US foundations reported an average annual return of 13.7 per cent in the last fiscal year, up from 7.9 per cent in fiscal year 2005, helped by strong equity markets and an increase in alternative investments, according to a report.
The study, by Commonfund Institute, which provides investment information to the non-profit community, found that average returns ranged from 15.6 per cent for the largest institutions – those with $1bn or more in endowment assets – to 12.4 per cent for the smallest – those with assets between $51m and $100m.
Foundations use endowments to fund their operating expenses; the health and size of an endowment is an indicator of an institution's long-term financial stability.
The benchmark leaders – those foundations which report the highest average returns – reported average annual returns of 18.5 per cent for the top decile and 17.1 per cent for the top quartile. Average three-year and five-year returns for all institutions were 11.3 per cent and 9 per cent, respectively.
John Griswold, executive director of the Commonfund Institute, said the improved investment performance was mainly due to “more favourable market conditions” as well as the “continuing increases in allocations to international equities and alternative investments”.
Historically, most endowments devoted the lion’s share of their assets to fixed income and cash to provide shelter from market downturns. But in recent years, endowments have moved away from traditional asset classes, instead investing in asset classes once considered esoteric, such as hedge funds and private equity.
According to the survey, which is carrried out annually, average domestic equities allocations continued to decline to 33 per cent in fiscal year 2006, compared with 36 per cent the previous year.
Meanwhile, average fixed income allocations declined to 16 per cent in 2006 versus 18 per cent in the year before.
Alternative strategies increased to 23 per cent versus 21 per cent, and international equities rose to 20 per cent versus 18 per cent. Foundations by and large reported that they expect to increase allocations to international equity and alternative strategies, and to decrease allocations to domestic equity, fixed income and short term/cash in fiscal year 2007.
“These strategies should continue to help foundations achieve respectable returns when combined with proper diversification, due diligence and good management practices,” said Mr Griswold.
The move toward alternative investments has paid off so far, but the true test will come in the next downturn. Some hedge funds use strategies that are designed to generate positive returns no matter what the market is doing, but these approaches may not be able to withstand a downturn in the market as well as cash or bonds.
The spending rates at most foundations held steady, but spending dollars increased. The average spending rate was 5.5 per cent of total assets, unchanged from the previous year. This is the lowest level in the five years covered by this study.
Spending rates were slightly higher at smaller institutions than at larger institutions. Nearly one-half – 41 per cent – of respondents said they determine spending policy as a percentage of a moving average, with the average spending rate reported at 5.2 per cent of total endowment value.
Thirty-eight per cent of respondents reported that their spending policy was to meet the Internal Revenue Service’s minimum spending rate of 5 per cent.