Executive Summary
This white paper addresses a number of challenges that charitable foundations around the world, particularly in the United States, face regarding capital preservation over multiple generations. We found that over the last decade more charitable foundations chose an endowment approach to manage their portfolios to achieve a goal of sustainable philanthropy.
Introduction
Perpetual philanthropy is a noble goal and one that has been executed by many of the world’s most fabled and storied families; the Getty, Ford, Rockefeller, Wellcome and Carnegie families are notable examples. Endowment size and more importantly, impact, provided by such families through their foundations has endured for over a century while also expanding tremendously in scope and scale.
In 1981, the U.S. federal tax-code changed to allow foundations to distribute at least as much as they earned on their assets each year. Since then, foundation assets have greatly increased from $47.6 billion in 1981 to $865.2 billion in 2016, while foundations distributions have expanded dramatically as well; $60.2 billion was distributed to stakeholders in 2015—up more than three times since 2002, and six times more than in 1981 when federal legislation changed.
However, many foundations have not enjoyed the same such triumphs. Indeed, it takes strong discipline and a long-term view to support charitable giving in a sustainable manner.
An Endowment Approach for Sustainable Philanthropy
In developing an appropriate approach for sustainable philanthropy, it is crucial to;
Crystallize your philanthropic goals and mission; this is the core of philanthropic giving—giving a steady direction and stability to the foundation
Create a customized and appropriate structure. This component is critical to building a philanthropic organization with longevity that can weather through cycles.
Create a well thought out investment management program. This part, sometimes is overlooked, but is absolutely essential in order to continually achieve the first two criterions.
A Well-thought-out Investment Program is Critical for a Successful and Sustainable Philanthropic Endeavor
Benefactors of foundations should aim to create philanthropic foundations that can provide sustainable and altruistic services that will continue throughout ages. Looking at past performance, over a three-year period, all U.S. foundations must donate an annual average of 5% of their foundation assets in order to maintain their tax-exempt statuses. Thus to fulfill their philanthropic and legal goals, foundations must generate sufficient income to sustain their “giving” power. After taking into account the 50-year average annual inflation rate of 3.7%, to maintain the same impact from Year 1 to Year 100, the investment portfolio must generate 8.7% annualized returns. This is not necessarily an easy feat for long-term purchasing power preservation.
Real Buying Power of $1 billion with 5% Spending Policy (3.7% inflation rate)
This imposes added difficulty in the ability of the foundation to maintain and further its original mission and complete its goals. As such, important must be asked and resolved by benefactors in order to maintain the long-term purchasing power and foundation status of their organization. Thus, it advised to;
Coordinate your foundation’s investment objectives with its distribution policy,
Outline investment time horizon, risk tolerance, and asset allocation,
Address questions of outside investment managers,
U.S. Foundations by size
In order to maintain lasting giving power, foundations must adopt a sound investment program. This should (1) achieve appropriate diversification as a means for successful capital preservation and appreciation, and (2) focus on an investment program that takes into account the historical performance of key financial asset classes.
Historical Performance of Key Asset Classes
The asset allocation of major U.S. foundations generally varies, with more institutional foundations divested from more volatile single-name equity exposure that is often the root of the foundation’s wealth.
U.S. Largest Foundation Average Allocation
U.S. Largest Foundation Average Allocation
Case Study: Carnegie Corporation
The Secret to a Century of Philanthropy
Founded by steel magnate Andrew Carnegie in 1911, the Carnegie Corporation has existed for over a century. With a core ethos “to promote the advancement and diffusion of knowledge and understanding”, the organization is responsible for founding the National Research Council and Carnegie Endowment for International Peace and the Carnegie Institute for Science.
Seeking advice from long-time friend and legal adviser Elihu Root, a Nobel Peace Laureate, serial philanthropist Andrew Carnegie established a trust to which he could distribute the bulk of his wealth until and after his death. Having already used the conventional labels for his previously endowed institutions, he selected “Corporation” for this last and largest organization. This organization was chartered in the State of New York as the Carnegie Corporation of New York. Between 1911 and 1912, Carnegie bequeathed the Corporation with $125 million. The mandate of the foundation was to mainly benefit those in the United States, but Carnegie did reserve a similar portion for Canada and other British Colonies through the British Dominions and Colonies Fund (later becoming the Commonwealth Program and Special Fund).
In all, the Corporation was founded with $135 million (1911) which has thus grown to $3.3 billion (as of 2014) while giving away on average 5% of its assets every year with a higher target of 5.25% distribution annually.
Carnegie Foundation Inflation Adjusted Performance
Carnegie Foundation Summary
Allocation by Strategy
Key to the Carnegie Corporation’s success has been its steady diversification, including a gradual movement away from high direct equity exposure—particularly in response to the 2007-08 financial crisis.
Alternative Investments (%) in the Carnegie Foundation’s Endowment
In particular, alternative investment allocation has steadily increased to over half of the corporation’s endowment assets.
Manager Selection and Performance
One particular strength of the Corporation’s approach was its use of a policy known as “smoothing”. Smoothing entails targeting distributing at a specific percentage—not at an average market value. This policy, still in place today, uses an equally weighted, 12-quarter lagging average of the assets’ market value to calculate its 5.5% yearly spending target. During periods of extreme market dislocation, the Corporation may adjust its spending to preserve capital. In sum, “Smoothing” is designed to weather short-term market fluctuations to enable long-term predictability in grant-making.
Assets and Grant-Making: 3-Year Spending (% of Assets)
Growth and Spending
An appropriate organizational structure and investment management program are critical to the long-term survival of a philanthropic entity. From 2002 to 2014 Carnegie generated an annualized return of 9.4% and made $1.64 billion of grants without impeding its purchasing power. For lasting impact, foundations must adopt a sophisticated investment program with a diversified portfolio, including alternative investments managed by external managers.
Case Study: The Barnes Foundation
How a Strong and Stubborn Founder Can Endanger His Legacy
Not every foundation has had the same success as those established by Henry Ford, Andrew Carnegie and the Getty family. Some foundations have become more of side notes in history either from mismanagement or even, by the Founder’s wish. The 94 year-old Barnes Foundation is one near example.
The Barnes was established by the eccentric Dr. Albert C. Barnes (1872-1951) to “promote the advancement of education and the appreciation of the fine arts”. Barnes himself was born a poor Philadelphian, making his way through that city’s public schools and eventually graduated from the University of Pennsylvania’s Medical School. Taking his medical training and business savviness, Barnes found success with a German scientist, Hermann Hille, by developing a silver-based pharmaceutical product named Argyrol used for fighting eye infections. Through the sale of Argyrol, Barnes quickly became a wealthy man—his timing couldn’t have been better as his invention timed well with the onset of worst war the world had ever seen (WW1: 1914-1917). With his financial status secure, Barnes devoted most of his time to his true passion; the arts. As Barnes believed that he was not much of an artist, he collected notable works of French maestros and impressionists. As such, he amassed the world’s largest collection of Impressionist art outside of the Louvre. Barnes bought most of his paintings at pennies on the dollar while France was suffering from high post-War inflation and deep societal stagnation. Today, his collection is now valued at between $6 billion and $10 billion.
Governing the 700-piece collection was an indenture that Barnes created detailing the intended function, use and administration of the foundation. In particular, the Indenture outlined a severely limited investment policy for the Foundation’s endowment—including most critically, restrictions setting that the endowment could only be held in U.S. treasury bonds. Barnes, a strident New-Deal socialist and also having sold his business prior to the 1929 stock market crash, stipulated that the foundation could only invest in government bonds. Little did Barnes realize at the time that because of inflation, his no-equity mandate had decimated the purchasing power of his endowment and resultantly, put his collection at huge risk through financial neglect.
From the initial endowment in 1951 of $10 million, only $6 million existed in 2000. Only after the indenture was broken through a long and exhaustive court-process was the Barnes Foundation saved from total ruin through a bailout led by the fellow Philadelphia-based Pew Foundation.
Indeed, an inflation adjusted return of Barnes’ initial investment resulted in a colossal depreciation of -91.93% over 49 years[1]. Even worse still is that an opportunity cost calculation assuming a 10% return in the S&P 500 index and after deducing inflation adjusted museum expenses would give higher loss at -99.1%[2]. Barnes’ stubbornness formed from the depths of the Great Depression was indeed very expensive.
Barnes Foundation Endowment Performance (Smoothed)
What we can see here is the dangers of being too personalistic and too inflexible in one’s approach to philanthropy. Barnes’ approach, while it could be understood through his progressive social desires, almost destroyed his world-renown collection through neglect and mismanagement.
Case Study: Yale University
The Pioneer of the Endowment Approach
An endowment approach is a philosophical and commonsensical way of investing based on the method pioneered by David Swensen and Dean Takahashi at Yale University. Swensen did not attend Yale or an Ivy for that matter for his undergraduate degree. He originally obtained dual bachelors in arts and science in economics from the University of Wisconsin-River Falls in 1975. He went straight on to graduate school, this time at Yale, completing a doctorate in economics in 1980.
Taking his degree, Swensen spent six years first at Salomon Brothers then at Lehman Brothers—eventually being promoted to Senior Vice President. One of his career notables on the sell-side was his role engineering the first swap transaction between IBM and the World Bank that allowed the technology company to hedge its currency risk to Germany and Switzerland. Throughout this time, Swensen kept close to his alma-mater—teaching an undergraduate course one evening a week. Eventually the call back to Yale won out and instead of pursuing a much more lucrative career at a hedge fund, Swensen returned to his alma mater full-time and joined Yale’s investment office in 1985 at the age of 31. Despite the 80% pay-cut, Swensen was still concerned about his own qualifications to run the fund[3]. Nonetheless 30 years later, in turned out that he had no reason to be concerned about his abilities.
Swensen’s approach to investing has, put simply, transformed the management of endowments and institutions—moving away from traditional allocations in shares and fixed-income, and instead, into alternative investments such as hedge funds, private equity and real estate. This approach is perhaps second only in fame to the “value investing” model of Warren Buffett and is often simply called the “Yale model” or the “Endowment model”.
Change in Investment Syle
Yale has led the pack into allocations to alternatives
What Swensen’s model has shown is that a less liquid and less stable income portfolio can still serve its purpose, and ultimately, deliver superior returns. Take the case of the 2009 draw down, Yale was still able to outlay 3% of its endowment for the running of the university.
Annualized Return vs. Average Spending
Overall, the fund has enjoyed a 12.3% p.a. return vs. 4.6% average payout ratio since 1999. This payout ratio of close to 5% has remained remarkably consistent over time and steadily increased in response to Yale’s outsized performance and growing ambitions.
Long-term Outperformance
Yale: Growth and Spending
Concluding Comments
Overall, we can see that using an external manager driven approach characterized by the delegation of investment decisions to professionals in each asset class has been able to achieve longevity, strength and breadth of mission for foundations and non-profits. Although other investment strategies could potentially reap higher returns through increased risk and concentrations at certain times, no model is more effective in achieving high returns and ultimately high purchasing power over the long-term.
The Barnes Foundation has taught us the costs of going wrong; when endowments are not allowed to properly adapt or are too concentrated into one asset class, they will shrink and ultimately the foundation’s core mission will be critically compromised.
The Carnegie Corporation’s approach has shown that an endowment with a high payout ratio and high pressure to distribute as quickly as possible, has been able to exist for over a century.
Ultimately, a broad-based usage of external managers across asset classes—allocating like an endowment—consistently yields strong results without significant, long-term downsides.
Originally published in 2016-11
[1] Calculated using a 3.97% average inflation rate between 1951-2000.
[2] Source: Warren Buffett Wealth: Principles and Practical Methods Used by the World’s Greatest Investor. Miles, Robert (2004) 47
[3] “Lunch with the FT: David Swensen” Freeland, Chrystia. URL: https://www.ft.com/content/dd91a3ec-b461-11de-bec8-00144feab49a