Free CFA Level III: Portfolio Management Case Study: Endowment Practice Questions

C is correct. The spending policy (also called the distribution or payout policy) determines how much of the endowment's value is distributed each year to support the institution. Common approaches include a fixed percentage of a moving average of endowment market value (e.g., 5% of the 3-year rolling average). The spending rate directly affects the required investment return and the endowment's ability to maintain purchasing power.
A is incorrect because position limits are part of the investment policy, not the spending policy.
B is incorrect because credit quality requirements are investment policy constraints, not spending policy parameters.

C is correct. Derivatives overlays allow endowments to adjust asset class exposures quickly and cost-effectively without selling or buying physical securities. This is advantageous because: (1) futures and swaps have lower transaction costs than selling illiquid alternative investments, (2) execution is faster (immediate market exposure adjustment), and (3) underlying manager positions are not disturbed (the overlay operates on top of the existing portfolio). This is particularly valuable for TAA timing decisions.
Choice A is incorrect because derivatives can and do generate losses depending on market movements.
Choice B is incorrect because derivatives are subject to investment regulations, margin requirements, and counterparty risk management rules.

B is correct. The primary risk of shifting from fixed income (liquid, low-volatility) to infrastructure (illiquid, higher-volatility) is liquidity risk. Fixed income is the endowment's primary liquidity buffer: it can be sold quickly to meet capital calls, spending distributions, and other urgent cash needs. Reducing fixed income from 15% to 5% (100 million to 50 million at 2 billion AUM) halves the liquid cushion. Hargrove already has 300 million in unfunded PE commitments (100 million/year), and spending distributions of approximately 110 million/year. The liquid buffer must cover multiple simultaneous demands. Infrastructure investments have 10-15 year lock-up periods and limited secondary market liquidity, making them inappropriate as a liquidity source. The mean-variance improvement (higher real return and reasonable Sharpe ratio) is real but incomplete — traditional mean-variance analysis does not capture liquidity risk because it uses returns and volatilities that assume positions can be liquidated at fair value at any time, which is false for infrastructure.
Choice A is incorrect because while currency risk is a concern for international infrastructure, it is not the primary risk relative to liquidity. Modern infrastructure managers typically hedge significant currency exposure, and many endowments focus on domestic infrastructure to avoid this issue. Currency risk is manageable and secondary to the structural liquidity problem.
Choice C is incorrect because concentration within real assets is a portfolio construction concern, not the primary risk of this specific reallocation. The 12% volatility estimate for infrastructure is typical for diversified infrastructure funds; the concern about small commitment sizes is valid but secondary to the fundamental liquidity risk created by cutting fixed income in half.