In the 2013 AM exam, there is a question about a particular foundation which is described as tax-exempt. One of the questions is to ID reasons why the foundation has a higher RT.
I could swear in an earlier mock, I saw that as a reason in the guideline response to a similar question. So I used that as one of my supporting reasons.
But i’s not listed in the guideline answers on this one. Anyone have insight on whether this would or would not be a factor in determining RT?
I think tax status would be more of a return objective approach, rather than tolerance for risk.
I wouldn’t think being tax-exempt would increase risk tolerance. If anything, being taxable should increase risk tolerance, as after-tax risk is lower than before tax risk: Std. Dev. (AT) = Std. Dev. (PT) * (1-T). At least, this is the case for individual investors.
Bearing in mind that the efficient frontier is curved – marginal risk/marginal return increases as return increases – consider two taxpayers: Mary and Bob.
Mary is tax-exempt and needs a 7% after-tax return; on the efficient frontier she can get 7% expected return with 8% standard deviation of returns.
Bob is not tax-exempt; he needs a 7% after tax return and pays 30% in taxes, so he needs a 10% before-tax return. Ten percent returns come with13% standard deviation of returns. So Bob’s after-tax return is 10%(1 − 0.3) = 7% and his after-tax volatility is 13%(1 − 0.3) = 9.51%.
Mary can tolerate 7% after taxes more easily than Bob can, ceteris paribus.
If I’m understanding correctly, then, taxable status is not a direct function of risk tolerance. Rather, a non-tax exempt entity would potentially require taking more risk, regardless of risk tolerance.
I was initially thinking that being tax-exempt meant that higher turnover was more acceptable, hence a higher ability to take risk.
I guess the bottom line is that for exam purposes, it’s not a reason for a higher risk tolerance.
Im thinking that if an organiztion is tax exempt, then they get to keep all the profits, therefore they can take greater risk.
However im open to clarificaiton.
Risk should be independent of return.
Your risk tolerance won’t improve if you can suddenly make 50% on your risk free assets.
Except if you consider risk here a function of itself, or in others, a multi-period simulation.
I believe the “tax-exempt” status is not a risk tolerance item, but a item to clarify “unique circumstances” because foundations, pensions, endowments are subject to “Unrelated Business Income” tax if they stray from their sole objective(s). However, I haven’t come across any questions that specifically ask for “Unique Circumstances” in the written exams; usually the questions ask about liquidity and time horizon.
I would try to find other case-specific items that are specific to risk tolerance…for example, Pensions (average age of workforce, percentage of retired vs active lives, health of a sponsor based on debt-to-equity or net income/sales ratios); Foundations (percent spent per year and whether that is a “goal” or a “mandatory” amount, recent returns on plan assets, perpetual or finite time period); and Endowments (impact to operating budget for the school, current size of the portfolio, ability to receive additional donations, size of the endowment and whether it can bear additional due-diligence costs for investing in alternative assets).
I also saw a question in a previous mock that listed the fact that the Foundation being Tax Exempt meant its risk tolerance was higher.
What are final thoughts on this?
I would say so. Because a foundation won`t have to pay any tax, it will have more funds available to meet its spending requirements and it will face less of a liquidity constraint.
From the questions I have seen so far, however, I am gathering that a foundation`s risk tolerance is largely determined by
a) its spending requirements
b) liquidity constraints (i.e. a foundation plans to make a significant contribution in the future).
c) time horizon (infinite, unless stated otherwise)