Investment flexibility

An adviser writes down how much cash a client needs to keep. Two reasons are obvious. One is an emergency. The other is a goal falling due within a year.

There is a third reason, and it is easy to miss. Markets move. Some asset classes become overvalued and others become cheap. Acting on that needs money that is ready to spend.

That is investment flexibility. An investor with no spare cash cannot buy when prices fall. The only way to act is to sell something else, often at a bad price.

So a part of the portfolio is kept in cash or in cash-like securities. Not because a bill is coming, but because an opportunity might.

Section 15.5.1 lists 3 liquidity requirements an adviser must size before building a portfolio: emergency needs, a near-term goal, and investment flexibility. The workbook's wording for the third is the ability to take advantage of market opportunities as asset classes become overvalued and undervalued, which requires a greater degree of liquidity.

To meet all three, some portion of the portfolio should be in cash or cash like securities. The size of that portion is a judgement the adviser has to make, and the workbook frames it as a two-sided error:

• Keeping too much money for liquidity may hit the overall portfolio return.
• Not maintaining sufficient liquidity leads to inconvenience, and to selling of other investments untimely.

The liquidity constraints of the investor must then be clearly specified in the Investment Policy Statement, alongside the other constraints — regulatory, tax, time horizon and unique circumstances.

The workbook gives no percentage or rupee figure for this holding. It sets no minimum cash weight, no band, and no rule of thumb. Any number an adviser uses is the adviser's own judgement on the client's circumstances, not a workbook threshold — so a question asking "what percentage must be held for investment flexibility" has no answer in this paper.

Illustrative figures. Meera has a Rs 50,00,000 portfolio managed against an Investment Policy Statement. Her liquidity section reads:

Only the third line is investment flexibility. The first two are committed money.

Six months later, mid-cap valuations fall sharply and her adviser sees the mid-cap allocation drop to 14% against a target of 20%. Meera deploys the Rs 3,00,000 into mid-caps and brings the allocation back to target.

Now the other case. Suppose that Rs 3,00,000 had not been there. To buy the same mid-caps she would have had to redeem from her equity holdings in a falling market, or break into the car money, or touch the emergency fund. The first sells low to buy low and achieves nothing. The other two raid money already promised to something else.

And the cost of holding it: the liquid fund might return 6% while her long-term portfolio target is 11%. On Rs 3,00,000 that is a drag of roughly Rs 15,000 a year — the price of being able to act. If she had parked Rs 15,00,000 for flexibility instead, the same arithmetic would cost about Rs 75,000 a year, which is why the workbook warns that too much liquidity hits the portfolio return.

Chapter 15 (Portfolio Construction Process), section 15.5.1, on liquidity constraints — the first of the investment constraints, immediately before regulatory constraints at 15.5.2. Expect a question listing the liquidity requirements an adviser must provide for, where investment flexibility is the option candidates forget, or one asking which constraint explains why a portfolio holds cash when no goal is due.

• It is not the emergency fund. The emergency fund covers a loss of income; investment flexibility covers an opportunity. The workbook lists them as separate requirements in the same section.
• It is not a regulatory constraint. The Liberalised Remittance Scheme limit of $250,000 a year sits in section 15.5.2 and has nothing to do with liquidity. Do not carry that figure into a liquidity answer.
• More cash is not a safer portfolio. The workbook says plainly that keeping too much money for liquidity may hit the overall portfolio return.
• The constraint has to be written down. Liquidity needs belong in the Investment Policy Statement, not in the adviser's head.
• Near-term means within a year. Goals due within a year go into assets with relatively good liquidity and less risk; that is the second requirement, not this one.