4.2 Foundations and Endowments

Question 1

What is an endowment:
1. maintain on what basis for how long
2. purpose is to generate AI in P to help fund ____
3. initial gift is known as ___

Answer 1

An endowment refers to a large capital base that is maintained on an inflation-adjusted basis in perpetuity. The purpose is to generate annual income in perpetuity to help fund operational costs for organizations such as universities, hospitals, and museums. The nominal value of the initial gift is known as the corpus.

Question 1

Contributions to endowments (cash and noncash) are treated as _____ that generate ______. Additionally, the investment income generated by the endowment may be ______

Answer 1

Contributions to endowments (cash and noncash) are treated as charitable donations that generate tax deductions for donors.
Additionally, the investment income generated by the endowment may be tax free

Question 2

What is a restricted gift in relation to an endowment?

Answer 2

e.g. the initial gift (i.e. the corpus) might be restricted such that it is maintained at the same level with income generated used

Question 3

What is a foundation? (NP for CP)

Answer 3

A foundation is a nonprofit fund established for charitable purposes to support specific types of activities

Question 4

Four types of foundations:
1. OF
2. CF
3. CF
4. IF

Answer 4

1. operating foundations - similar to endowments in that the income generated is used to fund operating expenses of the organization
2. community foundations - focus on a specific region, don’t operate their own programs but distribute to local charities
3. corporate foundations - funded by corps and their employees - support charities in the local area
4. independent foundations - funded by an individual or family and often consist of a one-time gift (e.g., stock shares) with no subsequent gifts. The donor avoids the capital gains on the appreciated gift while also receiving a tax deduction based on the market value of the gift

Question 5

Differences between endowment and foundation:
1. spend on
2. length
3. donations
4. spending

Answer 5

1. Endowments assist with operating expenses, while foundations provide grants
2. Endowments usually exist in perpetuity, while foundations often have a limited life
3. Endowments have ongoing donations, while foundations often do not
4. Foundations have annual minimum spending rates (e.g., in the United States, it is 5%); endowments have more flexibility in determining their spending rate

Question 6

What is the formula for the change in value of the endowment or foundation?
(income, spending, returns)

Answer 6

change in value = income from gifts – spending + net investment returns

Question 7

What is intergenerational equity referring to? Expressed as?

Answer 7

Intergenerational equity refers to balancing the current spending needs (based on percentage of assets) with future spending needs, which are met by maintaining sufficient funds in the endowment.

It can also be expressed as a % chance that the real value of the endowment will be maintained in perpetuity

Question 8

Why are endowments are more likely than foundations to remain permanent?

Answer 8

Endowments are able to cut their spending rate, while foundations must keep at a minimum level.

Question 9

Should endowments keep spending rates consistent or fluctuate with performance?

Answer 9

From a long-term management perspective, endowment managers should consider consistent spending rates irrespective of periods of high or low portfolio returns. Doing so may allow for an increased ability to cope with economic downturns and increased wealth in the long term.

Question 10

What four things could reduce the real values of endowments and foundations?

Answer 10

1. increase in inflation
2. increase in spending
3. decrease in gifts
4. decrease in returns

Question 11

Example of why endowments must seek returns in excess of inflation - e.g. universities (what benchmark).

Answer 11

University costs tend to increase at a rate higher than that of overall inflation. Therefore, a university endowment must seek a return target that exceeds the growth rate of university costs to preserve its current real level of spending. As a result, a university endowment would likely use the Higher Education Price Index (HEPI) as a benchmark inflation measure rather than the Consumer Price Index (CPI).

Question 12

For a foundation that wants to exist in perpetuity with no loss in the real value of the portfolio and no donors, what is its minimum return target?

Answer 12

5% plus inflation.

Question 13

What is David Swensen’s endowment model view?

Answer 13

Focus on diversification and an equity tilt. Focusing on assets with higher expected returns such as alternative assets

Question 14

Endowment model:
- corporate bonds
- foreign fixed-income
- domestic government bonds
- alternatives

Answer 14

corporate bonds - not used/minimised - due to corporate management bias against bondholders, low incremental returns over risk-free bonds, and the risk of significant value and liquidity reductions in times of crisis

foreign fixed-income - not used, due to their low incremental returns over domestic bonds, currency risk, and event risk

government bonds - used, as they provide the endowment portfolio liquidity and serve as a tail risk hedge

• alts - constitute a large percentage of the asset allocation

Question 15

Endowment allocation over last decade to alternatives? %
Impact on returns?

Answer 15

Over the last decade, large university endowments (in excess of $1 billion) had alternative asset exposures comprising, on average, 59% of assets under management.
Endowments earned returns far in excess of domestic equity and fixed-income investment returns from 2008–2020
Smaller endowments tend to allocate significantly less to alternative investments, but they have also been increasing their alternative asset allocation over time

Question 16

Correlation between endowment size, returns, allocation to alternatives?

Answer 16

There seems to be a positive correlation between the size of the endowment, the returns generated, and the allocation to alternative investments.

Question 17

Investment return attribution consists of contributions from three areas:
1. SAA
2. SS
3. TAA/MT

How is each measured?
What is the attribution for endowments in Brown study? Relative to pension funds? Why is it difficult for others to accurately replicate their investment strategy?

Answer 17

1. strategic asset allocation (long term) - calculated as target long-term asset allocation weights multiplied by benchmark returns for each asset class
2. security selection - asset class return relative to a benchmark
3. tactical asset allocation/market timing - earning excess returns by using asset class weights that differ from target asset class weights

Study by Brown from 1984-2005, showed endowments earn 74% return from SAA, 8% from SS, and 15% from TAA. Pension funds have a much higher proportion from SAA. It is difficult to replicate the strategy, as they have higher return attribution from SS and TAA.

Question 18

Six reasons why endowments outperform?
1. AAS (alts, rebalance, undervalued)
2. MS
3. FMA
4. TA (network effect)
5. LR
6. S

Answer 18

1. aggressive allocation strategy - high proportion in alts, frequent rebalancing to maintain target allocation, buying undervalued asset classes)
2. manager selection - use best managers, and as in altenatives this is important as they are inefficient markets, sophisticated selection process
3. first mover advantage - top endowments invested in alternative investments much earlier than their peers, many of the best funds are now closed to new investors
4. talented alumni - network effect, strong correlation between the most-successful hedge fund managers and the most-prestigious universities, may be able to allocate to the funds they manage
5. liquidity risk - perpetual nature means able to access illiquidity risk for premium
6. sophistication of investment staff - may also employ consultants

Question 19

What spending rate did David Swensen suggest?

Answer 19

Swensen advocated for a spending rate that was the sum of 80% of last year’s spending rate and 20% of the average spending rate over the past decade

Question 20

What are the inflation betas of the following (according to Alliance Bernstein from 1965-2009):
1. Commodity Futures:
2. Farmland:
3. TIPs
4. 3m T Bills
5. S&P 500
6. 20Y T Bonds

Answer 20

1. Commodity Futures: 6.5
2. Farmland: 1.7
3. TIPs: 0.8
4. 3m T Bills: 0.3
5. S&P 500: -2.4
6. 20Y T Bonds: -3.1

Question 21

In 1972, the Uniform Management of Institutional Funds Act allowed endowment spending rates to be determined on the basis of…

Answer 21

In 1972, the Uniform Management of Institutional Funds Act allowed endowment spending rates to be determined on the basis of portfolio total return

Question 22

The ability of an asset to hedge inflation is indicated by its PIB (i.e., sensitivity of…).

Answer 22

The ability of these assets to hedge inflation is indicated by their positive inflation betas (i.e., sensitivity of an asset’s returns to inflation).

Question 23

It was demonstrated during the recent credit crisis that many endowment funds did not have ________. As a result, these endowments were forced to sell illiquid assets at severe discounts, postpone crucial investments, and take on debt financing. Such unfavorable situations led endowments to _______.

Answer 23

it was demonstrated during the recent credit crisis that many endowment funds did not have proper liquidity risk management. As a result, these endowments were forced to sell illiquid assets at severe discounts, postpone crucial investments, and take on debt financing. Such unfavorable situations led endowments to reduce portfolio allocations to alternative investments.

Question 24

What is liquidity driven investing? (3 tiers)

Answer 24

Matching liquidity of investments to the investor’s time horizon using a tiered system.
T1: low risk very liquid (e.g. short term fixed income)
T2: high risk very liquid (equities)
T3: high risk and illiquid (PE and HFs)

liquidity-driven investing requires a sufficient allocation to Tier 1 and Tier 2 assets in the endowment portfolio. allocation to T3 cannot be too high, as they are meant to be held for the long term (i.e., in excess of 10 years)

Question 25

The liquidity risk of an endowment portfolio can be roughly determined by looking at both the (1) and (2). The higher the sum of these two components as a percentage of endowment size, the higher the endowment’s liquidity risk.

Answer 25

1. size of potential capital calls from recent commitments
2. the size of private equity and real estate partnership investments

Question 26

Typical capital rates for real estate funds versus VC? (faster/rates)

Answer 26

Usually, real estate funds will call capital faster than venture capital. Real estate funds typically call 40% of uncalled capital per year.
VC funds, on the other hand, usually call 25% of uncalled capital in year one, 33% of uncalled capital in year two, and 50% of uncalled capital in each year thereafter

Question 27

What % allocation to cash and fixed-income is suggested to avoid liquidity issues in a crisis (while minimising cash drag)?

Answer 27

an allocation of 6% to 14% of assets is reasonable to avoid liquidity problems 95% of the time

another suggestion to avoid liquidity issues is to stagger allocations to private equity and real estate funds over several years rather than having one large commitment in a single year

Question 28

Why is it important to rebalance portfolio?
What is a key constraint?
When is it usually done?

Answer 28

Rebalance to prevent allocation drift, whereby the best-performing assets begin to dominate the portfolio - portfolio risk if assets are overvalued and volatile
It works best with liquid asset classes - so may be difficult with alternatives such as HFs, so may be best to focus on liquids while controlling allocations to less liquid alternative investments through the amount of future commitments
Can be done periodically (ie monthly) or when allocations deviate from their specified range

Question 29

What is tail risk?

Answer 29

Tail risk refers to the potential occurrence of an event that causes a severe decline in portfolio value, with returns occurring in the extreme left tail (i.e., large negative returns) of the distribution of returns

Question 30

Three ways to avoid tail risk:
1. c/rf
2. op (how to reduce price)
3. within asset class

Answer 30

1. allocation to cash/risk free bonds - but these have low returns and an inability to outpace inflation so not commonly used
2. equity options hedges - i.e. buying puts. To reduce the cost you may use a COLLAR i.e. combine the put option purchase with the sale of a call option with a strike price above the current price which reduces upside potential but the call option premium reduces the cost of the put. Or can use a PUT SPREAD, buy a put option out of the money and at the same time sell a put option even more out of the money. For example, assuming a current market price of $100 for the underlying, the portfolio could purchase a put with a strike price of $85 and sell a put with a strike price of $65. Such a strategy provides protection for up to 20% of the equity portfolio, but once losses exceed 35%, there is no protection.
3. specific allocations within asset classes i.e. within the fixed-income asset class, using high-quality bonds rather than corporate bonds will decrease tail risk, for hedge funds, better to allocate to a macro fund/MF fund that does well in times of vol, than an arb strategy that requires narrow spreads and liquid markets