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Optimal Investment Strategies for University Endowment Funds

In: Studies of Supply and Demand in Higher Education

  • Robert C. Merton

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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This chapter was published in:
  • Charles T. Clotfelter & Michael Rothschild, 1993. "Studies of Supply and Demand in Higher Education," NBER Books, National Bureau of Economic Research, Inc, number clot93-1, December.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 6102.
    Handle: RePEc:nbr:nberch:6102
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    1. 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.
    2. Bergman, Yaacov Z., 1985. "Time preference and capital asset pricing models," Journal of Financial Economics, Elsevier, vol. 14(1), pages 145-159, March.
    3. Eisner, Robert, 1974. "Endowment Income, Capital Gains and Inflation Accounting: Discussion," American Economic Review, American Economic Association, vol. 64(2), pages 438-41, May.
    4. Fischer, Stanley, 1975. "The Demand for Index Bonds," Journal of Political Economy, University of Chicago Press, vol. 83(3), pages 509-34, June.
    5. 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.
    6. Bodie, Zvi, 1976. "Common Stocks as a Hedge against Inflation," Journal of Finance, American Finance Association, vol. 31(2), pages 459-70, May.
    7. 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.
    8. Grossman, Sanford J & Laroque, Guy, 1990. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Econometrica, Econometric Society, vol. 58(1), pages 25-51, January.
    9. 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.
    10. Hansmann, Henry, 1990. "Why Do Universities Have Endowments?," The Journal of Legal Studies, University of Chicago Press, vol. 19(1), pages 3-42, January.
    11. Detemple, J. & Zapatero, F., 1989. "Optimal Consumption-Portfolio Policies With Habit Formation," Papers fb-_90-02, Columbia - Graduate School of Business.
    12. Duffie, Darrell & Epstein, Larry G, 1992. "Stochastic Differential Utility," Econometrica, Econometric Society, vol. 60(2), pages 353-94, March.
    13. Fama, Eugene F. & Jensen, Michael C., 1985. "Organizational forms and investment decisions," Journal of Financial Economics, Elsevier, vol. 14(1), pages 101-119, March.
    14. 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.
    15. 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.
    16. Tobin, James, 1974. "What Is Permanent Endowment Income?," American Economic Review, American Economic Association, vol. 64(2), pages 427-32, May.
    17. 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.
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