Hi can someone offer a clear and good way to think about liquidity needs. I have a potential confusion about what exactly is defined as liquidity need. Let me give an example.
- I go to an investment manager and say here is 1 million dollars make a portfolio and invest it for me.
- He proceeds to put the money in stocks, bonds and whatever.
- Two months later I call him up and say hey man i need a 10000 dollars in cash fast.
- Part of the portfolio is invested in bonds and the manager recieves a monthtly interest of 5000 dollars, monthly dividends is 3000 dollars and monthly realized capital gains is 1000.
Given this information,
- is the liquidity need 10 000 i.e. liquidity is what you want from the manager in cash, how he gets it is his problem
- is the liquidity 2000 dollars i.e liquidity is cash needed net of cash generated in the portfolio from interest and dividend income
- is the liquidity 1000 (10000 - 5000 - 3000 - 1000) i.e. it is cash needs which have to be satisfied by selling as asset in the portoflio which did not have to sold before. i.e cash need - interest - dividend - realized capital gain (these gains were going to be realized and the asset sold indpendent of the liquidity issue and due to some other economic reason
- liquidty is some other thing then all three above
Can someone please clarify, what is the real defination of liquidity and a good mental process to go through in your head to identify liquidity needs and liquidity constraint portion in the individual ips section. Thank you
let me ask you a question in reverse. you need 10000$ - would you be satisfied with anything less and would you then praise your manager for giving you 1000$ when you really needed 10 times more?
aren’t you complicating this situation?
you also would have seen that this is the precise reason that there is a “cash/money market” balance on the asset allocation. Albeit the cash drag it creates - the cash which is worth about 6-9 months of monthly expenses depends on you (the client’s needs, risk tolerance, anticipation of needs etc). If it goes beyond that - the manager would have to sell stuff from the investment portfolio - but the amount he gives you should be what you need.
as i understand your point is that liquidity need is 10 000 in my example. whether it can be met by “income” (interest income or dividend income) or met my selling an asset, does not change the amount of need. i.e liquidity need is percieved from the clients perspective i.e. how much cash he needs and not from managers perspective i.e. Whether he can meet need by income (interest/dividend) coming into the portfolio or he will have to sell an asset is not relevant.
In the context you mentioned , the $10,000 is clearly an unanticipated need from the portfolio . The manager would have to maintain a cash reserve or invest partly in very liquid assets if she knew you were going to come up with oddball requests .
Usually CFA starts with some known “liquidity” needs in their vignettes. Otherwise they may take you thru scenario1 with some level or none of liquidity needs and then take you to a scenario2 some years after and give you a new liquidity needs situation.
Normal living needs are not considered liquidity needs because you knew what they were and as you rightly said you don’t have to necessarily generate that thru income producing assets ( not from dividends or interest income, which would attract top line tax, no offsets ) .You could invest in a long term assets and generate income by selling appreciated assets ( with some tax strategy overlay) .
But in the past papers ( CFA has put some of q’s from past papers in the EOC ) it turns out that if they don’t show any particular liquidity needs , in the guideline answer they would mention living expenses as liquidity needs . In other situations they might even add some given liquidity need and living expenses for a total liquidity. Not completely sure if that be wrong or right in a given context in light of the variability in definition . So I am going to just give the points to CFA if they are ambiguous.
Bottom line is living expenses are planned , known ones, liquidity is also known but a large piece , can only be generated by selling assets in fairly substantial amount