The Gifts That Keep On Giving
Why smart investment policy is critical to healthy philanthropy.
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Does the world's largest philanthropic foundation suffer from the same investing affliction that cripples many mere financial mortals—"myopic loss aversion"? Or is there another explanation for why the $32 billion Bill and Melinda Gates Foundation invests its massive endowment so conservatively that it might lose value and influence in future years?
Given the brains behind the curtain, Bill and Melinda Gates and their financial adviser, Michael Larson, one suspects that there is method to the overconservative madness—a foundation portfolio composed of 72 percent bonds and cash and 28 percent stocks (at Dec. 31, 2005), with a target rate of return of only 5 percent. Before we tackle that mystery, though, we should review why smart investment policy is so critical to the long-term health of philanthropic organizations, and how other major foundations approach the challenge.
The primary investment goal of most foundations is to earn a rate of return sufficient to maintain the value of their endowments (and grant-making capacity) in perpetuity—after adjusting for the cost of annual disbursements, expenses, and inflation. Achieving this goal has allowed the Carnegie Corporation, the Rockefeller Foundation, and other mainstays of philanthropy to remain important for almost a century, so much so that they now grant more dollars each year than their founders originally donated 90-odd years ago. Like university endowments, foundations have the luxury and responsibility of investing for the truly long-term. If Carnegie and Rockefeller had not earned a rate of return on their endowments well in excess of the Gates Foundation's current target, their annual grant-making would have long since ceased to be meaningful. The same can be said for Kellogg, Mellon, Ford, and other private foundations.
How much do grants, expenses, and inflation consume of philanthropic endowments each year? To maintain their nearly tax-exempt status, foundations must disburse at least 5 percent of their endowments annually, and most disburse slightly more than this. Inflation usually gobbles about 3 percent of the remaining value every year, and operating expenses (e.g., salaries for the folks who figure out to whom to give the money) eat another percent or 2. Together, grants, inflation, and expenses cause the value of most endowments to shrink by at least 9 percent to 10 percent each year (before new donations and investment returns). To offset this, the foundations need to generate at least that much in investment returns or new donations.
Keeping pace with these outflows is more difficult than it sounds, and not all foundations manage to do it. In recent years, for example, the Ford Foundation has granted and spent more than it has earned, and the fund has not yet recovered the value it lost in the horrific investment environment of the 1970s. Because foundations make grants every year, they cannot simply plunk their endowments into highly volatile investments designed to deliver strong returns over the long term; instead they must strike a balance between returns and stability. Foundations that have their endowments concentrated in a single risky investment or asset class—such as the Kellogg Foundation (Kellogg & Co. stock accounts for two-thirds of the endowment), the Lilly Foundation (Eli Lilly & Co.), and, arguably, Gates—sometimes have to reduce their grant-making in years in which the value of their endowments fluctuates. Most foundations, therefore, have a secondary investment goal, which is to generate meaningful returns with the lowest possible volatility.
The remedy for both of these hazards—poor returns and high volatility—is twofold. First, a foundation's endowments should have a strong equity orientation—an emphasis on public stocks, private equity, "real" assets (real estate, timber, energy), and other investments likely to outperform inflation over the long term. And, second, it should be broadly diversified, across asset classes, geographies, investment styles, and time horizons. If a foundation's only goal were to avoid volatility, a heavy concentration in bonds and cash (a la the Gates Foundation) would make sense. But this allocation would be extremely unlikely to maintain a constant inflation-adjusted endowment value over the long term.
How important will investment returns be to the Gates Foundation? In the absence of new donations, very. If the Gates Foundation earns a 5 percent return—the current target—the foundation's grant-making capacity will likely shrink considerably in future years. Assuming annual disbursements of 5 percent, expenses of 1 percent, and inflation of 3 percent, the foundation's annual grant-making capacity would fall from about $1.6 billion this year to about $600 million in 25 years, $200 million in 50, and $75 million in 75 (in current dollars). (To put the vastness of Bill Gates' generosity in perspective, however, it bears noting that at this rate of return, in three-quarters of a century the Gates Foundation would still be disbursing almost as much each year as the Carnegie and Rockefeller foundations do now.)
So, why have Bill and Melinda Gates chosen to invest the endowment in such a fashion? The first possibility is that they know something we don't—that the world's equity markets are about to crash. Although stock valuations are indeed high and crashes are always a possibility, attempted market-timing is a low-probability game, and it would be a very myopic strategy for a foundation whose investment horizon should be measured in centuries, not months. The second possibility is that the Gateses simply want to set a low target hurdle so the foundation's returns always "exceed expectations." This explanation, too, seems unlikely, though the endowment has indeed exceeded the 5 percent target in recent years.
So, what's the real reason? It probably has to do with the new donations that the Gates Foundation expects to receive—to the tune of another $30 billion to $40 billion or so from Bill and Melinda and another $30 billion or so from Warren Buffett. The exact timing and value of the gifts are not known, but their asset composition is: A big chunk of Gates' future donation is invested in Microsoft stock, and all of Buffett's is in Berkshire Hathaway. Although these equity positions could benefit from additional diversification, especially greater international exposure, they radically change the overall asset allocation picture of the future Gates endowment.
If one assumes that the future endowment can be roughly divided into three parts—the current $32 billion (about one-third stock), the expected $30-odd billion from the Gateses, and the expected $30 billion from Buffett—the endowment's allocation increases to about two-thirds equities, one-third fixed income. This investment mix, those who benefit from Gates Foundation grants will be glad to hear, is wiser and more appropriate for this kind of organization than the endowment's current allocation. And it's far more likely to maintain the foundation's grant-making power over the long term.