Endowments foundations and SWFs - Risk tolerance governance ...

Learning Outcomes

After studying this article, you will be able to identify the risk tolerance characteristics, governance structures, and investment policy goals applicable to endowments, foundations, and sovereign wealth funds (SWFs). You will be able to compare their objectives, recognize typical constraints and stakeholder influences, and evaluate the core features of their investment policy statements for the CFA Level 3 exam.

CFA Level 3 Syllabus

For CFA Level 3, you are required to understand the unique challenges and policies of endowments, foundations, and SWFs as institutional investors. Revision should focus on:

• Defining and contrasting the risk tolerance of endowments, foundations, and SWFs
• Recognizing the role of governance including oversight bodies, stakeholders, and fiduciary responsibilities
• Analyzing and structuring the investment policy statement (IPS) for these institutions, including objectives, constraints, asset allocation, and reporting requirements
• Evaluating the impact of external (legal, regulatory, tax) and internal (spending rules, payout requirements, legacy gifts) constraints on investment decisions
• Assessing liquidity needs, time horizons, and liability structures relevant to these institutions

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following statements best describes the risk tolerance of a large university endowment compared to a corporate pension plan?
2. Name two key stakeholders for a private charitable organization and explain how their interests might differ.
3. In the context of governance, which policy document is considered foundational for an institutional investor’s investment strategy?
4. List three typical legal, tax, or regulatory constraints that influence the investment strategies of sovereign wealth funds.

Introduction

Endowments, private foundations, and sovereign wealth funds (SWFs) are important institutional investors with distinct purposes, governance structures, and investment policy considerations. Success in managing these institutions’ portfolios hinges on clear articulation of risk tolerance, transparent governance models, and robust investment policy, all of which are core CFA Level 3 topics.

Institutional Overview

Endowments and foundations generally represent pools of capital accumulated through charitable donation. Their primary goal is supporting the long-term missions of entities such as universities, hospitals, or social organizations, with a strong focus on intergenerational equity.

SWFs, in contrast, are government-owned funds aiming to steward public wealth, often from commodity surpluses, forward for national development, budget stabilization, pension funding, or wealth transfer across generations.

Despite diversity in purpose, all three must formalize their approach to balancing risk, return, liquidity, time horizon, and external constraints, applying strong governance to ensure mission fulfilment.

Risk Tolerance

Institutional risk tolerance is the level of investment risk an institution is willing and able to undertake, determined by mission, liability profile, cash flow needs, and spending policies.

Key Term: Risk Tolerance
The maximum level of risk an institution willingly assumes in order to achieve its investment objectives, factoring in its obligations, liquidity needs, mission, and ability to bear loss.

Generally:

• University endowments: Long time horizons, low defined liabilities, high risk tolerance—especially with diverse donors and no legal minimum spending.
• Private foundations: Varies with type; perpetual grant-making foundations resemble endowments in risk tolerance, but those with mandatory payout rates or a defined lifespan may exhibit lower risk tolerance.
• SWFs: Highly heterogeneous. Intergenerational savings funds—long-term, high risk tolerance. Stabilization or development SWFs—shorter horizons, higher liquidity needs, and thus lower risk tolerance.

The risk tolerance for all institutional investors is shaped by regular reviews and stress-testing of projected portfolio values against spending needs, legal requirements, and reputational risk.

Key Term: Mission-Driven Investing
An investment approach where risk and return decisions are aligned directly with an explicit institutional mission, requiring periodic reviews to ensure ongoing alignment.

Governance

Effective governance is essential for these institutions. Good governance ensures prudent fiduciary oversight, manages principal–agent problems, and clarifies decision rights.

Key elements include

• A formal board of directors and investment committee
• Clearly documented investment policy, including mission, objectives, and asset allocation guidelines
• Strategic delegation of authority (e.g., tactical asset allocation, manager hiring/firing, operational risk)
• Transparency in reporting, performance measurement, and fees

Endowments and foundations must also handle donor-imposed restrictions, conflict of interest policies, and, for larger entities, often maintain a professional investment office.

SWFs vary—the governance structure may be embedded within government ministries, central banks, or stand-alone professional investment offices. All should document clear stakeholder accountabilities and lines of reporting.

Key Term: Investment Policy Statement (IPS)
A written policy document formalizing investment objectives, risk tolerance, constraints, implementation guidelines, and monitoring/reporting protocol for the institution.

Investment Policy Statement (IPS): Structure and Objectives

The IPS provides a framework for sound decision-making and continuity across generations.

Key IPS elements for endowments, foundations, and SWFs:

• Objectives: Typically maximizing long-term, inflation-adjusted spending ability (intergenerational equity), net of fees and inflation. Some SWFs pursue stabilization or development goals.
• Risk Tolerance: Explicit, including probability of negative returns, spending rule volatility, or minimum fund value.
• Constraints: Spending policies, legal/tax, donor or sovereign restrictions, payout requirements, liquidity, and eligible asset classes.
• Asset Allocation: Strategic target weights and rebalancing rules, with clear policy ranges. For endowments/foundations/SWFs with long horizons, may include significant allocations to equities, real assets, and alternatives.
• Governance Roles: Defines roles for board, committee, investment staff, and any external managers or consultants.
• Reporting/Monitoring: Frequency and scope of performance measurement, risk reporting, spending policy review, and IPS revision cycles.

Worked Example 1.1

A private university endowment has a $2 billion portfolio, a 10-year time horizon, and a goal to maintain purchasing power while spending 4.5% per year. Trustees are considering a major shift to private equity and infrastructure assets after recent strong public equity returns. Should they increase their risk tolerance?

Answer:
The endowment enjoys a long time horizon, perpetual mission, and flexible (non-mandatory) spending. Provided liquidity is managed, increasing risk tolerance and allocating more to growth and illiquid assets may be justified. IPS amendments should document this change, trigger a stress test of spending under negative scenarios, and ensure the board is comfortable with greater portfolio volatility.

Worked Example 1.2

A SWF in a commodity-exporting country is mandated mainly for budget stabilization but, after several years of surplus, wishes to diversify into equities. How should governance address this transition?

Answer:
The SWF should first clarify its core objective—is it preserving wealth for future generations or smoothing short-term budget volatility? If stabilization remains primary, the SWF’s IPS should limit allocation to less volatile, liquid assets. For a blended purpose, the portfolio could split assets into distinct sub-portfolios, each with suitable risk tolerance and governance controls, including separate reporting lines and performance benchmarks tied to their objectives.

Exam Warning

In CFA Level 3, do not assume all endowments and foundations share identical risk tolerance or liquidity. Assess the specifics—payout rules, donor restrictions, or legal requirements may lead to very different constraints and attitudes toward risk.

Spending Policy and Constraints

Endowments and most private foundations use a payout or spending policy (often a percent of trailing average market value). In the U.S., private foundations are legally required to spend at least 5% of assets per year; endowments usually set a payout in the 3–5% range, but with flexibility.

High mandatory payouts or defined lifespans limit risk tolerance and require higher allocations to liquid assets. Donor-imposed restrictions, state laws, or government policies further influence investible universe and rebalancing flexibility.

Key Term: Spending Rule
A policy defining how much of an endowment or charitable organization’s assets may be spent or distributed each year, often aiming to balance current needs with intergenerational equity.

Liquidity constraints should be carefully mapped to spending, expected future gifts, and rebalancing requirements. SWFs aimed at stabilization must overweight liquid government bonds and cash versus savings-focused SWFs or endowments, which can accept greater illiquidity to capture long-run growth.

Key Term: Liquidity Stress Test
A forward-looking analysis assessing whether the institution could meet all expected and possible unplanned outflows in adverse markets without impairing mission or forced fire sales of assets.

Asset Allocation

Strategic asset allocation is tailored to match risk tolerance and spending rules:

• Long-horizon, perpetual funds can commit large portfolio shares to equities, private markets, real assets, and alternatives.
• Shorter-horizon, development, or mandatory-payout foundations must balance growth with liquidity.
• SWFs with stabilization mandates must focus on liquid, low-volatility assets.

Governance should specify maximum and minimum allocations, rebalancing triggers, and liquidity buffers.

Worked Example 1.3

A private charitable organization has $200 million and aims to pay out 5% per year. It faces statutory minimum spending and donor wishes to restrict certain investments. Outline a scalable and compliant asset allocation and IPS governance solution.

Answer:
The policy should ensure liquidity for the statutory 5% payout, establish ranges for each asset class (e.g., minimum 40% in liquid assets), and explicitly record donor restrictions as binding. The investment committee should codify oversight of exceptions and the IPS must include a schedule for donor-reporting of compliance with their restrictions.

Summary Table: Institutional Characteristics

Key Point Checklist

This article has covered the following key knowledge points:

• Compare the risk tolerance, liquidity, and horizon of endowments, foundations, and SWFs
• Identify the governance structures and documentation (IPS, committees, roles) essential to institutional investment
• Structure clear investment policy statements with objectives, risk, constraints, asset allocation, and monitoring/reporting
• Distinguish the differing legal, regulatory, and tax constraints impacting each institution type
• Assess how spending rules and liquidity needs influence portfolio construction and risk management

Key Terms and Concepts

• Risk Tolerance
• Mission-Driven Investing
• Investment Policy Statement (IPS)
• Spending Rule
• Liquidity Stress Test