Developing a Liquidity Management Policy

As Balentine has articulated over the years, proper liquidity management should not be taken for granted. While a seemingly innocuous subject in the world of public equities, variable rate fixed income securities, hedge funds, commodities and derivatives, failure to prepare for distributions can lead to undesirable outcomes for an entire portfolio.

Portfolio distributions – fixed or variable – are typically non-negotiable; they cannot be ignored for timing purposes. Consider a situation where a distribution is due, but the portfolio is significantly down in value. If there is not ample liquidity or cash on hand, the investment advisor will be required to sell assets at depressed levels to provide for the distribution. Avoiding this situation is logical and is the basis for a liquidity management policy.

The policy consists of two primary components: how much and how. How much is a function of the economic and market outlook: how volatile does the future look? This is important because the greater the uncertainty over the next 12, 24, or 36 months, the greater the likelihood of a portfolio declining in value. Because it is very difficult to project market returns over the next 12 months with any degree of certainty – and even more difficult to forecast the path of returns within that 12-month window – our starting point is to fund the cash reserve with 12 months of distribution requirements. As the outlook changes, the amount to hold in the cash reserve will also adjust. A more uncertain or negative outlook warrants a larger balance in the cash reserve to shepherd portfolios through choppier waters. With cash in reserve to provide for distribution needs, clients can afford to take a longer-term approach to portfolio management.

The “how,” a seemingly simple question, can present its own challenges. Not all cash is created equally. Money market funds, which are generally considered proxies for cash, can be invested in securities that are actually derivatives. That is not to say that all derivatives are risky or bad, but they are not cash. Additionally, there are other factors to consider such as credit quality, duration (or time to maturity), interest rate risk and liquidity. Balentine goes to great lengths to balance these tradeoffs. For example, given the recent stresses in the global economy, we made the decision to move all client money market holdings into a vehicle only invested in U.S. Treasury bonds. This ensured the highest credit quality and near certain liquidity, and this was achieved at no cost to clients in terms of expenses or opportunity (yield).

Safeguarding client distribution/spending needs is an often-overlooked consideration in portfolio management. It does not need to be complicated nor expensive; however, it must be an explicit part of any investment process. As we move into 2013, our outlook dictates that client portfolios maintain 12 months of distribution needs in a cash reserve and a second 12 months in Safe assets. As economic and market dynamics evolve, this policy may change. However, regardless of the environment, rest assured that we monitor the how and how much very closely.

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