Modern Portfolio Theory and Nonprofit Arts Organizations

Abstract

This study examines the revenue structures of nonprofit organizations in the arts subsector to identify theoretically ideal revenue portfolios by examining the risk, return, and covariance of revenue streams. This article examines four major sources of revenue for arts organizations and builds on Kingma's work on nonprofit revenue portfolios by carrying out the theoretical modeling suggested in his seminal work. Beyond identifying the efficient frontier, this approach can also reveal the composition of theoretically efficient portfolios found along the frontier. These portfolios are optimal in that they maximize revenue growth and minimize variability. This study has practical implications for the understanding of revenue diversification in the nonprofit sector, which has been identified as one mechanism by which nonprofit organizations can mitigate risk and increase survivability. This research also suggests that a commonly used measure of diversity, the Herfindahl-Hirshman index, may not always correspond with theoretical efficiency.

Risk and diversification of nonprofit revenue portfolios: Applying modern portfolio theory to nonprofit revenue management

“…On the one hand, the dataset represents the population of nonprofits that were required to report to the IRS between 1998 and 2003, and provides comprehensive financial information that allows examination of detailed revenue categories. It has been regarded as “the most nuanced or comprehensive dataset available” (Chang, Tuckman, & Chikoto‐Schultz, , p. 25), and served other recent studies on revenue diversification (Chikoto et al, ; Grasse et al, ; Qu, 2016). On the other hand, it includes a short and representative time period, which covers both the economic growth in the late 1990s and the recession in the early 2000s.…”

“…A few studies have instead focused on what is an optimal combination of revenue sources, applying insights from MPT. In particular, recent studies have shown that lower revenue concentration as indicated by lower levels of HHI do not always correspond with optimal portfolios (Grasse et al, 2016;Qu, 2016). Extending the literature, this study examines the empirical relationship between the revenue diversification index based on HHI and the portfolio risk measure based on MPT.…”

“…Different from this dichotomous view of nonprofit revenue composition, a few studies have focused on what is and how to choose an optimal combination of revenue sources, borrowing insights from modern portfolio theory (MPT; Kingma, ; Grasse, Whaley, & Ihrke, ; Qu, ). In his pioneering work, Kingma () applied MPT to modeling nonprofit financial predictability.…”

“…In particular, revenue diversification works by carefully selecting revenue sources, the returns on which do not rise and fall together all the time. Building on Kingma's model, subsequent research used Form 990 data to estimate the return–risk‐covariance properties of nonprofit revenue sources at the subsector level, and use the information to identify theoretically optimal portfolios for arts nonprofits (Grasse et al, ) and other subsectors (Qu, ). Both studies have shown that revenue diversification as measured by lower levels of HHI does not always correspond with theoretical efficiency.…”

“…More specifically, it extends the limited research that applies portfolio theory to nonprofit revenue composition. Different from Grasse et al () and Qu (), this study estimates the properties of revenue sources at the organizational level (rather than subsector level) and calculates empirical portfolio risk (rather than hypothetical optimal portfolios) using the actual information on shares of revenue sources in total revenue for each organization in a given year. It allows us to explore questions that could not be answered using the subsector‐level information.…”