Hi, I’m going through an old forum file with the IPS sections for each type of institution (banks, endowments, life insurance, etc.), and there is one line in it that I am confused by.
"Factor affecting risk tolerance of endowments:
Endowment’s role in operations (As increased leads to Increased Risk Tolerance)"
I assume this means that as an endowment funds more of the operations of say a university, that it has more risk tolerance. I would think that the opposite is actually true though.
Does anyone have a clarifying thought on this? Thanks for your help.
(When we sort this out, I’ll be able to post a nice new version of this file in excel.)
Relates to this paragraph in the text: An institution’s risk tolerance depends on the endowment’s role in the oper- ating budget and the institution’s ability to adapt to drops in spending. If endow- ment income represents only a small portion of the budget, poor investment returns may have little impact on the bottom line. On the other hand, modest drops in endowment value may have serious consequences if endowment income contributes a large part of overall revenues. If the same market forces affect both its donor base and its endowment, an institution that relies heavily on donations for current income may see donations drop at the same time as endowment income. Large fixed expenditures such as debt service can aggravate damage inflicted by drops in endowment income. (Level III 2012 Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors, 5th Edition. Pearson Learning Solutions p. 428).
You are correct, Chaddy. The greater the reliance in the endowment to fund operations without any other sources of funds (e.g. fund raising), the lower the risk tolerance. It is the same concept as a defined benefit plan. If the plan sponsor is not profitable and is heavily indebted, its ability to contribute money into the DB plan is low. As a result, the Plan’s overall risk tolerance is low.
Thank you, gentlemen. As promised, here is a link to the IPS stuff. I copied 85% of it from someone else’s work, but I have no idea who he was. https://docs.google.com/spreadsheet/ccc?key=0AjArCEeqvO53dER0b29iZDVOYy1iRnprdER0bXFrakE Please don’t hesitate to make changes or improvements. Thanks again.
As I said, someone else did most of the work, but my pleasure! I’m currently working on a ‘List of CFA Lists’ to memorize. I’ll post it also when I’m finished.