Learning Outcomes
After reading this article, you will be able to differentiate endowments, foundations, and sovereign wealth funds (SWFs) with respect to their spending rules, liquidity requirements, and investment time horizons. You will understand the impact of spending policies on asset allocation, the importance of managing liquidity for both short- and long-term obligations, and how time horizon considerations drive portfolio construction for these institutions. You will also be able to compare key regulatory and operational differences relevant for the CFA exam.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand how endowment funds, foundations, and sovereign wealth funds manage their investments, including:
- Identifying core differences in the objectives, constraints, and stakeholders for endowments, foundations, and SWFs
- Describing the mechanics and implications of spending rules on portfolio policy
- Assessing factors influencing liquidity planning and requirements, including external spending, capital calls, and regulatory obligations
- Explaining how time horizon determines risk tolerance, asset allocation, and use of illiquid assets in institutional portfolios
- Evaluating the impact of spending rules and liquidity management on the long-term sustainability and intergenerational equity of institutional portfolios
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.
- What is a typical spending rule used by a university endowment, and how does it affect asset allocation?
- Why might a sovereign wealth fund have a different liquidity requirement than a private grant-making organization?
- Which characteristics of a grant-making organization’s liabilities will most impact the time horizon used for portfolio construction?
- True or false? Short-term liquidity needs generally limit the allocation to alternative assets in endowments.
Introduction
This article examines the distinctive investment features of university endowments, foundations, and sovereign wealth funds with a focus on spending rules, liquidity management, and investment time horizon. These institutions, each with specific missions, deploy their capital in service of long-term objectives but operate under diverse regulatory, spending, and liquidity frameworks. As a CFA candidate, you are expected to distinguish how spending policies and cashflow patterns inform risk appetite, drive asset allocation, and constrain portfolio implementation in these complex institutional settings.
Key Term: spending rule
A formalized policy used by an institution to determine the annual amount distributed from its investment portfolio, typically defined as a percentage of assets or a hybrid formula.Key Term: liquidity
The ability of an investor or institution to meet expected and unexpected cash outflows, including spending needs, obligations, and capital calls, without incurring significant losses.Key Term: time horizon
The investment period over which an institution plans to meet its objectives, affecting both risk tolerance and portfolio strategy.
SPENDING RULES AND THEIR IMPACT
A core function for endowments and foundations is to provide ongoing operational funding, usually via annual distributions based on a transparent spending rule. SWFs may also have explicit or implicit spending obligations, but the purpose, structure, and rules differ to reflect their national or intergenerational objectives.
Endowments
University endowments typically seek intergenerational equity, striving to fund current beneficiaries while preserving long-term purchasing power. The most common rule is the hybrid spending rule:
- A weighted average of a fixed percentage of the portfolio market value and the previous year’s distribution, often adjusted for inflation.
A common formula is:
Spending = (w × % of market value) + (1–w) × prior year spending × (1 + inflation adjustment)
This approach smooths annual distributions, reducing budgeting volatility for the institution.
The spending rule influences:
- The risk tolerance of the portfolio (more stable rules allow for higher equity and illiquid asset allocations)
- The required return target, as the portfolio must generate returns sufficient to meet spending needs and preserve real capital
- Decisions about drawdowns in years of poor market performance
Foundations
Private foundations are often subject to statutory minimum spending requirements (e.g., 5% of assets in the United States), regardless of market returns. The rule typically applies to the prior year-end market value. This legal distribution floor means that, in severe down markets, the organization may be forced to draw from principal, potentially compromising long-term capital.
Key impacts include:
- Lower risk tolerance if a high spending rate is mandated
- Tighter liquidity management, especially for foundations with illiquid or alternative investments
- Pressure on sustainability if spending regularly exceeds portfolio returns
Sovereign Wealth Funds
SWFs are established for purposes including stabilization, future savings, or supporting government budgets. The spending policies vary:
- Stabilization funds prioritize meeting short-term government deficits; spending may be highly variable and ad hoc.
- Savings funds or intergenerational funds may apply rules that limit annual withdrawals, such as a fixed % of assets (e.g., 3–4% rule) to safeguard capital for future generations.
Explicit spending rules anchor the fund’s long-term policy but may be informally overridden during crises.
LIQUIDITY POLICIES AND PLANNING
Effective liquidity management is essential for all institution types but reflects their unique goals and spending requirements.
Endowments and Foundations
- Liquidity planning must cover annual spending, capital calls for alternatives or private investments, and unplanned needs.
- With relatively predictable obligations, endowments and permanent foundations can allocate substantial capital to illiquid assets such as private equity, real estate, or hedge funds.
- Foundations with high pay-out rates or new 'spend-down' mandates (where the organization intentionally spends all capital within a set period) must hold a higher proportion of liquid assets.
Key considerations:
- Stress testing for simultaneous market drawdown and capital call scenarios
- Maintenance of cash buffers or lines of credit to reduce forced selling
- The effect of payout smoothing on the flexibility of illiquid allocations
SWFs
Liquidity management for SWFs varies based on fund type:
- Stabilization funds: Hold high levels of short-term, investment-grade bonds and cash equivalents to meet sudden government revenue shortfalls.
- Savings/reserve/time horizon funds: With longer-dated or undefined spending obligations, these funds invest heavily in equities and alternatives. Liquidity needs may rise over time as drawdowns or policy priorities change.
Exam Warning A common error is to ignore liquidity needs arising from capital commitments in alternatives. Even with generous endowment rules, unanticipated calls can lead to forced sales of liquid assets at disadvantageous prices.
TIME HORIZON AND ASSET ALLOCATION
The length and certainty of an institution’s investment horizon drive risk appetite and the appropriate allocation to illiquid or growth assets.
Endowments (Time Horizon)
- Investment horizon is perpetual—the institution’s goal is to fund future generations as well as current beneficiaries.
- Stable obligations and flexible spending rules allow endowments to take advantage of long time horizons, increasing allocations to equities, private markets, and real assets.
- Risks to horizon can arise from significant changes in university expenditure needs or external shocks to the institution.
Foundations (Time Horizon)
- Foundations may have perpetual or fixed periods (spend-down mandates).
- Perpetual foundations generally share endowments’ long horizon and high tolerance for volatility.
- Limited-life foundations have shortened time horizons, lower risk capacity, and must reduce illiquid allocations as the wind-down period shortens.
SWFs (Time Horizon)
- Horizons differ by fund type:
- Stabilization funds have short time horizons linked to immediate government needs.
- Savings/reserve and pension reserve funds aim for long (sometimes intergenerational) horizons, enabling allocations to higher-volatility, less liquid assets.
- Political intervention is a material risk to the stated time horizon of any SWF.
Worked Example 1.1
Question:
A university endowment has a 4% annual spending rule and a target return of 7% (net of inflation). It maintains a 25% allocation to illiquid alternatives. How would increasing the spending rule to 7% affect the endowment’s asset allocation?
Answer:
A higher spending rule requires higher annual payouts, increases the required target return, and makes it harder to sustain capital during market downturns. The endowment would likely have to reduce allocation to illiquid alternatives to ensure sufficient liquid assets for increased distributions and could need to lower overall portfolio risk.
Worked Example 1.2
Question:
A sovereign wealth fund has a stabilization mandate and faces unpredictable calls from the government to cover deficits during commodity downturns. What portfolio characteristics are suitable?
Answer:
The fund must prioritize liquidity and capital preservation. A high allocation to cash, treasury bills, and short-dated government bonds is required. Risky or illiquid assets must be minimized despite the long-term focus of other SWF types.
Revision Tip
When preparing for the CFA exam, pay close attention to how spending rules and liquidity requirements interact. Higher required payouts usually reduce risk tolerance and the viable allocation to alternatives.
Summary
Spending rules constrain annual distributions for endowments and foundations and shape asset allocation by setting the minimum required return target. Liquidity management ensures assets are available for payouts and capital calls, directly influencing the allocation to illiquid investments. Longer time horizons support greater portfolio risk, while limited or uncertain horizons call for more defensive, liquid asset mixes. In all cases, the practical details of spending needs, payout smoothing, capital commitment schedules, and regulatory minimums must be integrated in the institutional portfolio’s investment policy.
Key Point Checklist
This article has covered the following key knowledge points:
- Differentiate spending rules for endowments, foundations, and SWFs and their impact on asset allocation
- Explain liquidity planning and constraints for each institution type, including effects of capital commitments and payout schedules
- Analyse how investment time horizon shapes risk tolerance and the allocation to illiquid or growth assets
- Recognize how spending rules, liquidity, and time horizon interact in developing investment policy and strategic asset allocation
Key Terms and Concepts
- spending rule
- liquidity
- time horizon