Background risk and nonprofit endowment portfolio volatility

• DOI: http://doi.org/10.1002/nml.21415
• Published date: 01 September 2020
• Author: Heng Qu
• Date: 01 September 2020

RESEARCH ARTICLE

Background risk and nonprofit endowment

portfolio volatility

Heng Qu

The Bush School of Government and

Public Service, Texas A&M University,

TAMU College Station, Texas

Correspondence

Heng Qu, The Bush School of

Government and Public Service, Texas

A&M University, 4220 TAMU College

Station, TX 77843-4220.

Email: hqu@tamu.edu

Abstract

This article focuses on endowed operating public chari-

ties that receive income not only from sources such as

donations, grants, and service fees but also from endow-

ment portfolios. Using the Form 990 data between 2009

and 2016, this study examines if the risk from nonen-

dowment income sources, namely background risk, is

relevant to endowment portfolio volatility, and if there

are any differences across four types of nonprofits where

endowment assets are the most concentrated, including

museums, universities and colleges, K-12 schools, and

hospitals. The results show that the association between

background risk and endowment portfolio volatility is

significant and negative for universities; however, it is

either nonsignificant or significantly positive for other

types of organizations. This study extends research on

university endowments to other types of endowed non-

profits. The findings imply different endowment objec-

tives and reflect different asset allocation strategies

across types of organizations.

KEYWORDS

background risk, endowment, endowment asset allocation,

endowment objectives, nonprofit finance, portfolio volatility

1|INTRODUCTION

Some nonprofit organizations receive operating income not only from sources such as dona-

tions, grants, and service fees but also from their endowment portfolios. Scholars have defined

endowment differently. For instance, Bowman's (2002, 2007) definition encompasses both long-

Received: 9 December 2019 Revised: 3 April 2020 Accepted: 6 April 2020

DOI: 10.1002/nml.21415

Nonprofit Management and Leadership. 2020;31:11–32. wileyonlinelibrary.com/journal/nml © 2020 Wiley Periodicals, Inc. 11

term investment assets and board-designated operating reserves, while Hager (2006) used the

term more strictly to include only permanently restricted investment reserves. The official defi-

nition by the American Institute of Certified Public Accountants (AICPA) refers to endowment

as “an established fund of cash, securities, or other assets to provide income for the mainte-

nance of a not-for-profit entity”(American Institute of CPAs (AICPA), 2013, p. 145). Typically,

the endowment reported by a nonprofit on the IRS Form 990 (post-2008) is a combination of

“true endowment”(permanently restricted net assets), “term endowment”(temporarily

restricted net assets), and “quasi-endowment”(board-designated unrestricted funds). Therefore,

this article defines endowment broadly as a collection of both restricted and unrestricted assets

managed to provide an income stream for the current and future operations of a nonprofit

organization.

The current study concerns the management of a nonprofit's endowment in relation to its

other sources of income. An endowed nonprofit, according to Bowman (2002, p. 297), is like

“a holding company consisting of two subsidiaries: an operating entity producing goods and

services and a customized mutual fund”distributing a portion of its earnings to the operating

entity annually. He further postulated that the management of the operating subsidiary

might be affected by the risk inherent in owning a mutual fund. Indeed, prior research on

nonprofit endowments (using various operational definitions) has found different manage-

ment and organizational behaviors associated with endowed nonprofits. For example, well-

endowed nonprofits borrow more (Bowman, 2002). For nonprofit hospitals, in particular,

endowment assets are associated with higher tax-exempt borrowing (Gentry, 2002). More-

over, holding endowments is associated with decreased operating reserves by nonprofits

(Calabrese, 2013).

However, less is known about whether (and if so, how) the financial conditions of the oper-

ating entity affect a nonprofit's endowment management. When the operating and investment

functions of an endowed nonprofit are not kept separately, do the board and investment man-

agers consider nonendowment income sources in making endowment portfolio decisions? Spe-

cifically, is “background risk”from nonendowment income sources relevant to endowment

portfolio volatility?

Risks from income sources other than investment portfolios are called “background risks”

in the financial economics literature. Unlike portfolio risk that can be reduced through a delib-

erate selection of assets, background risks are considered undiversifiable and unavoidable.

However, as part of the decision-making context, background risks can affect people's tolerance

for other risks (Gollier & Pratt, 1996; Kimball, 1993). For investors who normally take higher

risks for higher expected returns, facing a greater background risk reduces their willingness to

invest in risky assets. Plenty of empirical literature has shown that the uncertainty of other

income (e.g., wages, real estate, private business) affects household portfolio decisions

(e.g., Guiso, Jappelli, & Terlizzese, 1996; Heaton & Lucas, 2000; Palia, Qi, & Wu, 2014; Vissing-

Jorgensen, 2002).

However, it is less clear if background risk is also relevant to endowment portfolio decisions.

If an endowment is treated as one of an organization's income sources and used to hedge

against overall financial risk, one would expect a negative association between background risk

and endowment portfolio risk-taking (Merton, 1993). On the other hand, if the goal of an

endowment is to ensure intergenerational equity (Tobin, 1974) or long-run institutional prestige

(Hansmann, 1990), other income would be ignored in making endowment portfolio decisions.

There are only two empirical studies on background risk and endowment funds

(Dimmock, 2012; Rosen & Sappington, 2016). Both focus on university endowments and find

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