, and hiring and firing managers based on performance, has not worked, and it is costing our community tens of millions of dollars every year. A new way of thinking should be adopted to help ensure the odds aren’t stacked against us. Rochester needs every advantage it can get. 

Mark Armbruster is president of Armbruster Capital Management Inc., a registered-investment adviser in Rochester, with $400 million in assets under management. He has given numerous talks on exchange-traded funds, alternative investments, and other financial topics to groups of professional investors and students around the country.

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