Yet, little is known about which NPOs have endowment funds and how they invest. A new paper by MIT Sloan School of Management Prof. Andrew W. Lo and Visiting Prof. Egor Matveyev sheds light on the “black box of endowments,” revealing that bigger funds and NPOs with stricter governance generate higher returns.

“Endowments are usually thought of as rainy-day funds for NPOs to help them survive crises like the COVID-19 pandemic when financial markets are under distress and donations decline,” says Lo. “NPOs are a big part of our economy, and we wanted to see whether their investment policies were achieving their intended goals.”

Matveyev notes, “NPOs employ 21 million people, pay around $830 billion in wages a year, and have $4.9 trillion in assets. While endowment research has been conducted for 50 years, little is known about what NPOs do with their endowment funds and how they invest. We opened the black box of endowments to analyze investments across the entire sector.”

The researchers looked at the tax returns of over 300,000 NPOs from 2009-2017 to better understand the nonprofit investment landscape. They found one in nine NPOs (11.2%) manage endowment funds – and that the size of the fund significantly correlates with investment returns.

Their data showed that bigger funds outperform smaller funds. This trend is pervasive across every year and all nonprofit sectors, with endowment funds worth more than $100 million earning average returns of 7.6% a year compared to endowments under $1 million, which earn average returns of 3.8%.

The difference, they note, is mostly due to portfolio allocations. Larger endowments invest in riskier and higher-yielding assets compared to more conservative investments by smaller endowments.

“Endowments in NPO sectors devoted to public and societal benefit, the environment, and the arts are among the top performers. High returns among higher education endowments are explained by size, while hospital endowments significantly underperform,” they write.

In addition to size, the study shows a correlation between governance structures and returns. Matveyev explains that organizations with independent boards have higher returns on their endowments. More specifically, the more NPOs pay officers and directors, the better their returns. This trend correlates to CEO pay as well. NPOs that pay their CEO more compared to officers and directors have better returns.

In contrast, he notes that spending on administrative and travel expenses negatively correlates to returns. The more organizations spend on those expenses, the worse the performance of the endowment.

“These findings help tell a larger story. Bigger funds outperform smaller funds, perhaps due to better access to professional management and better governance,” says Matveyev. “There may be less policing in smaller organizations, leading to wasteful spending.”

The researchers found that investment management fees also affect endowment returns, with higher advisory fees linked to lower returns. The study showed that a one percent increase in fees resulted in a .17 percent decline in net returns. However, NPOs that do not hire advisors at all perform even worse.

Based on this analysis, NPOs should look at their endowments to compare their earnings with the averages, says Lo. “Smaller endowments may want to consider hiring a low-fee investment advisor and investing in better governance.”

Matveyev adds, “This is the first time that a study has shed light on the asset allocation choices and investment returns of NPOs’ endowment funds. These funds are critical to help NPOs survive crises like the COVID-19 pandemic and it’s important to understand their investing behavior.”

Matveyev and Lo are coauthors of “The risk, reward, and asset allocation of nonprofit endowment funds,” along with Stefan Zeume of UIUC.