A Means to an End
Ask A CIO #58
How should we describe the year we’re having so far? It’s certainly been… eventful. And we’re only just 16 days into 2026. Who knows where the rest of the year will take us? We might even add an island.
On a more serious note, even if we could predict the headlines to come, it wouldn’t necessarily make us more accurate investors. Consider this my periodic reminder of the virtues of discipline and diversification.
I’m often asked about how endowments and foundations position their portfolios, how they select strategies or managers. And I’ve written before about how institutional investors evaluate people and processes and consider macro opportunities. This week’s question is a bit more blunt.
What is the return target for endowments and foundations, and how do they set their return goals?
My initial reflex was to deflect, recognizing that every endowment or foundation has its own goals and risk tolerances. But you know what? It’s a totally fair question. There are plenty of commonalities across these institutions, and their return goals often share similar starting points.
Investment performance is a means to an end, and functionally, there are two primary goals for any endowment or foundation’s long-term pool of capital: 1) meet the spending needs of the institution, and 2) maintain purchasing power. The return target is basically the number that allows an institution to meet those two goals.
On the first point, institutional spending needs vary, budgets vary, etc. Still, putting all the variables aside, the spend rate that most institutions use hovers around 5%. Some are slightly above, some are slightly below, but on average, endowments and foundations operate on an approximately 5% annual spend from their long-term portfolios.1
On the second point, maintaining purchasing power just means accounting for inflation. Most institutions assume 2% to 3% for long-term inflation rates. We can quibble on whether that’s right, but I would say those are reasonable assumptions.
Put it all together, and endowments and foundations require, at minimum, an approximately 8% annual return to meet the basic needs of their institutions. Of course, institutions don’t want to just tread water, they want to expand their programs and grow. Which means the actual return target for most institutions is going to be higher than 8%, allowing the institution to grow the corpus.
That’s basically the answer to this week’s question. We could stop here, but I’m going to take us on a quick digression.
Some might see that over 8% number and think – ‘hey, that’s a pretty high target for returns. And aren’t those endowments and foundations the ultimate long-term investors? It sounds like they should put their money in equities and call it a day.’ And there would be merit in that line of thinking! In fact, it’s why endowment and foundation portfolios are philosophically equity-oriented.
But (there’s always a but), the spending needs of an institution reflect a dollar amount, not a percentage. Each year, 5% of an institution’s investment portfolio balance is withdrawn and contributed to the budget.2 Therefore, each year, the actual dollar amount spent from the investment portfolio is dependent on the portfolio’s balance.
Quick tangent. I’ve mentioned it here before, but endowments and foundations have some key differences. First and foremost, endowments are open pools of capital that accept new donations and inflows. Endowments, typically tied to educational or cultural institutions, rarely need to support the entire operating budgets of their institutions. These institutions typically have other sources of income, e.g., tuition or ticket sales. Generally speaking, private foundations are closed pools of capital, with no expectations for future inflows.3 Foundations also typically do not have additional sources of income.4 In other words, the corpus of a foundation’s long-term pool of capital needs to sustain that institution’s budget in perpetuity.
As you might imagine, endowments and foundations require a degree of stability and predictability in terms of the dollar amounts that their investment portfolios contribute to budgets. It would be highly disruptive for that 5% spend to equal $100 million of spend in one year, but only $75 million the next. The sequence of returns matters. Any major drawdown could impact an institution for years. A 100% equities portfolio, with all its downside volatility risk, would most likely not be sustainable for an institution. Certainly not if the institution intends to be around for a long time.
Consequently, endowments and foundations have ambitious return goals, but they also seek to achieve them without exposing their portfolios to excessive drawdowns. These challenging dual mandates ultimately inform investment decisions from portfolio construction to manager selection. It’s why endowment and foundation investors invest heavily in equity-oriented strategies, both public and private. And it’s why these institutions also allocate meaningfully to non-equity correlated opportunities across hedge funds, credit, real assets, etc. Over time, these multi-asset class, diversified portfolios have delivered the returns these organizations need alongside acceptable risk profiles.
Drilling down a layer deeper, these endowment and foundation portfolio expectations also lead to some not-always-obvious implications for fund managers. I won’t go into all of them here, but the most common misconception that I tend to see is one in which managers underestimate how high the return hurdles are to make it into an endowment or foundation portfolio.
Let’s say an endowment’s overall portfolio has to meet at least an 8% return (but ideally higher). Some portion of the portfolio is cash and fixed income. That segment is guaranteed not to meet the portfolio’s required rate of return. Some portion of the portfolio is designated for non-equity correlated investments. That segment will realistically probably just meet or maybe slightly exceed the portfolio’s 8% total return target. And the largest portion of the portfolio is equities, both public and private. Given all the above, this segment of the portfolio has to significantly outperform 8% in order to bring the portfolio’s total performance to its target.
Thanks for joining this week, and hopefully, I gave you a useful glimpse into how the sausage is made. As always, reach out with questions: askacio@ivyinvest.co!
See you in two weeks,
Wendy
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This is a very active area of discussion at the moment across institutions. I wouldn’t be surprised to see adjustments downward going forward.
For institutions, there’s usually a rolling spend, so it’s actually 5% of the portfolio’s 3-year (or however many year) rolling portfolio average balance.
Public foundations have different rules and generally greater flexibility.
Both endowments and foundations have the ability to issue bonds (taxable and tax-exempt).
Really insightful breakdown of the 8% target calculus. The part about sequence of returns mattering way more than people realize is crucial becuase even though endowments are "long-term" investors, that 5% annual wthdrawal makes them oddly sensitive to short-term volatility. It's the paradox of patient capital that still needs to fund immediate operations.