4.2 Foundations and Endowments Flashcards
(32 cards)
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 ___
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.
Contributions to endowments (cash and noncash) are treated as _____ that generate ______. Additionally, the investment income generated by the endowment may be ______
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
What is a restricted gift in relation to an endowment?
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
What is a foundation? (NP for CP)
A foundation is a nonprofit fund established for charitable purposes to support specific types of activities
Four types of foundations:
1. OF
2. CF
3. CF
4. IF
- operating foundations - similar to endowments in that the income generated is used to fund operating expenses of the organization
- community foundations - focus on a specific region, don’t operate their own programs but distribute to local charities
- corporate foundations - funded by corps and their employees - support charities in the local area
- 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
Differences between endowment and foundation:
1. spend on
2. length
3. donations
4. spending
- Endowments assist with operating expenses, while foundations provide grants
- Endowments usually exist in perpetuity, while foundations often have a limited life
- Endowments have ongoing donations, while foundations often do not
- Foundations have annual minimum spending rates (e.g., in the United States, it is 5%); endowments have more flexibility in determining their spending rate
What is the formula for the change in value of the endowment or foundation?
(income, spending, returns)
change in value = income from gifts – spending + net investment returns
What is intergenerational equity referring to? Expressed as?
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
Why are endowments are more likely than foundations to remain permanent?
Endowments are able to cut their spending rate, while foundations must keep at a minimum level.
Should endowments keep spending rates consistent or fluctuate with performance?
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.
What four things could reduce the real values of endowments and foundations?
- increase in inflation
- increase in spending
- decrease in gifts
- decrease in returns
Example of why endowments must seek returns in excess of inflation - e.g. universities (what benchmark).
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).
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?
5% plus inflation.
What is David Swensen’s endowment model view?
Focus on diversification and an equity tilt. Focusing on assets with higher expected returns such as alternative assets
Endowment model:
- corporate bonds
- foreign fixed-income
- domestic government bonds
- alternatives
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
Endowment allocation over last decade to alternatives? %
Impact on returns?
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
Correlation between endowment size, returns, allocation to alternatives?
There seems to be a positive correlation between the size of the endowment, the returns generated, and the allocation to alternative investments.
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?
- strategic asset allocation (long term) - calculated as target long-term asset allocation weights multiplied by benchmark returns for each asset class
- security selection - asset class return relative to a benchmark
- 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.
Six reasons why endowments outperform?
1. AAS (alts, rebalance, undervalued)
2. MS
3. FMA
4. TA (network effect)
5. LR
6. S
- aggressive allocation strategy - high proportion in alts, frequent rebalancing to maintain target allocation, buying undervalued asset classes)
- manager selection - use best managers, and as in altenatives this is important as they are inefficient markets, sophisticated selection process
- 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
- 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
- liquidity risk - perpetual nature means able to access illiquidity risk for premium
- sophistication of investment staff - may also employ consultants
What spending rate did David Swensen suggest?
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
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
- Commodity Futures: 6.5
- Farmland: 1.7
- TIPs: 0.8
- 3m T Bills: 0.3
- S&P 500: -2.4
- 20Y T Bonds: -3.1
In 1972, the Uniform Management of Institutional Funds Act allowed endowment spending rates to be determined on the basis of…
In 1972, the Uniform Management of Institutional Funds Act allowed endowment spending rates to be determined on the basis of portfolio total return
The ability of an asset to hedge inflation is indicated by its PIB (i.e., sensitivity of…).
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).
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 _______.
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.