An endowment fund is an investment fund established by a foundation that makes consistent withdrawals from invested capital. The capital in endowment funds (often used by universities, nonprofit organizations, churches and hospitals) is generally employed for specific needs or to further a company’s operating process.

Endowment funds are typically funded entirely by donations that are deductible for the donors. The primary source of invested funds for an endowment fund is its own assets. The endowment fund will invest its own assets to meet various funding requirements.

The primary source of invested funds for an investment company is assets pooled from investors. The investment company will collect funds from investors to meet the needs of the investors.

The primary difference between investment companies and an endowment fund is the source and use of their invested funds. The investment company will collect funds from investors to meet the needs of the investors while the endowment fund will invest its own assets to meet various funding requirements.

In the United States, foundations have a minimum required spending rule but endowments can decide, change, or just fail to meet their spending rate. The three forms of spending rules are as follows:

– Simple spending rule.
– Rolling 3-year average spending rule.
– Geometric spending rule.

The rolling 3-year average spending rule is a modification to the simple spending rule that generates a spending amount that equals the spending rate multiplied by an average of the three previous years’ market value of endowment assets. The idea is to reduce the volatility of what the portfolio must distribute and of what the sponsor will receive and can spend.

The most straightforward spending rule is the simple spending rule. The simple spending rule is spending to equal the specified spending rate multiplied by the beginning period market value of endowment assets.

The geometric spending rule weights the prior year’s spending level adjusted for inflation by a smoothing rate, which is usually between 0.6 and 0.8, as well as the previous year’s beginning-of-period portfolio value. The geometric spending rule gives some smoothing but less weight to older periods.

Cognitive biases are generally easier to overcome with education than are emotional biases. Typical cognitive biases include the following:

– Conservatism in maintaining existing beliefs.
– Confirmation in seeking support for what is already believed.
– Illusion of control when the investor believes he can control what will happen to the investment.
– Anchoring and adjustment in making decisions in reference to the current position held.
– Availability in making decisions based on ease of recalling information.

In an emotional bias, a person will be usually inclined to believe something that has a positive emotional effect, that gives a pleasant feeling, even if there is evidence to the contrary. Typical emotional biases include the following:

– Overconfidence, familiarity, and illusion of knowledge leading the investor to overestimate the probability the investment will produce favorable returns.
– Naive extrapolation of past results.
– Status quo bias and failure to consider making changes.
– Endowment in expecting to be able to sell the asset for more than the investor would pay for it.
– Loyalty bias in retaining employer stock or feeling an obligation to retain an inherited position.

The key difference between both biases is that cognitive biases involve decisionmaking based on established concepts that may or may not be accurate while emotional biases typically occur spontaneously based on the personal feelings of an individual at the time a decision is made. Cognitive biases are generally easier to overcome with education than are emotional biases.

Reviewing past performance and current risk may help an investor with emotional bias gain perspective and think rationally. Managers may be able to help these investors with emotional biases overcome them by asking questions such as the following:

– What would you do if the position were cash rather than a single asset?
– When grandmother left this stock to you, did the shares make more sense to hold?
– If an equivalent sum to the value of the investments inherited had been received in cash, how would you invest the cash?

Both assets and liabilities are sensitive to changing interest rates. Banks continually monitor their interest rate risk and Value at Risk (VAR) is one of the commonly used tools in monitoring interest rate risk.

Leverage-Adjusted Duration Gap (LADG) is defined as the duration of the bank’s assets, less the leveraged duration of the bank’s liabilities. It is a duration gap measure that takes into account a bank’s overall exposure to interest rate risk.

Leverage-Adjusted Duration Gap (LADG) is the duration of the bank’s assets, less the leveraged duration of the bank’s liabilities. If Leverage-Adjusted Duration Gap (LADG) is negative, equity value moves in the same direction as interest rates.

Leverage-Adjusted Duration Gap (LADG) is the duration of the bank’s assets, less the leveraged duration of the bank’s liabilities. If Leverage-Adjusted Duration Gap (LADG) is positive, equity change is inverse to rates (e.g., rates up equity down).

Risk tolerance for endowments (and foundations) can be quite high. Risk tolerance should be set at a level to meet long-term objectives and distribution needs. Factors that affect risk tolerance include the following:

– Risk tolerance is reduced if there is no smoothing rule to dampen the effect of market value volatility on distribution amounts.
– Risk tolerance is reduced if the institution funded by the endowment is heavily dependent on the distributions from the endowment.
– Poor recent performance that reduces portfolio value combined with a smoothing rule decreases short-term ability to take risk as the required distribution amount in relation to current market value will increase.
– Higher return objectives may indicate a higher willingness to take risk as the objectives can only be met through higher risk.

An investment time horizon, or just time horizon, is the period of time one expects to hold an investment until they need the money back. The time horizon for endowment funds is typically perpetual because the purpose of most endowment funds is to provide a permanent source of funding.

The liquidity requirements of an endowment are usually low. Only emergency needs and current spending require liquidity. However, large outlays (e.g., capital improvements) may require higher levels of liquidity.

Endowments are generally tax exempt. There are exceptions and these might occur and be described in a given situation. In the United States, some assets generate unrelated business income. In that case, Unrelated Business Income Tax (UBIT) may have to be paid. If a case does include details on taxation, note this as a tax constraint and consider the after-tax return of that asset.

Regulation for endowments is limited. Foundations and endowments have broad latitude to set and pursue their objectives. In the United States, 501(c)(3) tax regulations require earnings from tax-exempt entities not be used for private individuals. Most states have adopted the Uniform Management Institutional Fund Act (UMIFA) of 1972 as the governing regulation for endowments. If no specific legal considerations are stated in the case, for U.S. entities, state UMIFA applies. Other countries may have other laws.

Issues relating to social issues like defense policies and racial biases, the nature of endowments and many foundations, and the cost and complexity of assets are all examples of unique circumstances. Examples of endowment unique circumstances include the following:

– Social issues (e.g., defense policies and racial biases) are typically taken into consideration when deciding upon asset allocation.
– The long-term nature of endowments and many foundations have led to significant use of alternative investments.
– The cost and complexity of these assets should be considered.
– They generally require active management expertise.

Endowment funds have many unique circumstances due to their diversity. Social issues (e.g., defense policies and racial biases) are typically taken into consideration when deciding upon asset allocation. The cost and complexity of these assets should be considered. The long-term nature of endowments and many foundations have led to significant use of alternative investments. They generally require active management expertise.

Insurance companies sell policies that promise payment to the policyholder if a covered event occurs during the life (term or period of coverage) of the policy. With life insurance, that event would be the death of the beneficiary.

Insurance companies sell policies that promise payment to the policyholder if a covered event occurs during the life (term or period of coverage) of the policy. With automobile insurance, the event might be an accident to the automobile.

The objectives and constraints of a bank’s securities portfolio derive from its place in the overall asset-liability structure of the bank. The time horizon of banks is short and linked to the duration of the liabilities.

The underwriting cycle, also known as the insurance cycle refers to fluctuations in the insurance business over a period of time. A typical underwriting cycle spans a number of years.

A probate is a legal process to validate and implement the will after death. Probate also refers to the general administering of a deceased person’s will or the estate of a deceased person without a will. Probate can be costly and makes details of the will public.

The amount necessary to meet all of an individual’s liabilities plus a reserve for unexpected needs is referred to as core capital. Core capital is the sum of the products of expected spending for each year and the probability of living that long.

Systematic risk is the risk that cannot be diversified away through holding a portfolio of risky assets. Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk is also known as undiversifiable risk.