CAIA L2 - 4.2 - Foundations and the Endowment Model Flashcards
Define
Corpus
4.2 - Foundations and the Endowment Model
Nominal value of the initial gift
for an endowment
4.2 - Foundations and the Endowment Model
Define
Restricted gifts
4.2 - Foundations and the Endowment Model
Part of endowment fund established for specific purpose, such as a specific department or programmatic activity
4.2 - Foundations and the Endowment Model
List
4 primary types
of foundations
4.2 - Foundations and the Endowment Model
- Operating foundations - similar to endowments => investment income earned is used to fund the operating expenses
- Community foundations - specific geographical region - simply distribute amounts to local charities and other causes.
- Corporate foundations - funded by corporations and their employees. Usually support charities in the local area
- Independent foundations - funded by an individual or family - often 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. From an investment management standpoint, the donation of a concentrated investment (e.g., stock shares of one company) creates a significant amount of unsystematic risk that should be reduced through diversification.
4.2 - Foundations and the Endowment Model
Contrast
Foundations
and
Endowments
4.2 - Foundations and the Endowment Model
Endowments
- ability to cut spending
- funds set up to assist with operating expenses
- usually survive in perpetuity
- tend to solicit continuing contributions from donors
Foundations
- tend to have annual minimum spending rates (e.g., in the United States, it is 5%)
- provide grants
- often have limited lives
- tend not to solicit continuing contributions from donors
4.2 - Foundations and the Endowment Model
Define
Intergenerational equity
(Endowment)
4.2 - Foundations and the Endowment Model
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.
Low current spending rate benefits the future beneficiaries, and a high current spending rate benefits the current beneficiaries
4.2 - Foundations and the Endowment Model
Formula
Change in value
(Cash Flow of Endowment / Foundations funds)
4.2 - Foundations and the Endowment Model
change in value = income from gifts – spending + net investment returns
To exist in perpetuity:
* Endowments: cut spending
* Fondations with no ongoing contributions: return target = 5% + inflation (in US)
4.2 - Foundations and the Endowment Model
Define
Endowment model -
and implication to asset allocation
4.2 - Foundations and the Endowment Model
Considers the need to meet high return targets in order for the endowment to exist in perpetuity
How?
- through diversification and an equity tilt, focusing on assets with higher expected returns such as alternative assets
- through domestic government bonds (liquidity + serve as a tail risk hedge during market events)
- Low / no corporate bonds investments (low premium vs risk free + liquidity reduction in crisis)
- No foreign fixed-income investments (low premium vs domestic bonds + currency risk + event risk)
“Seems to be a positive correlation between the size of the endowment, the returns generated, and the allocation to alternative investments”
4.2 - Foundations and the Endowment Model
Identify
Six attributes
of the
endowment model
4.2 - Foundations and the Endowment Model
- Aggressive allocation strategy. Involves investing in alternative investments in larger amounts relative to smaller endowments and pension funds. + frequently rebalancing through selling a portion of outperforming assets and buying additional underperforming assets to return the portfolio to its target allocations + purchase asset classes with historically inferior performance (potentially undervalued). There is a significant emphasis on superior manager selection as opposed to mere asset allocation.
- Effective investment manager research. Allocating to the best managers in each asset class, because markets are generally less efficient in alternative. Process of selecting funds for the most-successful endowments is extremely sophisticated, which explains their above-average returns.
- First-mover advantage. - top endowments invested earlier in alternative investments than their peers. Successful fund managers generally stick with the original investors and allow limited entry of new investors. Therefore, investors who enter an alternative investment market after the first-mover group will have returns that lag behind those of first movers due to the inability to invest with established top managers who have closed their investments to new investors.
- Access to a network of talent alumni. There is a strong correlation between the most-successful hedge fund managers and the most-prestigious universities. Such graduates thrive from the continued association and may end up working for their university’s endowment fund or allow the endowment to invest in the funds that they manage.
- Acceptance of liquidity risk. Given the long or perpetual holding period of endowments, as well as few liabilities and no spending requirements, endowments are easily able to accept liquidity risk. An illiquidity premium may be earned by investing in a relatively illiquid investment. There is also an element of potential underpricing due to the inefficient nature of private markets.
- Sophisticated investment staff and board oversight. Large endowments are often composed of experienced staff, which allows them to manage assets internally and ensures competent investment manager recommendations. Also, these endowments sometimes employ outside, nondiscretionary investment consultants that provide recommendations on asset and manager selections, with the ultimate decisions being voted on by the internal investment committee.
4.2 - Foundations and the Endowment Model
Quote
Advantages of
Outsourced CIO (OCIO) model
4.2 - Foundations and the Endowment Model
External consultants have power to make decisions on assets and manager selections without involvement of the investment committee
- more robust infrastructure and staff
- cost benefits (vs internally staffing professionals, training and education qualities)
- more efficient research
- more efficient and timely decision-making
(rise in use in smaller endowments)
4.2 - Foundations and the Endowment Model
Identify
Liquidity-Driven Investing Tiers
4.2 - Foundations and the Endowment Model
Classification / Relative Risk and Liquidity / Examples of Investments
Tier 1 assets / Low risk and very liquid / Short-term fixed income
Tier 2 assets / Risky and liquid / Equities
Tier 3 assets / Risky and illiquid / Private equity and hedge funds
spending needs and capital calls => Tier 1 + 2
4.2 - Foundations and the Endowment Model
Identify
Risks of the endowment model
4.2 - Foundations and the Endowment Model
- Inflation - nominal return targets vs inflation linked liabilities. Endowments raised exposure to real assets (RE, Natural resources, inflation-linked bonds, commodities futures, PE) given inflation hedge nature.
- Liquidity Issues - inability to meet commitments / spending needs, as a consequence of a liquidity crisis (lack of IPOs, divestments). Cash allocation of 6-14% avoid 95% of liquidit problems.
- Leverage risk - Expensive credit in crisis periods => funds subject to large drawdowns as well as restrictions on redemptions during crisis periods
4.2 - Foundations and the Endowment Model
Define
Tail risk
and
methods to avoid it
4.2 - Foundations and the Endowment Model
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
Methods to avoid tail risk:
1. Allocation in cash or risk-free debt - not commonly used (low return) (cash = suggested 6-14%)
2. Use equity options hedges. Put (high cost), collar (buy put OTM + sell call OTM), put spread (buy put OTM + sell put more OTM)
3. VIX Call, currency/commodity put - Buying put options on currency, commodity, and credit markets and buying call options on volatility indices when they are underpriced and selling them when they are overpriced
4. Allocation in individual asset classes (high-quality bonds rather than corporate bonds, “macro, managed futures, vol arb HFs” rather than arb HFs)
4.2 - Foundations and the Endowment Model
Contrast the tactical asset allocation (TAA) model with the strategic asset allocation
LO 4.2.6
the TAA model deliberately drifts from thetarget weights in an effort to reap excess returns or reduce risk.
the TAA model sees asset classes from a short-term and somewhat contrarian perspective.
What is the range of the liquidity beta of most forms of alternative investments?
LO 4.2.5
Above 1.
Alternative investments tend to have a beta greater than one. This high liquidity beta means that alternative investments may perform poorly during a financial crisis due to their illiquidity risk.
Why would Fixed income securities have a negative inflation beta?
LO 4.2.5
Negative inflation beta suggests that the returns of assets are falling as a result of inflation.
Fixed income securities generally are not immune to inflation risks (with the exception of inflation-linked bonds) and so they would likely exhibit negative inflation beta. Commodity futures, private equity, and real estate are all examples of real assets whose returns should rise with inflation levels and thereby exhibit positive inflation beta.
