Robo-advisors for charitable investing?

In the last few years, one of the fastest-growing trends in personal investing has been robo-advisors. The concept of a robo-advisor is that your money is managed by rules set by a software program, with little or no contact with a human advisor. As a result, the fees for investment management are lower (0.5% of assets for robos, versus 1% or more for humans) and the holding costs are lower (0.25% for the exchange-traded funds held by robo-advisors, versus 2% or more for the mutual funds or hedge funds recommended by humans). The largest robo-advisor in Canada is Wealthsimple, founded in September 2014. If robo-advisors work well for individual investors, perhaps they could also work well for institutional investors, such as foundations and charities?

The ecosystem of charitable investing

At first glance, there is certainly a case to be made for robo-advisors. Costs are lower, returns are likely to be higher than those earned by most humans (index investing is hard to beat over the long term), while convenience and simplicity are higher. To fully consider the suitability of robo-advisors for charitable investing, however, we need to consider the ecosystem of investing for a foundation or charity. Charitable investing follows a series of decisions, ranging from Discern (deciding whether and why to invest); Invest (planning the investment program); and Govern & Lead (owning the investment plan and building leadership capacity for long-term success).

Where robos can’t reach

Clearly, a robo-advisor can add value for institutions in the Invest phase, especially if they have relatively little interest in investing or are holding high-cost investments such as mutual funds or hedge funds. However, it is not clear what a robo-advisor can add to the other phases. The Discern phase is about articulating the purpose of the organization; setting its objectives; deciding what impact it should achieve, for whom; and formulating a plan of action to achieve this, often with the support of partners or volunteers. This is pre-eminently a domain of human decision-making and it is difficult to conceive how a robo-advisor could contribute to this phase. The Govern & Lead phase is about owning and overseeing the investment plan but can also include using the plan as part of the strategy to build leadership capacity in the organization or the charitable system as a whole. Again, these are deeply human decisions, involving ethics, leadership and community-building.

Stronger together

If we look at investing as a technical exercise self-contained within the Invest phase, consisting of risk tolerance, asset mix and product selection, then foundations and charities would be well served by a robo-advisor. However, we have seen that the Discern and Govern & Lead phases are areas of human decision-making, where an algorithm cannot deal with the ambiguity and complexity of the decisions involved. Moreover, the phases are not separate but related. For example, when we decide that we want to contribute to a cleaner environment as a key objective and increase our investing in clean energy companies (the Discern phase), this in turn will affect how we structure the investment portfolio to balance long-term growth and short-term spending (the Invest phase). Or when we decide to engage the next generation of a family foundation with a focus on impact investing in our communities (the Govern & Lead phase), this in turn will affect the risk and return profile of the portfolio (the Invest phase).

Rather than choose between robos and humans, we want to take the best elements of both and create a better way. Robos are unable, at least for now, to tackle the complexity of the questions beyond the Invest phase. Humans are often unwilling to invest simply and at low cost. Yet combined, these approaches are stronger together.

How family foundations can reimagine their impact

The story of the Hyatt Family Foundation, recently profiled in The Globe and Mail, will probably strike a chord with many Canadian foundations:

“We worked very hard for that money, so we want it to go to a good place,” says Michael Hyatt, whose first family company, Dyadem International Ltd., was sold to IHS Inc. for almost $100 million. The brothers recently sold their second company, BlueCat Networks Inc., to U.S. private equity giant Madison Dearborn Partners LLC for a reported $400-million.

The duo is now looking at how to earmark some of the proceeds from the BlueCat sale to charity, which Mr. Hyatt says isn’t as easy as it sounds. “Giving away money sounds romantic and great, but it’s hard to do,” says Mr. Hyatt.

Having a family foundation also means agreeing on where to give. “We have to decide as a group, which isn’t easy,” he says. “It’s all important. It comes down to the passion and what matters to you and your family.”

In this post, we’ll consider three reasons why it’s hard for foundations to plan for impact and suggest an approach to reimagine the impact you want your foundation to have.

Strategy or structure?

Let’s compare how foundations and corporations get started. The founders of most corporations have a focus for what they want to achieve, then they start a business. For example, Bill Gates probably didn’t set up a corporate structure and then decide whether to enter the software business or some other business altogether. Like many founders, he tinkered, tested and tried out ideas, only setting up a corporate structure when it became necessary to hire more people or raise more capital. Arguably, this is not how many foundations get started. How many founders, before they even established a foundation, knew that they wanted to contribute to a cleaner environment, improve education for Indigenous communities or reduce the impact of income inequality? If this focus is not clear before the foundation is established, it does not become any easier to find over time.

Purposeful or personal?

Foundations, particularly small and medium family foundations, often have a personal and discretionary approach to supporting causes. After a successful career in business, which can involve difficult relationships and tough decisions, philanthropy is sometimes felt to be a relief from hard-headed calculation and a way of showing compassion. In not wanting to be too business-like, some founders miss out on the planning they would have insisted on in a business setting. How many founders have a statement of family values to guide their philanthropy? How many have a focus for the programs the foundation will support? How many have an impact statement that describes how the money they give out will achieve an impact in their communities? How many have a theory of change or framework to explain how the programs they support will achieve the desired impact? Finally, how many have discussed this at length with their board, asked what could go wrong, committed to a written plan of action and actually used the plan to make key decisions and oversee progress? I would imagine if we had a room of philanthropists who were raising their hands to answer these questions, we would gradually have fewer and fewer hands in the air.

Priorities or responses?

Even if foundations have priorities, there will always be opportunities to go in different directions. Applications from grant-seekers, requests from contacts and the priorities of stakeholders can take on a life of their own, especially when combined with the ongoing legal requirement to disburse funds. After reading The Philanthropic Mind: Surprising Discoveries from Canada’s Top Philanthropists (2015), I was struck by how often foundation boards would support a cause because they knew the people involved or would donate to an institution because of a previous family connection. From a social impact perspective, these are not necessarily the best reasons to support a cause. How many single mothers are personally known to the board members of a foundation? Recent immigrants? Members of Indigenous communities? In placing emphasis on personal connections and familiarity, foundations can miss opportunities to help those who are not well placed to ask. By having priorities that are carefully considered and clearly stated, foundations can set their focus to contribute their support where it is most needed, rather than where it is most requested.

Reimagine your impact

We challenge foundations to reimagine their impact. This is useful for all foundations but especially for foundations that have been established for several decades or where leadership has passed to new directors. How do we reimagine our impact? We use a three-part approach called Discern, Invest and Govern & Lead:

Discern: Reignite your passion to lead and make a difference. Develop a statement of family values that reminds you why the foundation exists. Put together a shortlist of causes that best support these values, regardless of what you are currently funding. Create an impact statement that shows how you will make a difference and how you will know you’re succeeding.

Invest: Once you have clarity on why you’re investing, the nuts and bolts of investing fall into place. You will naturally be drawn to investment programs that are sound and simple, to help you follow a plan; that reduce cost, to enable you to give more to others; and that reduce risk, to enable you to provide consistent support to causes over time.

Govern & Lead: Now that you’ve rediscovered your purpose and developed a sound process, you will naturally want to make sure you understand and own the investment process; build capacity for the next generation of leaders within your foundation; and build the capacity of others to learn from your success.

While this might sound clear enough, it’s certainly not easy. It involves reflection, discussion and, perhaps most difficult of all, firmness of resolution to translate good deeds into good outcomes. We encourage more and more family foundations to reimagine the importance of their grant-making to the communities and causes they serve.

The impact of inflation for foundations

We see a foundation paradox in Canada. The large majority of foundations with assets of more than $1 million are set up to achieve long-term objectives, such as contributing to education, health care or community development. Yet, based on our analysis of over 2,500 private foundations in Ontario, about one in three foundations mostly hold cash, Treasury bills or other short-term investments, while two in three foundations mostly hold long-term investments such as stocks and bonds. If foundations are set up for the long term, why are so many investing for the short term?

Reasons and feelings for holding cash

Cash is a short-term asset, typically matched to short-term liabilities. There are two main reasons for foundations to hold a significant level of cash:

  • The foundation receives and disburses funds on a current-year basis (some corporate foundations fall under this category).
  • The foundation is in the process of winding down and intends to disburse all of its funds in the next few years.

With about 35% of foundations mostly holding cash, we estimate that the above reasons account for about 10% of the total, still leaving about 25% of foundations holding cash, less for reasons than feelings. These feelings are valid and can reflect important truths about financial markets:

  • Greater familiarity with private companies, which are often the source of a foundation’s assets.
  • Healthy scepticism of public markets after the global financial crisis of 2008 and the dot-com collapse of 2000.
  • Well-founded belief that many investment managers do not reliably add value.

Required versus expected returns

Given modest expected returns for cash and bonds over the next decade, risk-averse foundations are likely to experience a funding gap between their required return and expected return:

Required return     Expected return  
Disbursements 3.5%   Cash (3% x 0.5) 1.5%
Inflation 2.0%   Bonds (4% x 0.5) 2.0%
Required return 5.5%   Expected return 3.5%

Expected return is based on a conservative portfolio, split equally between cash and bonds. Expected return for cash is just under 3%, which at half of the portfolio is 1.5%; expected return for bonds is just under 4%, which at half of the portfolio is 2%. Estimates for cash, bonds and inflation are from the Financial Planning Standards Council, projection assumption guidelines for 2017.

Mind the gap

While foundations have a required return of 5.5% to cover disbursements and inflation, their expected return from cash and bonds is only 3.5% – a funding gap of 2%. Below is what a funding gap of 2% looks like over the long term:

Starting amount After 10 years After 20 years After 30 years
$10 million $8.2 million $6.7 million $5.5 million

Cash-rich Canadian foundations have two principled options to address the funding gap:

The first option is to maintain the current risk tolerance. This offers a high likelihood of losing funding power over the long term, together with a high likelihood of preserving capital in even the worst year.

The second option is to adjust the risk tolerance (remaining similarly able to take risk but becoming more willing, perhaps with a different approach to setting the asset mix or managing risk). This offers a fair likelihood of losing a moderate amount in a bad year, together with a fair likelihood of preserving funding power over the long term.

From the perspective of the next generation, which one sounds better to you?

Investment advice from David Swensen

David Swensen is the Warren Buffett of institutional investors, having achieved phenomenal investment returns for several decades at Yale University, based on a philosophy of investing that many try to imitate but few can actually implement. Below are some words of wisdom from one of his rare interviews.

A Conversation with David Swensen, Chief Investment Officer, Yale University
Stephen C. Freidheim Symposium on Global Economics
November 14, 2017

Low-return environment

So for most of the 32 years that I’ve been at Yale, the standard assumption for endowment returns for the operating budget was 8.25% nominal. And that turned out to be a pretty decent working assumption. I think our 32-year rate of return is something like 13.5%, so we’ve generated a substantial cushion over the budgetary assumption for more than three decades. What I’ve been talking to the provost about for the past 12 or 18 months is, for the first time in this very long period, reducing the expected return assumption in the budget to 5% nominal.

Investing as a profession, not a business

In the investment world, if people are the way that you’re taught and – introductory econ – if they’re maximizers, they’re going to raise massive funds, charge high fees, and make a lot of money for themselves. I’m looking for somebody that’s got a screw loose and they define winning not by being as rich as they can be individually, but by producing great investment returns. And you do that – you can still make a great living, but instead of managing $20 billion, you probably manage $2 billion.

Track records

You know, I think track records are really overrated. Some of Yale’s best investments have been with people that don’t have a track record. We took a couple of people out of proprietary trading at Goldman Sachs 25 years ago. If they had had a track record, it wouldn’t really matter because Goldman Sachs has a very different form of organization and a different way of giving resources to the people that are making investment decisions. But we didn’t even have those numbers. And it was really just a decision that this was a woman and this was a man that we thought were going to produce great returns, and they’ve done a really good job for the university.

Relative peer performance

Comparing returns to peers is all-pervasive. And I think it’s incredibly dysfunctional when it comes to making really good investment decisions. People are concerned about underperforming, and that causes them to want to put together portfolio allocations that look like other similar institutions. And so the advice that I would give would be to try and put together a portfolio that really works for your institution, and try and pay less attention to the returns that others with riskier portfolios might be generating, knowing that ultimately, if you’re making well-grounded decisions, that the numbers will come.