Just a f..... question!

[Mol]

Hi Guys… I already started working for next June.
I am having difficulties with an issue for endowments/foundations. When the spending rule is not given, shall we use expected reutrn as a spending required rate?

 

[CFAbeatmeup]

It’s highly likely the spending rate is given on the test, but since you asked.
For foundations, if it’s not given and there are no clues in the question (unlikely), it’s most likely a private foundation that has a 5% spending rate. Add that (or multiply 1 + spending rate) to the management fees and inflation for spending rate.
If it’s an endowment, it’s extremely unlikely no information is given because there is no standard spending rate. The only other way this is given I would expect is for them to give a percentage funding rate.
Example: Big Return investments manages a $100 million endowment portfolio for Overpriced State University. The goal of the university is to support the university by paying 25% of operating expenses. Those expenses are expected to be $10 million this year. In this case, the real spending rate is 2.5% ($10 million X 25% is $2.5 million — $2.5 million/$100 million = 2.5%).
The only other way is if the endowment or foundation follows a spending rule. This should be disclosed in the question. The two main ones are:
Rolling three year average: (Ending balance t-1, Ending balance t-2, Ending balance t-3)/3 X Spending rate
Geometric average: Percentage Weight (usually given) X (last year’s spending figure) X (1 + Inflation) + (1- Percentage Rate) X Spending Rate X Ending Value t-1

 

[Mol]

Thank you for your answer, anyway, why would the data for expected return be provided? Because it is…

 

[CFAbeatmeup]

I don’t know the question or the context, so I can’t comment as to why it’s provided. Perhaps the question is to compare if the expected return of the portfolio will cover the spending needs?!? If so, you compare the figure I gave above to the expected return. If E(R) > spending need: yes; if E(R) < spending need: no.

 

[onlysimon]

firstly, thanks for the question. it is much appreciated on this forum…
if there is no spending rule, then the implication is that you should have memorized the (legal) rules and that management fees are not included.
you should also know that a foundation is supposed to preserve real value - so incorporate inflation or sector specific inflation (healthcare lower, education higher).
then comes to what you are spending the money on. If it is for a specific purpose (to cure malaria) then likelyhood is you do whatever is needed to pay salaries etc. If it is closer to a prize for the poorest pupil, then go with previous years return..

 

[Rogue Trader]

For Foundations the Required Return is a number and is composed of: spending rate + inflation + management fees
- If both numbers are provided, be sure to use sector-specific inflation rather than general CPI
- Smoothing rule can be used to set spending rate,
- Multiplicative method is recommended, but additive method appears to be acceptable for exam purposes
- IMPORTANT: The Return Objective is not a number, it will be something like: “maintain the portfolio’s real value and meet the annual spending requirement”.
For endowments: Total return is the common objective
- Provide “significant, stable, and sustainable” funding
- Maintain inflation-adjusted purchasing power is a minimum
- Remember to use sector-specific inflation

 

[Mol]

I’m still confused about the issue… There was I think a previous test that used the expected return instead of spending rate and then multiplied by the relevant inflation and mgm fees to calculate required return… I can’t find it now, but it was confusing…

 

[iamMichael]

Mol wrote:
Hi Guys… I already started working for next June.
I am having difficulties with an issue for endowments/foundations. When the spending rule is not given, shall we use expected reutrn as a spending required rate?

5%

 

[Mipato]

The institute likes their tricks.
Throwing out a red herring - i.e a number that isn’t really needed to answer anything, is a favourite. And to be fair, closer to reality, where you’ll have all sorts of irrelevant information.
That said, a very specific wording in a question might end up making the irrelevant information relevant, If it states something like the foundation requiring the expected return to meet XYZ…then that changes what your requirement is. Learning to read carefuly but fast is key.