I am reviewing a question from 2011 AM Q3 and have a question regarding to risk tolerance level for Foundation/Endownment.
Is it true that with higher spending need - the foundation/endowments have higher risk tolerance because the need/urgency to pay the spending needs? If so, is it higher risk taking ability?willingness? I am a bit confused now…I thought the opposite - that higher spending need/return requirement would/might erode the value of asset/return of the portfolio…Also, this is not true and not acceptable for DB but it’s ok for endowment/foundation?
In the question - with higher expected inflation --> endowment **demend higher real return to compensate for a perceived increase in risk. --> long-term real retunrs increase for the portfolio. (**but i think that Heavy inflation would eat your real value, and you can’t simply take on excess risk to combat it… or Endowment can??)
Also i read something from Schewser **- " The need to meet spending requirements and keep up with inflation can make higher risk appropriate" - does it mean higher risk tolerance (abilitiy?) (**my thoughts: how come? shouldn’t constraints drive return objective and not the other way around? isn’t taking more risk going to cause fund into trouble?? this is not acceptable for DB but ok for endowment/foundation? )
This is getting very confusing now. Need some help please guys (sorry for not being able to be clear, my brain is not working very well at the moment…)
In general, I would say the need for higher returns, and the wllingness and/or ability to take on more risk are separate characteristics.
So I don’t think the two are linearly related.
Your best friend could spend her life savings on drugs and alcohol, and subsequently have a greater need for a higher return to support her retirement, but based on her lower asset pool, she now has a lowe risk tolerance.
If the case doesn’t say anything specific that would lower willingness or ability, i think it is okay to use a higher return requirement/spending rate as evidence of a higher risk tolerance. I think this would fall into the “willingess” part of risk tolerance, but I dont know for sure. I think the same goes for higher inflation rates.
To be clear though, this would not be a good rationale for a pension plan or insurance company.
Hi Gersonide, thanks for your response. I am also confused and would like to get some help on my questions highlighted above. but guess what I was asking is for institutional investors such as foundaion/endowment and this doesn’t apply for individual investors to my opinion.
Thanks IhateMyLIFO. I agree this doesn’t apply to institutional investors such as DB/Insurance company, also not apply to individual investors i guess.
So just for exam purpose, can we be sure that this would be true for endownment/foundation that higher return requirement lead to higher risk tolerance? (but lower return requirement doesn’t seem to mean lower risk tolerance to me… it could be the case the fund can not only preserve value but also accumulate real value…as in the 2011 AM Part E answer)
Another related question could be: compare the risk tolerance level of two Endowments/foundations - one with 5% Spending need and another with 10% so we should choose the latter one? I thought that low spending rate would help ensure preservation of fund values so increase risk tolerance and also read it somewhere in past AM papers…Aren’t they conflicting maybe?
No absolutely not. Higher return requirement does not increase ur ability to take risk. Risk is determined by 1.) ability or 2.) willingness to take risk. If you have a higher return requirement, you need to compare that to your risk tolerance (determined seperately per 1 and 2) and determine if your high return requirement is possible in the context of risk tolerance and other portfolio constraints.
The risk tolerance is usually going to be driven by Time or the Objective (specific to Endowments). Endowments will have a low risk tolerance if the spend amount makes up a large chunk of operations. When an objective is tied to a contract or a liability it decreases risk tolerance. A foundation who’s objective is to fund research with lets say a 10% spend or 5% spend is still going to have the same high risk tolerance. Because the spend is just a liquidity constraint not an objective, their objective is to keep funding research till the money is gone. Most of the time whatever foundations are funding will be long term.
I think it is: take a DB scheme in deficit for instance - although their ability to take risk is low (because of deficit), they would love to earn more than normally (because of deficit) which means their willingness is above average to say the least.
in the PM mock, there was a question where it was said that the foundation was financing 75% of the spending of a college, but it STILL had a high risk tolerance. From this, and all the questions I have done previously, I’ve come to realise that endowments and foundations always seem to have a high risk tolerance, regardless of their spending. There only justification that I have seen for this high risk tolerance seems to be the time horizon, which is perpetual (in most cases).
If you look closely there isn’t enough detail to really conclude that answer, so most likely they just went with Long time horizon because it’s the safest answer right? Typical CFA thinking.
75% of operations is a tiny fraction at most 3% of the spend. The spend is being covered by inflows. So if you net everything the endowment is just sitting neutral. Lot of unclear things though so that’s why it wasn’t the “best” answer.
It’s usually above average, because of the time horizon and the spending rule they have to keep.
If it were 90-100% of a college ongiong operations, hospital…etc, and there are no donations or contributions, then it might be average.
Anything else like research, scholarships, or any non-profit organization cause is disposable and okay to gamble in the casino for according to the CFAI.
the question you are referring to about 75% of budget spend was annoying ( i remember making the same mistake) but I went back and read the passage and I believe they had something in there that they could accept donations to make up the difference
correct me if im wrong I think that was the underlying reason of them having a higher risk tolerance
The whole idea of high risk tolerance and perpetual time horizon was impressed upon me from the various questions I did from the CFAI EOCs, as well as some Elan practice questions, but what MrSmart says seems to make more sense!
Guys in the Modern Portfolio Theory everything spins around Return vs Risk tolerance so If we assume :
Higher return objectives = Higher risk taking hence is YES
also cause if you assume a Foundation (except for the “community”) has technically 5% annual spend and you increase your return requirement with unchanged spending you’ll be able in the long term to accumulate a larger asset base which increases your ability to take risk AND btw I come however across something like this in a past mock exam which confirmed the above question
Thanks guys, guess i will go with the general way to deal with endowment/foundation questions - refer to the part E of the same questions in 2011 mornign paper and it gave us a pretty good idea (which is the normal way ot thinking):
Lower (relative) commitment to university/(other org.)'s operating budged --> less likely to face a spending obligation short-fall --> higher risk tolerance holding all else constant
Only commited to cover operating deficit up to its spending rule. If the operating deficit is smaller than its spending rule, it will spend less. Therefore, in any period where it is required to spend less than spending rule (say 5%), it can accumulate real value.
Lower operating expense growth (due to inflation) --> (same as above)–> higher risk tolerance
I ncreasing donations (from government, private donations) —> endowment needs to provide fewer liquid assets and relieds less on the portfolio returns to satisfy spending needs --> higher risk tolerance
Smoothed spending rul e --> decrease volatility in spending requirements --> allowing to assume higher risk tolerance
Also I refer to 2014 AM paper Q6 Part A - endowment above-average risk tolerance
“T he endowment’s low spending rate of 2% helps ensure preservation of fund value”.
I think the way to conclude higher risk tolerance from higher inflation is thinking from a portfolio manager’s point of view instead of the fund itself. So the other explanation given by the CFAI that higher inflation would lead to lower risk tolerance makes more sense and I quote as below for reference:
" An increase in expected inflation may cuase the endwment to use inflation hedges, or to hold more iliquid assets in the portfolio to meet expected increased spending needs. This reduction in risk exposure may be considered a reduction in risk tolerance."
Please share if you have other thoughts/summary. Thanks!
Hey Sunseeker, i was a bit lazy above so didnt make it very clear.
The past exam was asking to compare the risk tolerance of two endowments and endowment A’s forecasted inflation for its operating expenses is expected to be 4% and endowment B 1%. So the answer suggests " B’s operating expenses are expected to gow a a slower rate than A’s, thus it is less likely to face a spending obligation shortfall in the future --> higher risk tolerance."
To me, this sounds like lower return requiremnt (lower growth of operating expense) so a higher risk tolerance. Let me know if you think this makes sense?
the lower operating expense lower the need to distribute more assets, but it doens’t lower fund’s risk tolerance because…lower need to distribute more money doesn’t reduce the capability/ability of fund to do so. It would increase more likely as real value of asset now increase.
Hmm it’s like, say i have 100 million and i only need to make 1 million per year and could live a good live, but it doesn’t mean i can’t take higher risk to earn more - as long as I want, i have the ability to do so but i might not do so on the quite opposite, if i have 100mm and i can only earn 5mm per year and i want to earn 10mm, my willingness is higher but my ability might not be (big lose would make me in trouble so lower abilitliy -->lower of ability and willingness for individual)
oh well, its really just my personal thoughts! that risk tolerance links with the capability (and willingness to the individual) of investor to take more risk.
Say you are superman and you can fly, but you don’t need to or not allowed to fly --> you still have the ability to fly and your super power ability is not decreased because of the limitation put on you
on the quite opposite, if i have 100mm and i can only earn 5mm per year and i want to earn 10mm, my willingness is higher but my ability might not be (big lose would make me in trouble so lower abilitliy -->lower of ability and willingness for individual)