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E-MailSandeep Dahiya is Associate Professor at Georgetown University and David Yermack is Albert Fingerhut Professor of Finance and Business Transformation and Chair of Department of Finance at New York University Stern School of Business. This post is based on their recent paper.
Endowment funds are repositories for gifts and operating surpluses generated by non-profit organizations. Often described by their parent organizations as “nest eggs” or “rainy day funds,” endowments invest in stocks, bonds, and alternative asset classes such as hedge funds and private equity, and they pay income to their parents to subsidize operating costs and capital expenditures. In recent decades, many endowments have grown rapidly due to an influx of gifts as well as riskier investment policies that have increased their returns. Probably the best-known example is Yale University, which in 2018 reported having grown to $29.4 billion with an annualized return of 11.8% per year over the prior 20 years. The exponential growth of Yale’s and other high-profile universities’ endowments has led to political scrutiny of the objective functions of their parent organizations and, as of 2018, a new 1.4% federal income tax on a portion of their profits. There is an old joke that describes Harvard as a “$37 billion hedge fund with a university attached.”
This fixation on university endowments has meant that up to now, nearly all research on endowments has focused on a small, self-selected sample of major research universities, using self-reported survey data from these organizations. Our paper, in contrast, focuses on the entire non-profit sector rather than a small number of university endowments.
While the non-profit endowment funds have grown into a $0.7 trillion institutional investor class in the U.S. economy, surprisingly little is known about the overall size, performance, and use of these endowments. The small number of papers on endowment returns have typically focused only on funds that support major universities. These studies all rely on self-reported information from voluntary samples that take no account of selection bias or survivorship bias. The best known study, Lerner, Schoar and Wang (2008), uses annual data from the National Association of College and University Business Officers (NACUBO) and studies an opt-in sample that increased from 533 schools in 1993 to 726 in 2005 (the NACUBO sample grew to 809 schools by 2017, the latest edition available today). The same source is used by Brown, Garlappi and Tiu (2007). Cejnek, Franz, Randl and Stoughton (2014) provide a literature review of the extensive academic and trade research into the university endowment sector, which seems to have crowded all other non-profit endowment research to the sidelines.
Our paper presents a comprehensive survey of endowment returns and distribution policies for the period 2009-2016 in all U.S. non-profit sectors. We use data provided by non-profit organizations in annual Form 990 filings with the Internal Revenue Service (IRS), and our download of these filings yields a sample of 167,675 annual endowment observations reported by 28,696 organizations in all non-profit sectors. To our knowledge, the only other paper to use this IRS data to date is Yermack’s (2017) study of a much smaller sample of 120 major art museums. Within the universe of non-profits, colleges and universities account for 6% of the observations and 54% of the assets, and one of our conclusions is that they are not particularly representative. In our study, the subclass of higher education institutions significantly under-performs the community of other non-profit endowments that support organizations in diverse areas such as the arts, human services, health care, and religion, among others, and the disappointing returns reported by educational institutions to the IRS appear to belie those touted in commercial surveys that have made their way into the press and academic papers.
Overall the funds in our study earn negative abnormal investment returns. The median annual investment return for endowments is 3.75% between 2009 and 2016. Weighting our observations by the time periods in which they occur, the benchmark returns on ten-year Treasury bonds are 4.89% per year and the equity market index returns 12.21% per year over the same measurement periods. In other words, the typical endowment fund under-performs a 60-40 combination of the equity and Treasury bond market indexes by about 5.53 percentage points annually. When we employ a more sophisticated model that adjusts for risk (the standard Fama-French-Carhart four factor model) we estimate that the non-profit endowments on average have an alpha of -1.01%. The largest endowments (with endowment assets greater than $100 million) generate the worst performance. These poor investment results largely agree with those for other investor classes, which typically exhibit zero or negative alpha estimates in standard performance measurement models.
We also study the distribution policies of non-profit endowments to their parent organizations, which resemble the shareholder dividend policies that are an important research topic in corporate finance. We find that most endowments have conservative distribution policies that imply payouts below their long-run expected returns, and well below the actual returns realized during the sample period for our study. For example, while the median endowment return is 3.75%, the median distribution is only 2.37%. These cautious distribution policies would tend to cause endowments to grow without limit over time. The smallest endowment funds make no payouts at all in most years, implying that organizations seek to grow them to a critical mass before using them as a permanent funding source. For the very largest endowments, those with asset values above $100 million, distributions occur almost every year, with mean and median distribution rates near 4.5%, which appears to have become a heuristic that enjoys wide acceptance in the non-profit sector without theoretical justification.
Finally, we examine if (and how big) a role the endowment performance plays in future donations to the parent organization. In other words, do donors respond to successful years in which funds earn strong investment returns? Our results indicate a modest but significant positive relationship between investment performance and the willingness of donors to contribute in future periods. If a fund out-performs the equity market benchmark by 10%, for instance, donations would grow by about 1.3% in the following year, all else equal. These results parallel those found in other “flow-to-performance” studies in the asset management industry that document increased inflows of management fee income after years in which a money manager outperforms market benchmarks.
The complete paper is available for download here.
