Reading 4.2

Question 1

An endowment is a _____ that is intended to be invested to maintain the _____ and to provide an annual income to support a purpose ____ of the capital

Answer 1

donated pool of capital

real value of its originally contributed assets in perpetuity

specified by the donor

Question 2

What is a corpus?

Answer 2

The nominal value of the initial donation that is to be maintained

Question 3

The endowment fund may have restrictions on the capital, thus referred to as

Answer 3

restricted gifts, which may require the university to maintain the corpus, while spending the income generated by the gift to benefit a stated purpose.

Question 4

Most endowments are run by a single organization, which, in the U.S., is typically a ___ charity

Answer 4

tax-free

Question 5

What are the 6 largest endowments in US & Canada and what are their sizes in 2008 and 2022

Answer 5

Question 6

What is a foundation and how does it differ from an endowment?

Answer 6

A foundation is a non-profit organization that either funds its own charitable causes or donates funds to other organizations.

While similar to endowments, foundations differ in the following ways:
1. They are grant-making institutions; whereas endowment funds are investment funds established by educational, health-care, or religious organizations to provide funds for a specific purpose.

2. They tend to have finite lives; whereas endowment funds have perpetual lives.
3. They are subject to minimum spending requirements.
4. They are less likely to receive funding from ongoing donations.

Question 7

4 types of foundations:

Answer 7

1. Operating foundations - most like endowments, income generated is used to fund the foundation’s operations. Many large operating foundations are sponsored by global pharmaceutical companies for the purpose of distributing medicine to those who cannot afford it.
2. Community foundations - located in a specific geographic region and distribute gifts and investment returns received as grants to other charities in the local community.
3. Corporate foundations - sponsored by corporations and, like community foundations, tend to donate to local charities in regions in which the company has the most employees or customers.
4. Independent foundations - funded by an individual or a family often with a single gift in the form of stock, and typically no subsequent gifts.

Question 8

2 challenges of a INDEPENDENT FOUNDATIONS to portfolio managers.

Answer 8

i. CONCENTRATION: The foundation’s wealth is often concentrated in a single stock, resulting in an undiversified portfolio with significant idiosyncratic risk.

ii. NO ADDITIONAL DONATIONS: Independent foundations do not typically receive additional donations after the initial donation is made.

Question 9

What is the largest foundation type in terms of asset size?

Answer 9

Question 10

Asset size of U.S. foundations ($___trillion at the end of 2022; most held by independent, individual, and family foundations) exceeds that of university endowments.

Of grants made by the top 1,000 foundations in 2020, ___ was
awarded to educational charities, ____% to health and human services, __% to arts and culture, __% to religion, and __% to other charities.

Answer 10

1.1

14%, 26%, 9%, 20%, 31%

Question 11

10 largest (by asset size) foundations in the world (2016)

Answer 11

Question 12

Donating stock to a charity may provide 2 significant tax benefits:

Answer 12

1. The charitable donation may be tax deductible at the current market value.
2. Capital gains tax is not charged on the appreciated stock position.

Question 13

What is intergenerational equity and what does it entail?

How can Intergenerational equity be expressed?

Answer 13

= equity through generations

This entails striking a balance between spending on the current generation of
beneficiaries and maintaining assets that can fund the organization’s operations to benefit future generations of beneficiaries.

Quantitatively as a 50% chance of maintaining the real (i.e., inflation-adjusted) value of the endowment in perpetuity

Question 14

What is the spending rate?

Answer 14

The fraction of asset value spent each year

Question 15

If longevity is highly important for intergenerational equity emphasis may be placed on what kind of approach?

Answer 15

On a barbell approach = combination of long-term risky assets and short-term conservative investments, with only part of the portfolio yield distributed.

Question 16

Change in endowment value formula

Answer 16

Change in endowment value = Income from gifts - Spending + Net investment returns

Question 17

U.S. foundations that are required to spend at least _% per year on operating expenses and charitable activities

In 2022, the average U.S. endowment spent __% of its assets.

Answer 17

5%

4.2%

Question 18

What is a return target?

Answer 18

Performance level that meets the objectives of the asset owners or beneficiaries

Question 19

A study shows that U.S. endowments with more than $1 billion in assets generated a ___% 10-year return.

Answer 19

9.4%

Question 20

David Swensen, chief investment officer of Yale University’s endowment fund, suggests that an endowment’s chance of surviving cyclical drawdowns and of generating returns in perpetuity are increased if ____

Answer 20

spending rates are not increased after periods of high returns

Question 21

What is the endowment model?

Answer 21

It is an investment approach that aims to generate high returns through
aggressive asset allocations, particularly to alternative investments, with limited investments to listed traditional investments

Question 22

Large university endowments have an average exposure of __% to alternative investments.

Smaller endowments hold fewer alternative assets: endowments with $101 million to $250 million hold __% and endowments with less than $25 million hold ___% .

The largest endowments allocate only _% to fixed income and cash; smaller endowments typically hold ___% in fixed income and cash.

Fairly large allocations are made to inflation hedging assets (i.e., real estate and natural resources), with the largest endowments holding about __% of their portfolio in these assets.

Answer 22

62%

28%, 8%

8%

15%-30

10%

Question 23

How fixed income securities are treated under the endowment model?

Answer 23

Only treasuries are bought.

Foreign national bonds are excluded to avoid currency risk associated with foreign bonds

Corporate bonds are excluded because of the illiquidity and relative risk compared to sovereign bonds (only 1% risk premium over treasuries)

Question 24

For an equally-weighted endowment (which averages allocations across 678 endowments, ranging from those with assets less than $25 million to those over $1 billion), the average allocation to alternatives nearly ___ (from __% to __%) from 2002 to 2022.

• College and university endowments’ allocations to alternatives ____: those with less than $25 million in assets have the ___ allocations to alternatives and those with $100 million to $500 million have the ___ allocations.
• Returns over the past 5 and 10 years are similar: the largest endowments have the ___ returns (and the ____ allocations to alternatives).

Answer 24

tripled, 11.8% and 36%

increase monotonically with asset size

smallest & largest

highest

largest

Question 25

Evidence indicates that all aggressive allocations to alternative investments do not earn the high returns generated by large endowments.

The historical investment outperformance of large endowments may be due to advantages that these endowments possess, which may be explained by 6 attributes of the endowment model that may provide these advantages:

Answer 25

1. Aggressive asset allocation
2. Effective investment manager selection 8
3. First-mover advantage
4. Access to network of talented alumni
5. Acceptance of liquidity risk
6. Sophisticated investment staff and board oversight

Question 26

Total return formula

Answer 26

= Returns from SAA+ Security selection (return of an asset class relative to a benchmark return) + Market timing or TAA

Question 27

What is TAA?

Answer 27

tactical asset allocation = return earned using different asset class weights compared to a policy or target asset class weight. Value is added when overweighted assets outperform underweighted assets

Question 28

A number of studies show that, with traditional investments, the SAA of pension plans accounts for about ___% of the variance in fund returns, with the remaining portion of variance explained by security selection and market timing.

Answer 28

91-94 %

Question 29

2 Findings of Brown, Garlappi, and Tiu (2010) on endowment funds over the period 1984-2005:

Answer 29

1) only 74% of returns can be explained by SAA, while 14.6% of returns come
from market timing and 8.4 % from security selection. This reveals that, in endowment funds’ less passive strategies, more returns come from dynamic asset allocation and manager selection.

2) policy portfolio returns are similar across endowments funds, with security selection explaining 72.8% of return differences, asset allocation contributing 15.3% (only about 20% of security selection), and timing explaining 2.5%. This underscores the importance of superior manager selection in the endowment
model relative to asset allocation. Given the contribution of manager selection, individual investors will find it difficult to duplicate the success of the endowment model.

Question 30

Large endowment funds allocate to ___ managers within traditional,
efficiently priced asset classes and to more than ___ managers in less efficiently priced alternative assets.

Answer 30

8 & 11

Question 31

Return dispersion across asset managers in alternative investments is relatively high: _% for hedge funds, over __% for private equity buyouts, and over __% for venture capital between first- and third-quartile managers.

In liquid, efficient markets, return dispersion across asset managers is
fairly small. For instance, Swensen shows that the spread between first- and third quartile managers of fixed-income investments was only ___%, and equity returns across managers ranged from _% to _% .

Answer 31

5, 10, 25%

0.5; 2-4.8%

Question 32

What are follow-on PE funds and what are their return characteristics?

Answer 32

Follow-on private equity funds are investment vehicles raised by private equity firms specifically to invest additional capital into companies they already own (their portfolio companies) from a previous fund.

Follow-on private equity funds selected by endowments are found to outperform private equity funds to which endowments do not make future commitments.

Question 33

Barber and Wang (2013) findings on alphas?

Answer 33

• Ivy League schools generated alphas greater than 3%
• 30 other schools with top SAT scores generated an alpha greater than 1.7%.
• schools with average SAT scores have considerably lower alphas.

Question 34

Anson (2010) the liquidity premium findings

Answer 34

liquidity premium is about:
- 2% for PE
- 2.7% for direct real estate.

Question 35

What is a non-discretionary investment consultant?

Answer 35

They advise on issues such as asset allocation and manager selection, and advice/ decisions are taken to the investment committee for a vote

Question 36

Who are putsourced CIOs (OCIOs), when did their usage increase and who tends to use them?

Answer 36

They are external consultants with discretionary authority to make and implement specific decisions without the investment committee’s vote.

Use of OCIOs by endowments increased considerably after the 2008 financial crisis.

Small endowments, foundations, and pension funds with liability-driven investing targets tend to use the OCIO model

Question 37

The Commonfund Institute (2013) discusses benefits to hiring OCIOs, particularly for endowments with large allocations to alternative investments:

Answer 37

i. Improved resources
■ OCIO firms have a large staff, considerable resources, and substantial infrastructure that they use for their clients.

ii. Economies of scale in manager research
■ Alternative investment managers can visit the OCIO firm rather than
visiting dozens of underlying investors.

iii. More cost-effective
■ OCIO firms can be cost-effective compared to training and retaining
investment professionals experienced in managing endowment assets.
OCIO firms may also help train endowment staff.

iv. More efficient decision-making
■ OCIO firms can make investment decisions faster and more efficiently
than investment committees (which often take more than three months to
make investment decisions). This is accomplished by enabling the
investment committee to provide oversight rather than being involved in
the fund’s daily management.

Question 38

Portfolio management of large endowment funds needs to address 3 special set of risks:

Answer 38

1. Interaction between spending rates, inflation, and the endowment’s long-term asset value
2. Liquidity risk and challenges with rebalancing
3. Protecting against tail risk (i.e., large drawdowns in value during times of high systemic risk)

Question 39

a spending rule should be established ____

Answer 39

Once an asset allocation is determined,

Question 40

How did endowment spending rules have changed over time?

Answer 40

1) initially only spent income, which tilted the portfolio toward income-producing securities;
2) later adopted spending rates that were a fixed percentage (e.g., 4%) of the endowment’s value.
3) Between the 1950s and 1970s, endowment managers began to adopt the notion that spending rates depended on total return and, as such they became total return investors

Question 41

Who are total return investors

Answer 41

investors who consider income and capital appreciation as components of return

Question 42

What are sticky spending rates and their pros/cons

Answer 42

(e.g., $4 million per year)

provide certainty of income, but create concerns of intergenerational equity after large gains or losses in endowment value

Question 43

What are the common spending rates?

Answer 43

1) 70% of endowments use spending rates of 4%-6%.

2) While 5% is a popular spending rate, it has a 50% probability of losing half of the endowment’s real value over the course of a generation.

3) Yale endowment’s 4.5% long-term spending rate is based on a
five-year average of endowment values

Question 44

To reduce the effect of the volatility of portfolio returns on the income available to universities what approach was introduced?

Share 2 different types of approaches?

Answer 44

smoothing processes (e.g., simple moving averages) were introduced to develop more flexible spending rules.

1) set a spending rate that is 4% of the average endowment value over the trailing 3-5 years.

2) The Yale University endowment fund’s spending rule was a spending rate of 80% of the prior year’s dollar spending plus 20% of the endowment’s long-term spending rate (set at 4.5% ). This rule incorporates the prior ten years of endowment value into the spending rate, resulting in a stronger smoothing effect than a simple moving average.

Question 45

What are inflation betas

Answer 45

(i.e., sensitivities of asset returns to changes in inflation

Question 46

Inflation betas of 20yr Treasury, S&P500, 3mn Treasury, 10yr TIPS, Farmland and Commodity Futures according to Alliance Bernstein report (2010)

Answer 46

Question 47

What are TIPS

Answer 47

Treasury Inflation-Protected Securities

Question 48

What is liquidity-driven investing strategy and how does it work?

Answer 48

a strategy that matches investments’ liquidity to investors’ time horizons in asset allocation decisions

The strategy uses a three-tiered system of assets, where tier 1 and tier 2 assets can be liquidated quickly at relatively low cost and tier 3 assets are long-term investments that are not typically liquidated before maturity.
1. Tier 1 assets are low-risk, liquid assets (e.g., short-term fixed income).
2. Tier 2 assets are risky, liquid assets (e.g., stocks).
3. Tier 3 assets are risky, illiquid assets (e.g., private equity and hedge funds).

endowment funds estimate spending amounts and capital calls for the
next ten years and invest in tier 1 and tier 2 assets to cover those expenses

Question 49

Takahashi and Alexander (2002) from Yale’s endowment fund stress the importance of understanding private equity and real estate funds’ uncertain capital call and distribution schedules. What are the general schedules for capital calls and distributions?

Answer 49

In general, private funds typically call committed capital over the first three years, make investments for the next few years, and then distribute proceeds in later years (e.g., in years 7-12).

When the investment program has matured, distributions may be used to fund new partnerships.

Question 50

Sheikh and Sun (2012) find that the optimal level of cash and fixed-income holdings for an endowment should be:

Answer 50

6%-14% of assets to avoid liquidity crises in 95% of market conditions.

These liquid holdings may need to be as high as 35% to eliminate liquidity risk entirely, but this level is far higher than allocations most endowments make.

Question 51

To avoid liquidity crises, Siegel (2008) suggests …

Answer 51

staggering (or laddering) allocations to private equity and real estate funds over several years, where distributions from maturing funds are used to fund capital calls of more recent vintages.

Question 52

Why Keating (2011) believes that, after slight changes to liquidity, confidence in the endowment model has increased?

Answer 52

He contended that the liquidity crisis was not due to over-allocating to
alternatives, but to under-allocating to cash and fixed-income. Therefore, the solution is to increase allocation to cash and fixed income

Question 53

Why not rebalancing regularly increases a portfolio’s risk?

Answer 53

Without rebalancing, the portfolio’s asset allocation will drift and allocate more to the asset classes earning the highest return

Question 54

There are a 2 main ways to rebalance a portfolio:

Answer 54

1) Rebalancing activity can occur on a calendar basis (e.g., after an investment committee’s quarterly meeting).

2) Rebalancing can be based on a comparison between the actual asset allocation and the longterm policy asset allocation.
► Investors with exact target allocations (e.g., 35% for domestic equity) may have a rebalancing deviation. For instance, they may rebalance when the allocation has strayed 3 % from its target weight.
► Investors with target asset allocation ranges (e.g., 25%-35% for domestic equity) may rebalance once the allocation has moved outside of the range. These investors also need to establish the value in the range to which they will rebalance.

Question 55

When is rebalancing is beneficial and detrimental?

How do some portfolio managers deal with this issue?

Answer 55

in mean-reverting markets can increase returns, but can reduce returns in trending markets.

Some portfolio managers delay rebalancing when markets are trending or rebalance half-way back to the target.

Question 56

Some endowment funds use tactical asset allocation (TAA), which differs from strategic asset allocation in 2 main ways:

What data is used in TAA?

Answer 56

1) Instead of regularly rebalancing to long-term target weights, TAA involves deviating from target weights in order to capture excess returns or reduce portfolio risk.

2) Instead of a long-term perspective of 10-20 years, TAA has a short-term perspective (often of less than one year) that overweights undervalued assets and underweights overvalued assets.

TAA models use valuation, fundamental, macroeconomic, and price momentum data.

Question 57

TAA is used by alternative investment strategies like: managed futures funds (that focus on price momentum) and global macro funds (that examine governmental actions to predict currency moves).

While TAA funds may use both price and macro data, they differ from managed futures and macro funds in 2 main ways:

Answer 57

1) TAA funds are typically long-only, unlevered funds, whereas managed futures and macro funds take both long and short positions and are often levered.

2) TAA funds may reallocate assets across a few macro markets, whereas managed futures and global macro funds tend to have a larger universe of potential investments

Question 58

What is Tail risk?

Answer 58

Refers to the risk of sizeable portfolio value loss, resulting from returns that are in the far left tail of a return distribution.

Question 59

In periods of market stress, correlations between many assets ___ , which ___ above those assumed in mean-variance optimization that may have been used to determine the ____

Answer 59

increase

raises portfolio volatilities

initial asset allocation

Question 60

Tail risk can be reduced in a number of ways:

Answer 60

1. Increase allocations to cash and risk-free debt (This approach reduces portfolios’ expected returns and may reduce long-term wealth, thus it is not typically used by endowment funds)
2. Use equity option hedges (primarily established to reduce a portfolio’s equity risk)
   - Buying puts directly provides the strongest hedge but is costly.
   - To reduce costs, investors can use collars (selling calls to offset put costs) or put spreads (buying one put and selling another at a lower strike price) which offer some protection but at a reduced cost.
3. Structure allocations within asset classes to reduce exposure to extreme events:
   - invest in high-quality bonds whose values are expected to rise during crises and avoid corporate bonds
   - small allocations can be made to arbitrage strategies that depend on narrowing spreads, availability of leverage, and liquid markets
   - large allocations can be made to strategies designed to perform well
   during crises (e.g., macro funds, managed futures, and some volatility arbitrage funds) - success less certain than buying put options, cost is significantly less

Question 61

What is a collar in options trading?

Answer 61

simultaneously buying a put option and selling a call option

=

buying a selling right & accept a possible selling obligation