Managing liquidity and rebalancing constraints

This extension of previous research by Morgan Stanley’s Martin Leibowitz and Anthony Bova provides an analysis of the relationships between rebalancing liquidity, portfolio flows, and diversification into illiquid assets.

The analysis shows that while spending programs and allocations to illiquid assets naturally reduce a fund’s overall liquidity, they may also lower cash required for rebalancing.

However, over multi-year horizons, spending costs can dominate the rebalancing effect and drive a portfolio’s fixed income reserves down to perhaps an intolerable level, the paper finds.

“Spending and illiquid assets have the effect of lowering cash required for the rebalancing process. However, spending itself consumes cash and a greater allocation to illiquids also detracts from a fund’s overall liquidity posture.

“These developments lead to smaller rebalancing transactions; however, this combination of higher spending and more illiquid allocations can place an increasing liquidity strain on the portfolio that is likely to exceed any benefit from smaller rebalancing transactions.”

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