Question

You are a portfolio manager and senior executive vice president of Advisory Securities Selection, Inc. Your firm has been invited to meet with the trustees of the Wood Museum Endowment Funds. Wood Museum is a privately endowed charitable institution that is dependent on the investment return from a \(25 million endowment fund to balance the budget. The treasurer of the museum has recently completed the budget that indicates a need for cash flow of \)3 million in 2013, \(3.2 million in 2014, and \)3.5 million in 2015 from the endowment fund to balance the budget in those years. Currently, the entire endowment portfolio is invested in Treasury bills and money market funds because the trustees fear a financial crisis. The trustees do not anticipate any further capital contributions to the fund.

The trustees are all successful businesspeople, and they have been critical of the fund’s previous investment advisers because they did not follow a logical decision-making process.

In fact, several previous managers have been dismissed because of their inability to communicate with the trustees and their preoccupation with the fund’s relative performance rather than the cash flow needs.

Advisory Securities Selection, Inc., has been contacted by the trustees because of its reputation for understanding and relating to the client’s needs. The trustees have asked you, as a prospective portfolio manager for the Wood Museum Endowment Fund, to prepare a written report in response to the following questions. Your report will be circulated to the trustees before the initial interview on June 15, 2013.

Explain in detail how each of the following relates to the determination of either investor objectives or investor constraints that can be used to determine the portfolio policies for this three-year period for the Wood Museum Endowment Fund.

a. Liquidity requirements.

b. Return requirements.

c. Risk tolerance.

d. Time horizon.

e. Tax considerations.

f. Regulatory and legal considerations.

g. Unique needs and circumstances.

Short answer

As below

Step-by-step solution

Explanation on liquidity requirement ‘a’ 

Liquidity requirement: The need for quick cash from securities without any concession. For Wood Museums, considering the tight budget and fears of trustees for financial crisis indicate low tolerance for this risk.

Explanation on return requirement ‘b’

For Woods Museums Treasurer, the minimum returns to meet the budget requirements are:

$\text{Minimumreturns\hspace{0.17em}}=\frac{\text{Cashflowperyear}}{\text{Endowmentfund}}\times 100$

$\begin{array}{c}2013=\frac{\$3\text{\hspace{0.17em}million}}{\$25\text{\hspace{0.17em}million}}\times 100\\ =12\%\\ 2014=\frac{\$3.2\text{\hspace{0.17em}million}}{\$25\text{\hspace{0.17em}million}}\times 100\\ =12.8\%\\ 2015=\frac{\$3.5\text{\hspace{0.17em}million}}{\$25\text{\hspace{0.17em}million}}\times 100\\ =14\%\end{array}$

12%, 12.8% and 14% respectively from the year 2013 to 2015. The trustees would have to clarify how do they intend to treat capital gains relative to the budget.

Explanation on risk tolerance ‘c’ 

For Wood Museums, considering the tight budget and fears of trustees for financial crisis indicate low tolerance for the risk of financial meltdown .

Explanation on Time horizon ‘d’

Time horizon: For Woods Museums, the immediate requirement of budget in (1-3) years, suggests a very short time horizon for the major portion of the portfolio

Explanation on Tax considerations ‘e’

Tax considerations: Woods Museums is tax exempt hence Non-taxable

Explanation on regulatory and legal considerations ‘f’

Regulatory and legal: In the case of endowment fund, prudent man factors, legal structure of the fund and any state or federal regulation that might influence the management of investment portfolio must be considered.

Explanation on unique needs and circumstances ‘g’

This may include any condition or requirement that reflects the discretion of the trustees. For example, social factors could be a concern of the museum that the trustees may want reflected in the types of investments deemed appropriate for the fund.