Although the direct method works well in meeting short-term and predictable cash flows, its heavy utilization of unproductive cash assets can make it a costly form of liquidity management over the longer-term. It is therefore worth considering a more dynamic hybrid process that complements the limited use of a direct approach with a structured indirect method. The indirect method attaches liquidity metrics, or scores, to all asset classes to accommodate the inclusion of important liquidity considerations when identifying and analyzing portfolios during asset allocation studies.
A liquidity metric can be quantified on a scale from zero to 100%, with zero reflecting low levels of liquidity and 100% reflecting a high level of liquidity.
The overall liquidity metric for each asset class can be derived by applying liquidity penalties to a beginning level of assumed market liquidity, constructing the framework as follows:
1. Establish market liquidity levels. The liquidity scoring process begins with a general notion of marketable vs. private/off-market transactions. Most marketable asset classes reflect a 90% or 100% starting level of market liquidity, while private asset classes reflect zero for market liquidity. This step of the process attempts to capture the tradeability of the assets.
2. Identify liquidity penalties. Market liquidity levels are further reduced by applying a liquidity penalty concept to reflect the potential erosion of liquidity that can result from asset class volatility and, perhaps more importantly, the sensitivity of that volatility to specific economic regimes. We include the following three liquidity penalties:
a. Growth penalty. The growth penalty captures the potential loss in liquidity that can result from asset class vulnerability to environments with disappointing or decelerating economic growth. Growth penalties range from zero, for asset classes with negative or low sensitivity to economic growth, to -50% for asset classes with significant positive exposure to growth. While it is not our intention to imply great precision in the -50% maximum penalty, the growth penalty attempts to generally quantify the liquidity impact as it relates to the risk of selling assets at distressed prices during growth-driven bear markets.
b. Inflation penalty. The inflation penalty captures the loss in potential liquidity that comes from asset class vulnerability to inflationary economic environments. Inflation penalties range from zero, for asset classes with positive or low negative sensitivity to inflation, to -17% (a third of the maximum growth penalty) for asset classes with significant negative exposure to inflation. The inflation penalty quantifies the liquidity impact as it relates to the risk of selling assets at distressed prices due to an inflationary-driven event.
c. Volatility penalty. Although the combination of growth and inflation penalties described above adequately capture the liquidity impairments for most asset classes, the process includes an additional check on each asset class' general level of volatility to ensure that the overall penalty accounts for all sources of volatility, whether driven by growth, inflation or some other factor exposure. Volatility penalties range from zero, for low-volatility asset classes, to -40% for asset classes with elevated levels of absolute volatility. Importantly, the volatility penalty is only applied if it is larger than the combined impact from the growth and inflation penalties. This treatment protects against the potential double-counting of volatility impacts already accounted for through the growth and inflation penalty process.
3. Overall liquidity metric: The overall liquidity metric reflects the combination of market liquidity and the impact from applying the various liquidity penalties. Since zero is the lowest value to express illiquid asset classes, we apply a zero value to those scores that would have otherwise resulted in negative values (i.e., where the size of the penalty exceeds the market liquidity level).
The following exhibit illustrates our current liquidity metric assumptions for several major asset classes across the three steps described above and includes a formula to demonstrate how the penalties are applied within the process.