Working Paper: NBER ID: w3820
Authors: 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.
Keywords: endowment funds; investment strategies; university finance
JEL Codes: G11; I22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Management of endowment assets (G23) | Overall financial health of the university (I23) |
| Nonendowment cash flows (G19) | Optimal investment strategy (G11) |
| Endowments (D64) | Hedging against unexpected changes in costs (F31) |