When Cash is King: Liquidity Management (Part Two)

Often, when we talk about the importance of maintaining a cash reserve, it conjures images of cash stored in a coffee can, under a mattress or in a safety deposit box. The idea of saving cash for a rainy day makes sense. However, while it makes sense conceptually, it is rarely effectively practiced.

Managing cash is an important component of risk management. By “immunizing” near-term spending requirements in an appropriate way (which is a bit more involved than simply storing money in a Maxwell House can), Balentine helps clients pursue their long-term investment goals while maintaining a pool of assets and reserves.

Last fall in our piece, “When Cash is King,” we outlined Balentine’s reasons for holding cash and other liquid reserves and our process for determining how much to hold at any given time. In part two of our discussion, we will discuss how and when to refund cash and implementation options for this part of the portfolio.

How and when should a cash reserve be refunded?

While there is a clear need to hold cash, it is also important to develop a plan for refunding a reserve. The frequency and the source of replenishment for this reserve ultimately dictate when and how the cash should be refunded. Where the fund is sourced will determine when to refund. In an neutral risk environment, by holding the second year of spending needs in safe assets, the probability of having to refund the cash reserve from a severely depreciated asset class is greatly reduced. If the situation were reversed and safe assets were underperforming, then riskier assets should be the source of funds. At worst, this creates a choice between two uncorrelated asset classes and requires “forced rebalancing.” This forced rebalancing affords the opportunity to sell high and buy low. By refunding the cash reserve from the better performing asset class, the portfolio is selling appreciated assets rather than underperforming assets. This provides an additional level of risk management.

The question of when to refund the cash reserve is more arbitrary and is tied to environmental risk outlooks. Typically, we suggest refunding the liquid portion of the cash reserve when there are three months of spending remaining. By beginning the process with three months of liquidity in the cash reserve, the portfolio should have time to ride out any temporary market events. While exact timing is difficult, the frequency of refunding should correlate directly with the risk outlook. For example, as environmental risks increase, the frequency of refunding should increase. As global risks rise, the probability for asset prices to erode increases as well.

What are the implementation options for the cash reserve?

In liquidity management, the cash reserve is managed across the liquid and safe assets. It’s important to remember though that not all cash is created equal. In addition to money held in checking or savings accounts, marketable fixed income instruments with a maturity of less than one year are generally considered “cash.” For our purposes, we limit “cash” to investment grade securities with a maturity of less than one year. In doing this, we ensure both marketability/liquidity and low risk of principal loss.

Despite its role as a risk management tool, liquidity management in and of itself does come its own set of risks. For example, when holding cash, here is a risk of inflation, particularly in an environment where inflation exceeds short-term interest rates. Managing both liquidity risk and principal risk amplifies the potential for inflation risk; however, short duration TIPS could be used to manage the dangers of inflation in certain environments. Low principal risk does not necessarily imply low liquidity risk. For example, a bank CD always protects the principal, but it has high liquidity risk, meaning the funds will not be easily accessible (without a penalty). However, low liquidity risk coupled with low credit risk and low duration risk usually implies low principal risk. Therefore, we are willing to slightly relax the duration risk constraint in an effort to preserve purchasing power in certain environments (extraordinarily low interest rates with normal or high inflation), provided that credit risk is kept to a minimum. This exception allows for duration beyond the three months typically utilized by money market funds. By extending the duration up to 24 months in a cash-type vehicle, the opportunity cost of holding cash is somewhat reduced. However, a rapid rise in interest rates could negatively impact the value of the longer duration cash fund.

Because economic forces are at odds with one another, it is not possible to effectively manage all the risks present to a cash portfolio - inflation, principal, interest rate, credit, and duration - simultaneously. However, since the primary purpose of a cash management policy is to prevent a short-fall in immediate and near-term spending needs, a marginal amount of duration risk provides an opportunity to mitigate most of the risks without much cost.

No matter what the situation, an inherent amount of risk is a given. However, the strategies outlined above and in part one of this series should explain the processes and reasoning behind liquidity management. By immunizing near-term spending requirements in a proper way, portfolios are provided principal protection and investors become empowered to embrace a long-term investment approach.