The investment objective of an endowment may vary depending on the overall mission of the organization, but the underlying goal is typically the same: to grow the endowment at least fast enough to maintain or increase distributions while keeping up with inflation. This is much easier said than done. Prior to the global financial crisis, endowments had a reputation for being consistent outperformers with unparalleled investment prowess. Since then, many endowments have found stellar outperformance to be elusive. Indeed, a deeper dive into the data suggests that many of the more sophisticated (and costly) strategies have struggled in recent years. We will discuss the implications of this on portfolio returns and share our outlook for alternative investments later in this paper.

We base our analysis on the NACUBO-TIAA Study of Endowments® (NTSE), a joint research project of the National Association of College and University Business Officers (NACUBO) and TIAA. The 2019 study included 774 institutions, representing $630.5 billion in endowment assets. One of the benefits of the study is that repeat participation is high, allowing for better and more informative year-over-year comparisons. The latest data cover the 2019 fiscal year, which ran from July 1, 2018 through June 30, 2019.

Here we expand the analysis we provided in the March 2020 report, Endowments and Foundations: 2019 in Review, which was based on preliminary information from the executive summary of the 2019 NTSE. This commentary will cover some of the same information while adding further insights gleaned from the complete NTSE study.

Fiscal 2019 Results

The complete 2019 NTSE study revealed several ongoing trends among the endowments of higher education institutions. New information available from the full report in this section includes:

  • relatively high long-term investment objectives;
  • little change in fund flows; and
  • the rise of social restrictions for investing.

Long-Term Investment Objectives

The purpose of an endowment is typically to support a distribution for a specific purpose, such as academic institutions. Survey respondents cited student financial aid as the greatest purpose of these distributions (49%), with academic programs (17%), endowment faculty positions (11%), operation and maintenance of campus facilities (7%), and “all other purposes” (16%) as the other choices. The investment policy statement or other policies governing the investment program will typically describe the methodology for determining the spending rate/amount in a given year. This process, in turn, helps to determine an investment objective that accounts for the distribution, inflation, and overhead costs without impairing the principal of the assets. In the fiscal 2019 report, the average and median return objective for all responding institutions was 7.0% and 7.2%, respectively. Chart 1 shows the distribution of these return objectives by size. Perhaps most surprising is the large portion of the respondents (27.4%) who did not have a return objective, which we believe is contrary to investment program best practices.

Chart 1: Investment Return Objective by Size Cohort


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While the objectives of these investment programs have remained high, the last decade has not been kind to the average institution, with many struggling to meet their goals. In fact, fiscal 2019 marked the first year in over a decade that the 10-year annualized return exceeded long-term return objectives (orange line in Chart 2). Because the average 10-year investment return has consistently fallen short of the long-term objective, there is an increased focus on generating inflows of gifts to maintain purchasing power, which is not a sustainable strategy in our opinion. Chart 2 shows the deficit spread between target and realized returns averaging 1.4% over this time period.

Chart 2: Average Return versus Long-Term Return Objectives


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Fund Flows

Endowment spending rates moderated year over year, perhaps in response to the low-return environment. The average annual effective spending rate remained steady at 4.5%, largely in line with the 10-year average of 4.40%. Most of the endowment size cohorts posted a moderate increase in their average spending rate of 0.1-0.2%; one notable exception was the smallest cohort posting a moderate decrease of 0.2% year over year in its average effective spending rate. Not surprisingly, effective spending rates are positively correlated with endowment size: the largest endowments generally have the largest spending rates. In Chart 3, we show average annual effective spending rates by size cohort relative to the average percentage of the operating budget funded by the endowment. This might help explain why larger institutions, which tend to fund more of their operating budgets from their endowments than smaller institutions, average a higher overall effective spending rate than the smaller cohorts.

Chart 3. Effective Spending Rates versus Percentage of Operating Budget


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There should be a strong negative correlation between the aggregate portfolio risk profile of the endowment and the degree to which the operating budget is dependent on distributions from the endowment. As a general example, institutions for which the distribution is a low percentage of the operating budget might be able to take more equity risk, thus increasing sensitivity to a downturn; on the other hand, an institution for which the distribution is a high percentage of the operating budget might need to take less equity risk to reduce the likelihood of forcing large cuts in the operating budget during a major downturn in the market.

There have been calls in the institutional investment industry over the last few years to reduce distribution rates where possible in light of muted future return expectations. This year’s NACUBO report included information on institutions’ plans regarding the direction of their spending policy over the next two to three years. Approximately 75% planned to maintain their current policy, while 11.5% planned a decrease and 3.7% planned an increase (9.8% of respondents chose not to answer).

While spending rates remained fairly steady on a year-over-year basis, spending in dollar terms was less steady in fiscal 2019. Indeed, 33.2% of institutions reported distributing more dollars (a median increase of 9.4%) and 46.3% reported distributing fewer dollars (a median decrease of 4.9%). It is difficult to tell from the data if this is a result of spending rule-related calculations or a disparity in returns, but it is worth noting that 74.3% of endowments report using a moving average spending rule to calculate spending rates. While this usually tempers immediate spending in a downturn, it can also result in steady increases over a period of positive market returns.

Responsible Investing

This year marked another increase in the data available around responsible investing compared to previous NTSE studies. As an example, 195 of the survey participants responded to a question asking what responsible investing strategies they have implemented. Answers included (multiple responses allowed):

  • joined environment, social, and governance (ESG) network (14%);
  • appointed chief sustainability officer (6%);
  • implemented a [responsible investing] proxy voting committee (8%);
  • ESG in investment policy (56%); and
  • offered ESG (16%).

At the same time, a small subset of endowments report intentionally disavowing ESG considerations. This year, 16% of institutions said their board voted specifically to exclude any responsible investing considerations because of “potential conflicts with mission’s fiduciary duty,” rising 8% above its fiscal 2018 level. We think this decision may be misguided and more so due to a lack of proper education and guidance around ESG portfolio integration than an immediate performance tradeoff. Nevertheless, each organization’s approach is likely to be different and nuanced, so we would prefer to review on a case-by-case basis rather than make broad generalizations.

Despite these trends, we believe more endowments will implement some type of ESG or responsible investing overlay in the coming years, given growing social reform and environmental awareness among investors and donors.

Performance by Endowment Size

Based on data compiled over the past few years, the primary differentiating factor in performance among endowments has been size. On average, large endowments, those with assets exceeding $1 billion, historically have outperformed smaller endowments, namely those with less than $500 million in assets. These largest endowments, which account for about 14% of all endowments by number and about 78% of total endowment dollar value tracked in the NTSE report, typically attract the most headlines and scrutiny, resulting in several misconceptions about overall endowment performance.

In general, this year’s returns were positively correlated with endowment size, with the larger endowments outperforming the smaller ones. However, the difference in overall performance was significantly narrower than in recent years. The gap between net returns of the largest endowments in the study (5.9% for endowments with more than $1 billion in assets) and the smallest in the study (5.8% for endowments with less than $25 million in assets) was just 0.1 percentage point (Chart 4). This compares to the 2.1 percentage-point gap seen last year. It is worth noting that the lowest performing endowments, those with asset size between $50 and $100 million, generated a return of about 100 basis points below the largest endowments, with a reported 4.9% return.

Chart 4: Average Net Investment Return


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While one-year performance is not insignificant, in our view, most endowment managers use a longer-term view for planning purposes. While the performance was relatively flat across size cohorts on a one-year basis, the largest endowments remain the best performing cohort over longer investment periods. The relative outperformance increases as the investment period is extended: The 3-year spread between the largest cohort and the smallest cohort is 1.3 percentage points, the 5-year return spread is 0.6 percentage point, and the 10-year spread is 1.3 percentage points.

Over each of the timeframes, the best performing cohort was the largest, with an average return of 9.6%, 6.1%, and 9.0% over 3, 5, and 10 years, respectively. Similar to the prior fiscal year reported, there was little correlation this year between size and return on a 1-year basis. Indeed, the smallest endowments were not the worst performing; instead, the medium-sized endowments (those with $25-500 million in assets) were the worst. This U-shaped return curve seen in the past few years, where the largest and smallest endowments on average outperformed mid-sized ones, appeared in the 1-year and 5-year return series; however, the 3-year and 10-year returns showed a linear trend between larger size and larger returns.

Asset Allocation by Endowment Size

A more granular look helps decipher how endowments have adjusted their asset allocations based on size. Only firms with assets in excess of $1 billion have an above-average allocation to alternatives on a dollar-weighted basis; on an equal-weighted basis, the $251 to $500 million and $501 million to $1 billion cohorts also have an above average allocation to alternatives. The smaller the endowment, the more traditional the asset allocation tends to be; that is, there is greater emphasis on public equities and fixed income investments with less exposure to alternative strategies (Chart 5).

Chart 5: Asset Allocation by Endowment Size


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With alternative asset classes logging the best performance in the study results for fiscal 2019 (led by venture capital and private equity with an average return of 13.4% and 10.2%, respectively), it seems logical to us that the largest institutions, which have the greatest exposure to alternative asset classes, outperformed the smaller cohorts, with their lower exposures to alternative asset classes. Conversely, international equities were cited as a drag on performance in fiscal 2019, causing those portfolios with higher exposures to underperform relative to their peers. This was seen in the one-year performance of institutions in the middle size cohorts ($50 million to $1 billion) that had the greatest exposure to the “dedicated non-US equities” and “global equities” asset class categories in the report.

Insight into Fiscal 2020

With fiscal 2020 ended on June 30 (recall that fiscal years for most respondents in the study, higher education institutions, run from July 1 through June 30), it may be possible to glean a few insights into how these endowment portfolios are likely to fare in the next study.

As we have noted, those endowments that had the greatest exposure to equities (both domestic and international) benefited the most over the past few years. Despite a volatile first and second quarter in 2020, the S&P 500® finished with a total return of 6.69% from July 1, 2019, to June 30, 2020. This is down a little over three percentage points from the previous year’s comparable period.

Domestic equity returns for fiscal 2020 were challenged by a downturn in March 2020 following the global pandemic and resulting stay-at-home orders. With that said, investment programs that rebalanced equity allocations at quarter end would have potentially benefited from the historic performance of domestic equities in second-quarter 2020. Looking forward, however, domestic equities are becoming priced to perfection. Put another way, markets are pricing in a V-shaped recovery from the global pandemic. We are skeptical of this outcome, and point to PNC Economics forecasting that US GDP does not return to 2019 levels until 2022.

Following a lackluster performance of -0.4% in fiscal 2019, the MSCI World ex USA Index finished fiscal 2020 down 4.7%. Going forward, we believe developed market equities look promising as the COVID-19 case curves are well ahead of the United States. For example, most of Europe is already in the recovery phase of the “first wave” of cases, and some Asian countries are experiencing a smaller “second wave” pop up; meanwhile, the United States is still challenged with daily new cases near an all-time high as of mid-July. We largely expect the path of the virus will have a meaningful impact on global equity performance.

Similarly, alternatives are also posting weaker returns compared to previous years. The HFRI Fund of Funds Composite Index, a proxy for hedge fund investments, is down 3.1% from May 1, 2019, through April 30, 2020 (the most recent data point available as of this writing), which is down from last year’s -0.9% over the time frame. Within the composite, the HFRI Macro Total Index had strong performance of +2.4% over the period while the HFRI Event-Driven Index lagged on performance of -7.5%.

Though official performance data are not generally immediately available for private equity and real estate at the end of a calendar quarter, some trends did emerge. In private equity, we saw opportunities in new/less efficient markets and a more diverse investable opportunity set, for example, via secondaries and co-investment options and in middle-market buyout strategies. In private real estate, key drivers include a still relatively constrained supply backdrop, modest leverage levels, and the fact that capital flows into the asset class are becoming increasingly global (i.e., investor demand is quite robust). In private debt, middle-market lending in the corporate sector is still quite constrained, continuing to create opportunities for private debt investors. We continue to see investors rewarded with a substantial illiquidity premium for taking on unrated, smaller-sized loans.

In traditional fixed income, the Bloomberg Barclays U.S. Aggregate Bond Index returned 8.9% in fiscal

2020, marking a second consecutive year of strong returns (in this case, resulting from falling interest rates). Conversely, as equities faced a record decline into a bear market amidst unprecedented uncertainty over COVID-19, the Bloomberg Barclays Corporate High Yield Index fell nearly six percentage points year over year to return -0.2% across fiscal 2020. The Bloomberg Barclays Emerging Market Index, supported by improving economic growth expectations and a weakening dollar, returned a modest 2.7% in fiscal 2020.

Reevaluating Allocations and Strategies

Where Do We See the Capital Markets Going?

After a long period of record-low market volatility, the global pandemic and subsequent global shutdown/reopening have created historically high levels of volatility. Some of this is a function of a structural shift in the underlying fundamentals in combination with an acceleration of preexisting trends. That being said, the ultimate path of COVID-19 is largely going to determine the timeline for an economic recovery, in our view.

Looking forward, are long-term equity returns in the 11-13% range considered reasonable, or are 7-8% returns more appropriate? At one time, the higher range was considered a reasonable assumption, at least by historical standards. This is not the case today, in our view. We think there will be a cyclical shift lower in returns, largely a function of the following items:

  • the “start and stop” nature of the economy as COVID-19 case counts rise and reopenings pause;
  • the potential for a dramatic shift in consumer behavior — not only the level of consumer spending, but the manner in which it occurs (namely, a shift to e-commerce, supporting the largest firms that have the size and scale to adapt to rapid change in consumer behavior); and
  • a lack of capital investment activity.

The implications from these views have had a material impact on how we think about designing portfolios with regard to long-term strategic asset allocation positioning, as well as tactical guidance, risk-taking/mitigating exposures, shortfall risks, and so forth.

The key consideration is, of course, how long do investment returns remain “under pressure”? Are these changes cyclical (i.e., specific to the current environment) or more of a secular phenomenon (i.e., with lasting, long-term effects)? We used 30-year capital market assumptions for modeling purposes in this analysis to more closely resemble what we believe a typical endowment would likely experience over the course of multiple market cycles. Despite this, we do not see a materially improved returns backdrop over the next 10+ years either. This translates into a heightened concern, in our view, regarding potential shortfall risks (i.e., the risks that an endowments’ returns fail to meet the required spending policy) and the associated implications of having to play catch-up over the remainder of the horizon — a highly undesirable outcome.

Reconciling the Future Outlook with Investment

Program Objective(s)

Every endowment must balance multiple and sometimes conflicting goals, including meeting return objectives, limiting undue volatility, managing shortfall risk, and minimizing expenses. It is a tall order indeed, and some endowments appear to be managing these objectives better than others. Returning to the objective discussed in the very first sentence, that is, to grow the endowment at least fast enough to maintain or increase distributions while keeping up with inflation, the math implies a 7.12% return necessary to achieve the average effective spending rate from this year’s survey of 4.5% (Chart 6).

Chart 6: Calculating a Spending Rate


Source: PNC

View accessible version of this chart.

At a time when the expected return on traditional asset classes are likely to be below historical norms, it has become increasingly important to consider the role of alternatives in investment portfolios. When carefully selected, we believe alternatives have the potential to add incremental return in an otherwise low-return environment, in addition to improving the overall rise profile of portfolios through the diversification benefits offered by certain strategies. Specifically, alternative investments can be an effective means of diversifying risk and ultimately reducing overall portfolio volatility. Given the volatile path of the market over the last year, we believe it is especially important to key in on the diversification of risk and volatility mitigation that alternative investments can provide.

With regard to alternative investment performance over the last decade, it is important to remember that active management performance is highly cyclical and alternative investment strategies are the epitome of active management. In the recent market environment of high correlation and low dispersion, active management in general has struggled to deliver excess returns. Additionally, low interest rates and compression on the cost of capital have made it structurally more challenging for active managers this cycle to earn their fees.

Regardless, the use of alternative investments requires significant due diligence. Alternatives are often sought for diversification benefits, which could lead to better risk-adjusted returns. However, alternatives tend to be less liquid, charge higher fees, and can be subject to regulatory limitations. While we continue to believe that a reasonable allocation of alternatives can add value to the average endowment’s portfolio, we nevertheless suggest all endowments should perform extra due diligence when deciding on their allocations.

Key Takeaways

As we move toward the end of 2020, nonprofit organizations will likely need to continue to implement tactical plans to manage their finances through the current adverse conditions. To weather this storm and prepare for future economic slowdowns, organizations may need to find ways to balance maintaining solvency in the present with being financially viable in the future. We highly recommend that decision makers consider carefully the right allocation mix in order to meet their investment goals and objectives while balancing considerations for both short-term volatility and long-term shortfall risk.

With regard to the challenge of liquidity and alternative investments, the PNC Institutional Asset Management® (IAM) Investment Strategy team has performed extensive simulation analysis based on explicit modeling of the structural characteristics to account for their relatively illiquid characteristics (i.e., subscription/redemption periods and capital commitment/drawdown/distribution processes).

The analysis showed that with a combined targeted allocation of approximately 20-30% to alternatives, the portfolio is unlikely to experience either explicit liquidity problems or excessive drift in portfolio weights, provided a significant portion of the allocation is directed to funds which allow the investor reasonable control over the timing of investment and redemption (e.g., hedge funds, which tend to be relatively more liquid). However, the risk of such problems rises rapidly with larger allocations.

Additionally, we believe the traditional/balanced asset allocation approach (60% stock/40% bond) is not sufficient to address the specific challenges facing endowments regarding liquidity needs, spending levels, and fairly high required rates of return necessary to achieve these objectives. With this as the backdrop, the IAM Investment Strategy team has performed extensive analysis to design and develop customized asset allocation frameworks (including and excluding allocations to alternatives) specifically for endowments. Indeed, we think they are effective solutions capable of meeting or even exceeding a typical endowment’s long-run spending and return objectives with the potential to actually grow real wealth and distributions over a 30-year investment horizon.

For more information about our approach, please contact your PNC Investment Advisor.

Accessible Versions

Chart 1: Investment Return Objective by Size Cohort

  Less than 5.0% 5.0-5.9% 6.0-6.9% 7.0-7.9% 8.0-8.9% 9.0% and Over Do Not Have Return Objective No Answer
Total Institutions 1.60% 6.50% 11.40% 24.30% 13.30% 1.00% 27.40% 12.30%
Over $1 Billion 0.90% 2.80% 5.60% 16.80% 17.80% 1.90% 21.50% 26.20%
$501 Million-$1 Billion 0.00% 3.70% 11.00% 30.50% 13.40% 1.20% 32.90% 4.90%
$251-$500 Million 1.20% 10.50% 11.60% 29.10% 16.30% 0.00% 22.10% 7.00%
$101-250 Million 1.00% 5.70% 13.40% 29.90% 12.40% 0.50% 24.20% 10.80%
$51-$100 Million 2.60% 7.90% 14.50% 24.30% 11.80% 0.00% 29.60% 7.90%
$25-$50 Million 3.20% 3.20% 15.10% 17.20% 8.60% 3.20% 29.00% 19.40%
Under $25 Million 1.70% 15.00% 1.70% 15.00% 15.00% 1.70% 40.00% 10.00%

Chart 2: Average Return versus Long-Term Return Objectives

  10-Year Average Returns Average Long-Term Return Objectives
FY10 3.40% 7.70%
FY11 5.60% 7.70%
FY12 6.20% 7.40%
FY13 7.10% 7.40%
FY14 7.10% 7.40%
FY15 6.30% 7.30%
FY16 5.00% 7.10%
FY17 4.60% 7.00%
FY18 5.80% 7.20%
FY19 8.40% 7.00%

Chart 3. Effective Spending Rates versus Percentage of Operating Budget

  Average Annual Effective Spending Rates Average Percentage of Operating Budget Funded by Endowment
Total Institutions 4.50% 11.90%
Over $1 Billion 4.60% 19.30%
$501 Million-$1 Billion 4.40% 13.40%
$251-$500 Million 4.20% 13.80%
$101-250 Million 4.70% 9.40%
$51-$100 Million 4.60% 11.00%
$25-$50 Million 4.50% 11.40%
Under $25 Million 4.10% 6.00%

Chart 4: Average Net Investment Return 

  Smallest Endowments Average Largest Endowments
1 Year 5.80% 5.30% 5.90%
3 Years 8.30% 8.70% 9.60%
5 Years 5.50% 5.20% 6.10%
10 Years 7.70% 8.40% 9%

Chart 5: Asset Allocation by Endowment Size

  Equities Fixed Income Alternatives Real Assets Other
Average 35.2 11.7 39 12.3 1.7
Over $1 billion 31.3 10.1 43.2 13.5 0.8
$501 million-$1 billion 45.3 14.4 30.3 9.2 1 .8
$251-500 million 46.9 15.7 27.1 8.4 1.8
$101-250 million 53.2 19.5 18.1 7.1 2
$51-100 million 54.6 23.1 14.8 6 1.5
$25-50 million 57.7 26.5 10.1 4.6 1.1
Under $25 million 60.6 29.7 5.6 3.2 0.9

Chart 6: Calculating a Spending Rate

Spending Rule: 4.40% of Market Value → 1.0450

Inflation: 2% Over the Long Term → 1.0200

Fees/Overhead: 0.50% of Market Value → 1.0050

Return Objective: [(1.044)*(1.02)*(1.005)] – 1 = 7.1230%