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Optimal Investment Strategies for University Endowment Funds

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  • Robert C. Merton

Abstract

A common approach to the management of endowment is to treat it as if it were the only asset of the university. This approach leads to prescriptions for optimal investment and expenditure policies that are essentially the same across universities. Indeed, the resulting optimal portfolio strategies are focused almost exclusively on providing an efficient tradeoff between risk and expected return, a generic objective that is just as applicable to individuals and non-academic institutions as it is to universities. In contrast, the model developed here provides intertemporally optimal investment and expenditure rules for endowment that take account of the university's overall objectives and total resources. The explicit inclusion of other university assets in addition to endowment leads to optimal endowment portfolios that are not efficient in the sense of the risk-return tradeoff. Moreover, two universities with similar objectives and endowments can have very different optimal portfolios and expenditure patterns if their non-endowment sources of cash flow are different. The model also takes account of the uncertainty surrounding the costs of the various activities such as education, research, and knowledge storage that define the purpose of the university. As a result, the analysis reveals a perhaps somewhat latent role for endowment: namely, hedging against unanticipated changes in those costs.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3820.

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Date of creation: Aug 1991
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Publication status: published as Journal of Economic Dynamics and Control Bodie, Meron and Samuelson eds., Vol. 16, 1992 pp. 427-449
Handle: RePEc:nbr:nberwo:3820

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  1. Fischer, Stanley, 1975. "The Demand for Index Bonds," Journal of Political Economy, University of Chicago Press, vol. 83(3), pages 509-34, June.
  2. Brovender, Shlomo, 1974. "On the Economics of a University: Toward the Determination of Marginal Cost of Teaching Services," Journal of Political Economy, University of Chicago Press, vol. 82(3), pages 657-64, May/June.
  3. William D. Nordhaus, 1989. "Risk Analysis in Economics: An Application to University Finances," Cowles Foundation Discussion Papers 924, Cowles Foundation for Research in Economics, Yale University.
  4. Fama, Eugene F. & Jensen, Michael C., 1985. "Organizational forms and investment decisions," Journal of Financial Economics, Elsevier, vol. 14(1), pages 101-119, March.
  5. Bergman, Yaacov Z., 1985. "Time preference and capital asset pricing models," Journal of Financial Economics, Elsevier, vol. 14(1), pages 145-159, March.
  6. Sanford J Grossman & Guy Laroque, 2003. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Levine's Working Paper Archive 618897000000000803, David K. Levine.
  7. Hansmann, Henry, 1990. "Why Do Universities Have Endowments?," The Journal of Legal Studies, University of Chicago Press, vol. 19(1), pages 3-42, January.
  8. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
  9. Merton, Robert C., 1986. "Capital market theory and the pricing of financial securities," Working papers 1818-86., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  10. Detemple, J. & Zapatero, F., 1989. "Optimal Consumption-Portfolio Policies With Habit Formation," Papers fb-_90-02, Columbia - Graduate School of Business.
  11. Duffie, Darrell & Epstein, Larry G, 1992. "Stochastic Differential Utility," Econometrica, Econometric Society, vol. 60(2), pages 353-94, March.
  12. Litvack, James M & Malkiel, Burton G & Quandt, Richard E, 1974. "A Plan for the Definition of Endowment Income," American Economic Review, American Economic Association, vol. 64(2), pages 433-37, May.
  13. Tobin, James, 1974. "What Is Permanent Endowment Income?," American Economic Review, American Economic Association, vol. 64(2), pages 427-32, May.
  14. Eisner, Robert, 1974. "Endowment Income, Capital Gains and Inflation Accounting: Discussion," American Economic Review, American Economic Association, vol. 64(2), pages 438-41, May.
  15. Black, Stanley W, 1974. "Endowment Income, Capital Gains and Inflation Accounting: Discussion," American Economic Review, American Economic Association, vol. 64(2), pages 441-42, May.
  16. Nichols, Donald A, 1974. "The Investment Income Formula of the American Economic Association," American Economic Review, American Economic Association, vol. 64(2), pages 420-26, May.
  17. Bodie, Zvi, 1976. "Common Stocks as a Hedge against Inflation," Journal of Finance, American Finance Association, vol. 31(2), pages 459-70, May.
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Cited by:
  1. Leippold, Markus & Trojani, Fabio & Vanini, Paolo, 2006. "Equilibrium impact of value-at-risk regulation," Journal of Economic Dynamics and Control, Elsevier, vol. 30(8), pages 1277-1313, August.
  2. Isabelle Bajeux-Besnainou & Kurtay Ogunc, 2006. "Spending rules for endowment funds," Review of Quantitative Finance and Accounting, Springer, vol. 27(1), pages 93-107, August.
  3. Steven L. Green, 2009. "Why 5 percent? An analysis of optimal endowment spending rates," Studies in Economics and Finance, Emerald Group Publishing, vol. 26(4), pages 216-231, October.
  4. Rudolf, Markus & Ziemba, William T., 2004. "Intertemporal surplus management," Journal of Economic Dynamics and Control, Elsevier, vol. 28(5), pages 975-990, February.

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