Glossary of Terms: Managing an Endowment
To provide donors and investors in an organization with a foundation of comprehension around managing an endowment, here is a short glossary of terms and definitions.
Glossary of Terms
Premium Return
This is the annual return over inflation and other indices. The premium return required over inflation (real return) is calculated from historical real return of each asset class. The "real" historical return of each asset class has been as follows since 1926 with records of international funds being from 1973.
Cumulative Averages
Cash Equivalents: 0.0%
Bonds: 1.5%
Domestic Stocks: 5.0%
Small Cap Stocks: 8.0%
International Stocks: 9.0%
Total Funds Calculation
For balanced funds (70% Stock and 30% Bonds)
Target Index: 70-30
70% X 5%+30% X 1.5% = 4.0%
Example:
Balanced Fund Total $100,000
X 70% $70,000
X 5% 3,500
X 30% 30,000
X 1.5% 450
Total Fund $103,950 equals plus 4% (3.950)
Using this methodology, the five year performance goal is to exceed inflation by 4% as measured by the Consumer Price Index (CPI).
Equity Funds-Five Year Cumulative Average
The premium return over the Target Index is a weighted premium required of each portfolio section.
Equity portfolio premium required: To exceed each equity sector index.
Fixed Income Funds-Five Year Cumulative Average
The premium return for fixed income investments shall be measured against the Barclays Intermediate Government/Corporate Bond Index.
The premium required over the Target Index shall be as follows: fixed income portfolio investments shall have a premium return which exceeds the BIG/B index.
Large Cap Funds
Corporations whose price per share of common stock times the shares outstanding, (market
capitalization), exceeds $8 billion.
Mid Cap Funds
Corporations whose price per share of common stock times the number of shares outstanding
are between $1 billion and $8 billion.
Small Cap Funds
Corporations whose price per share of common stock times the number of shares outstanding
are less than $1 billion.
Mini Cap Funds
A corporation whose price per share of common stock times the number of shares
outstanding is less than $250 million.
Derivatives
The term "derivative" has been used to identify a range and variety of financial instruments. A "derivative" is commonly defined as a financial instrument whose performance is "derived," at least in part, from the performance of an underlying asset (such as a security or an index of securities). These financial instruments include, for example, futures, options on securities, options on futures, forward contracts, swap agreements and structured notes. In addition, participation in pools of mortgages or other assets are often defined as derivatives.
As a policy, the organization will not invest in such instruments commonly known and broadly defined as derivatives.
Hedge Funds
Typically, hedge funds invest in limited partnerships and are open only to accredited investors. Generally, hedge funds are exempt from SEC and NASD regulations. At this time, McKinley Carter would advise the organization not to invest in hedge funds.
Indices
S&P 500 – Standard and Poor's Index of 500 selected large and medium cap companies.
Most domestic equities are measured against these selected securities.
Russell 3000 is a broad index composed of large, medium and small cap funds.
S&P Mid Cap 400 is a index for mid cap funds.
Russell 2000 is an index specifically designed for small cap funds.
Dow REIT Index is the generally accepted standard for measuring real estate investment.
B.I.G.C.B.I. Barclays Intermediate Government Corporate Bond Index (or equivalent index)
is a selection of bonds which have a maturity date of not more than ten years.
MSCI-EAFE – Morgan Stanley Capital International—Europe, Australia, and Far East
Funds; (or equivalent index) a widely accepted index for measuring international
performance.
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Risk
Income Risk
Assuming the organization's "endowment" income, dividends and interest, averages 4% to 8%, and should the expenditure needs equal 4% to 8% then the income risk is minimized. A total return concept utilizes dividends, interest and capital appreciation. By using a portion of capital, appreciation exposes the endowment to increased long-term risk.
Capital Risk
This form of risk is thought of as risk in absolute terms or the risk of loss in terms relative to inflation. Capital risk can also mean the risk of loss relative to unique inflationary characteristics. Endowing high-tech laboratories is an example of unique capital risk.
Inflationary Risk
Inflation risk is probably higher at times than most financial advisers admit. When inflation is low, people tend to become comfortable with the economy incur debt, and buying real estate often without regard for inflationary spirals. The organization must always be aware of inflationary possibilities and plan accordingly. At McKinley Carter our professionals are trained to monitor the signals that may predict
inflation factors.
Investment Risk
With the emerging markets and unstable international financial condition, the international market place offers opportunity as well as risk. These opportunities create great rewards but carry great risks. A balanced approach may be the most appropriate at this time until greater stability in evidenced in the international market place. Small exposure to a large pool is probably the most prudent approach at this time. A "mutual fund" approach seems appropriate.
Risk Tolerance
Institutions, including community organizations, must determine their tolerance for risk. Both the near and long-term expenditures must be defined in terms of risk tolerance. Should near term
expenditure plans, for example, be "x" and the income be one half of "x," then the board must invade principal to meet the expenditure need. Understanding risk tolerance provides a level of comfort for board members who have ultimate fiduciary responsibility. The organization cannot tolerate any risk at this time since it does not have discretionary funds under management.
Guarantee Risk
Many community organizations offer certain gifting instruments which provide retention of income. With limited discretionary funds under management, the organization is not in a position to offer gifting instrument such as a charitable gift annuity. Furthermore, the organization is not able to guarantee returns for any funds under management.