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of $7.5 million currently generate approximately $375,000 of annual income, up from
less than $200,000 five years ago. This increased income has been the result of somewhat
higher interest rates, as well as a shift in asset mix toward more bonds. To offset
operating deficits, the Good Samaritan Board of Governors has determined that the
endowment™s current income should be increased to approximately 6% of total assets (up
from 5% currently). The hospital has not received any significant additions to its
endowment assets in the past five years.
Identify and describe an appropriate set of investment objectives and constraints for
the Atkins Endowment Fund to be created after Mrs. Atkins™s death.

9. Several discussion meetings have provided the following information about one of your
firm™s new advisory clients, a charitable endowment fund recently created by means of a
one-time $10 million gift:
Return requirement. Planning is based on a minimum total return of 8% per year,
including an initial current income component of $500,000 (5% on beginning capital).
Realizing this current income target is the endowment fund™s primary return goal. (See
“unique needs” below.)
Time horizon. Perpetuity, except for requirement to make an $8,500,000 cash distribution
on June 30, 2006. (See “unique needs.”)
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Liquidity needs. None of a day-to-day nature until 2006. Income is distributed annually
after year-end. (See “unique needs.”)
Tax considerations. None; this endowment fund is exempt from taxes.
Legal and regulatory considerations. Minimal, but the prudent investor rule applies to
all investment actions.
Unique needs, circumstances, and preferences. The endowment fund must pay out to
another tax-exempt entity the sum of $8,500,000 in cash on June 30, 2006. The assets
remaining after this distribution will be retained by the fund in perpetuity. The
endowment fund has adopted a “spending rule” requiring a first-year current income
payout of $500,000; thereafter, the annual payout is to rise by 3% in real terms. Until
2006, annual income in excess of that required by the spending rule is to be reinvested.
After 2006, the spending rate will be reset at 5% of the then-existing capital.
With this information and information found in this chapter, do the following:
a. Formulate an appropriate investment policy statement for the endowment fund.
b. Identify and briefly explain three major ways in which your firm™s initial asset
allocation decisions for the endowment fund will be affected by the circumstances of
the account.
10. You have been named as investment adviser to a foundation established by Dr. Walter
Jones with an original contribution consisting entirely of the common stock of Jomedco,
Inc. Founded by Dr. Jones, Jomedco manufactures and markets medical devices
invented by the doctor and collects royalties on other patented innovations.
All of the shares that made up the initial contribution to the foundation were sold
at a public offering of Jomedco common stock, and the $5 million proceeds will be
delivered to the foundation within the next week. At the same time, Mrs. Jones will
receive $5 million in proceeds from the sale of her stock in Jomedco.
Dr. Jones™s purpose in establishing the Jones Foundation was to “offset the effect of
inflation on medical school tuition for the maximum number of worthy students.”
You are preparing for a meeting with the foundation trustees to discuss investment
policy and asset allocation.
a. Define and give examples that show the differences between an investment
objective, an investment constraint, and investment policy.
b. Identify and describe an appropriate set of investment objectives and investment
constraints for the Jones Foundation.
c. Based on the investment objectives and investment constraints identified in part b,
prepare a comprehensive investment policy statement for the Jones Foundation
to be recommended for adoption by the trustees.
11. You are P. J. Walter, CFA, a managing partner of a prestigious investment counseling
firm that specializes in individual rather than institutional accounts. The firm has
developed a national reputation for its ability to blend modern portfolio theory and

traditional portfolio methods. You have written a number of articles on portfolio
management. You are an authority on the subject of establishing investment policies and
programs for individual clients, tailored to their particular circumstances and needs.
Dr. and Mrs. A. J. Mason have been referred to your firm and to you in particular. At
your first meeting on June 2, 2001, Dr. Mason explained that he is an electrical engineer
and long-time professor at the Essex Institute. He is also an inventor and, after 30 years
of teaching, the rights to one of his patented inventions, the “inverse thermothrocle
valve,” has just been acquired by a new electronics company, ACS, Inc.
In anticipation of the potential value of his invention, Dr. Mason had followed his
accountant™s advice and established a private corporation, wholly owned by the Masons,
to hold the title to the inverse thermothrocle valve patent. It was this corporation that
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ACS acquired from the Masons for $1 million in cash, payable at the closing on June 7,
2001. In addition, ACS has agreed to pay royalties to Dr. Mason or his heirs, based on
its sales of systems that utilize the inverse thermothrocle valve.
Since ACS has no operating record, it is difficult for either the company or Dr.
Mason to forecast future sales and royalties. While all parties are optimistic about
prospects for success, they are also mindful of the risks associated with any new firm,
especially those exposed to the technological obsolescence of the electronics industry.
The management of ACS has indicated to Dr. Mason that he might expect royalties of
as much as $100,000 in the first year of production and maximum royalties of as
much as $500,000 annually thereafter.
During your counseling meeting, Mrs. Mason expressed concern for the proper
investment of the $1,000,000 initial payment. She pointed out that Dr. Mason has
invested all of their savings in his inventions. Thus, they will have only their Social
Security retirement benefits and a small pension from the Essex Institute to provide for
their retirement. Dr. Mason will be 65 in 2005. His salary from the Essex Institute is
$55,000 per year. Additionally, he expects to continue earning $10,000“$25,000
annually from consulting and speaking engagements.
The Masons have two daughters and a son, all of whom are married and have
families of their own. Dr. and Mrs. Mason are interested in helping with the education
of their grandchildren and have provided in their wills for their estate to be divided
among their children and grandchildren.
In the event that the royalty payments from ACS meet the projections cited above,
Mrs. Mason is interested in providing a scholarship fund in the name of Dr. Mason
for the benefit of enterprising young engineers attending the Essex Institute. The
scholarship fund ranks third behind the provision for the Masons™ retirement and for
the education of their grandchildren.
In your discussions with Dr. and Mrs. Mason, you have stressed the importance of
identifying investment objectives and constraints and having an appropriate investment
policy. Identify and describe an appropriate set of investment objectives and investment
constraints for Dr. and Mrs. Mason, and prepare a comprehensive investment policy
statement based on these investment objectives and constraints.
12. You are being interviewed for a job as a portfolio manager at an investment counseling
partnership. As part of the interview, you are asked to demonstrate your ability to
develop investment portfolio policy statements for the clients listed below:
a. A pension fund that is described as a mature defined-benefit plan; with the workforce
having an average age of 54; no unfunded pension liabilities; and wage cost
increases forecast at 9% annually.
b. A university endowment fund that is described as conservative; with investment
returns being utilized along with gifts and donations received to meet current

expenses, the spending rate is 5% per year; and inflation in costs is expected
at 8% annually.
c. A life insurance company that is described as specializing in annuities; policy
premium rates are based on a minimum annual accumulation rate of 14% in the
first year of the policy and a 10% minimum annual accumulation rate in the next
five years.

List and discuss separately for each client described above the objectives and constraints
that will determine the portfolio policy you would recommend for that client.
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Personal Diversification
Go to http://www.money.com/money/depts/retirement and find the calculator for diver-
sifying your portfolio. When you work in a given industry, other industries may be more
effective in diversifying your overall economic well-being. This calculator shows good
and bad choices for diversification for different employment industries.
Select the following industries and obtain the listing of the 10 best and 10 worst
industries for diversification: oil and gas (drilling and equipment); homebuilding; elec-
tronics (semiconductor). Then, answer the following questions:
1. Are the industries identified as best and worst considerably different for these
three employment industries?
2. Contrast the differences present in the categories for these industries.

1. A convenient and effective way to organize the answer to this question is to cast it in the context of
the investment policy statement framework.
< Concept
Risk: Endowment funds have no “safety nets” such as pension funds enjoy in the event of
difficulty, either in the form of corporate assets to fall back on or a call on public assistance, such
as from the Pension Benefit Guaranty Corporation. Moreover, endowment fund cash flows may be
highly erratic due to the uncertain timing of income from gifts and/or bequests, while pension fund
cash flows tend to be very predictable and steady. These differences suggest the typical endowment
fund will adopt a more conservative risk-bearing posture than will the typical pension fund, both as
to asset-class exposures and to the type of security content of such exposures.
Return: Because investment-related spending usually is limited to “income yield,” endowment
funds often focus their return goals on the matter of current spendable income; pension funds,
on the other hand, tend to adopt total return approaches, at least until a plan matures. Although
inflation protection is of great importance to both types of funds, endowment funds appear to be
less concerned with real return production than are pension funds, perhaps because of their
common emphasis on “income now” in setting return goals.
Time horizon: Theoretically, an endowment fund is a perpetuity while a pension fund may well
have a finite life span. Therefore, an endowment fund should operate with a very long-term view
of investment. However, such funds in practice tend to adopt shorter horizons than are typical of
pension funds (just as they typically assume less risk). Their tendency to emphasize income
production in the near term is the probable reason for this common occurrence.
Liquidity: Endowment funds, particularly those that use gifts and bequests to supplement their
investment income, often have fairly large liquidity reserves”both to protect against fluctuations in
their cash flows and reflecting their generally conservative outlooks”while, except for very mature

plans, pension funds tend to require minimum liquidity reserves. Endowment funds also frequently
maintain substantial liquid holdings to provide for known future cash payout requirements, such as
for new buildings.
Taxes: Here, although differing in detail, the situation of the two forms of institutions are very
much the same. In the United States, tax considerations are normally of minimal importance in
both cases.
Regulatory/Legal: Endowment fund investment is carried out under state governance, while
pension fund investment, in the United States, is carried out under federal law, specifically under
ERISA. The difference is significant. Endowment funds operate under the prudent investor rule,
where each investment must be judged on its own merits apart from any other portfolio holdings,
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622 Part SIX Active Investment Management

while pension plans operate under a broader context for investment”each security being judged in
terms of the portfolio as a whole”and an ERISA-mandated diversification requirement that often
leads to wider asset-class exposures.
Unique circumstances: Endowment funds often are faced with unique situations that
infrequently affect pension fund management, including the scrutiny of such special-interest groups
as trustees, alumni, faculty, student organizations, local community pressure groups, etc., each with
separate and often incompatible constraints and goals that may need to be accommodated in policy
setting and/or in investment content. Similarly, endowment funds often are subjected to severe
“social pressures” that, as in the case of tobacco firm divestment, can have an important investment
impact by restricting the available universe of investment securities, mandating participation or
nonparticipation in certain industries, sectors, or countries, or otherwise changing investment action
from what it would otherwise have been. In pension fund investment, ERISA requires that no other
interests be put ahead of the interests of the beneficiaries in determining investment actions.
2. Identify the elements that are life-cycle driven in the two schemes of objectives and constraints.
3. a. Policy, asset allocation.
b. Constraint, regulation.
c. Objective, return requirement.
d. Constraint, horizon.
e. Policy, market timing.
f. Constraint, taxes.
g. Objectives, risk tolerance.
h. Constraint, liquidity.
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