A museum’s endowment plays an important role in supporting its mission, providing crucial funding for both day-to-day operations and public programs. Faced with budget cuts and the ongoing difficulty of raising admission fees while still attracting public interest, institutions must invest for maximum return while also giving prudent attention to risk management. Many would like to narrow the gap between their current investment performance and the outsized returns of the country’s largest endowments, but to do so they will have to rethink their strategy. Museums should examine the best practices of university endowments for key lessons on boosting performance while maintaining a reasonable level of risk.

Learning from University Endowments
While museums are often private about their investing practices, university endowments have been making headlines for their outstanding investment strategies and performance. Harvard University’s $34.9 billion endowment recently reported returns of 23 percent in fiscal year 2007, and Yale University’s 28 percent return for fiscal year 2007 increased its 10-year average annual investment return to 17.8 percent.1 Harvard and Yale, as well as other large universities, attribute much of their success to diversification into alternative investments. But are these asset classes—hedge funds, private equity and real assets (real estate and natural resources)—right for your endowment fund?

“Not all museums can invest like Yale, but they can emulate their strategies even though their assets may be much smaller,” said Alan Wurtzel, former board member and investment committee chair of the Phillips Collection in Washington, D.C., a museum with a $20 million endowment. These strategies include a strong commitment to broad diversification, with a tolerance for illiquidity and a focus on manager selection.

An endowed institution must continually focus on achieving investment returns that, at a minimum, keep pace with the budgeted spending rates. A constant tension exists between funding current operating expenses from the endowment and preserving the endowment to meet generally increasing spending objectives in the long term. Traditionally, because of perceived safety, many museums have simply invested in a portfolio of stocks and bonds. Yet the lack of diversification between stocks and bonds, especially with regard to changes in interest rates, inflation and economic cycles, often carries significant risks.

“Every museum should be well diversified. Too many eggs in one basket—one manager, one style, one strategy—does not benefit the endowment,” said Mark Stalnecker, chair of the investment committee of Winterthur Museum & Country Estate in Wilmington, Del., which has a $400 million endowment.

The largest endowments—those of more than a billion dollars—have demonstrated that broad diversification across asset classes is a critical component of success. These endowments have moved away from high allocations to traditional investments and distributed more to alternative asset classes: private equity, hedge funds and real assets. Their managers understand that asset classes that move in varying degrees independently of each other (non-correlated) respond differently to economic cycles and factors (interest rates, inflation, etc.) and achieve greater return at a given level of risk. The result: a more efficient portfolio, one in which risk is lowered without sacrificing return.

The 2006 Endowment Study by the National Association of College and University Business Officers reports that the portfolios of the largest endowments are allocated across all asset classes, with approximately 40 percent in alternative investments. Commonfund’s Benchmark Study 2007 details this even further by reporting endowments with $50 million or less in assets average only 4.2 managers in alternative strategies, whereas the largest endowments average 62.9 (both direct and via fund-of-funds).

Year over year, the portfolios of large endowments generate significantly higher returns than their smaller peers.

Any museum diversifying into alternatives should consider that higher risk-adjusted returns available through alternative investments comes with a trade-off: a relative lack of liquidity. Some of these assets have a long-term time horizon due to the nature of the asset class itself, such as timber. However, including even a small portion of alternatives to help diversify the portfolio can lead both to attractive returns and dampened volatility.

“We may not be able to afford, from a risk standpoint, to be in a large amount of illiquid investments,” said Stalnecker. “However, investing a significant portion of our endowment in marketable alternatives makes sense. It provides better diversification in down markets, which serves our endowment well.”

Securing Top Talent
Working with top-tier investment managers is critical to replicating the success of the large endowments. Those institutions often have access due to their investment size and relationships. They conduct extensive due diligence in selecting managers and monitor them regularly. This is often a detailed process that includes identifying and building a relationship with prospective managers and conducting both qualitative and quantitative due diligence.

Large endowments have the benefit of trained staffs and sophisticated investment committees to manage this process. According to the Commonfund Benchmarks Study 2007, the largest endowments have approximately ten investment staff members, whereas smaller endowments have only one. In addition, the number of investment committee members with alternative strategies experience is higher—almost twice as high—for larger endowments.

“We don’t have a full-time chief investment officer like larger endowments,” said Don Caldwell, board chairman of Philadelphia’s Pennsylvania Academy of the Fine Arts, which has a $35 million endowment. “It creates issues when you don’t have someone full-time dedicated and accountable for the endowment. It puts pressure on the volunteer investment committee members. The staff monitors the investments, but they have other full-time responsibilities, so it’s difficult to stay on top of it all.”

For endowments that do not have the time or budget to hire a dedicated investment staff, there are multiple options when adding alternative investments to a portfolio. The first is to establish the asset allocation in-house and hire targeted advisors to manage the various asset classes in the portfolio. This requires the time, staff and ability not only to evaluate advisors’ capabilities but also to monitor them on an ongoing basis.

The second is to hire an investment consultant to assist with asset allocation and manager selection. Investment consultants often have expertise on asset allocation and conduct due diligence and ongoing evaluation on managers. Services are often tailored to meet each client’s needs.

The third is to invest in a fund-of-funds. Funds-of-funds combine the talents of some of the best investment managers and make them available to investors who may not have access to such managers or cannot meet their high minimum account requirements. Investing in funds-of-funds often implies high fees. Investors should focus on net returns, however; many managers earn their fees and produce superior net returns to investors.

“It takes time to gain access to the highest quality managers. You may not be able to get a quality manager day one, if at all. It could take a few years—and a lot of patience,” said Wurtzel.

New Options, New Opportunities
Nonprofits, like businesses, can take advantage of the opportunities presented by globalization and new investment vehicles designed to improve returns and reduce risk. Institutions with large endowments know this, and those with smaller endowments should act on it as well. Museums willing to diversify their portfolios with alternative investments may not get the same eye-popping returns of Yale or Harvard, but they can experience dynamic growth of their own.

Jamie Biddle is chairman and CEO and Scott Lupkas is chief investment officer of Verdis Investment Management.

1: Conroy, Tom. "Yale's Endowment Totals $22.5 Billion Based on 28% Return," http://www.yale.edu/opa/newsr/07-09-27-00.all.html.