Liquidity Isn’t Cash: Building a Portfolio Liquidity Budget

Liquidity is often thought of as simply “liquid” or “illiquid,” but in reality it exists along a continuum. It represents how quickly and reliably an asset can be converted to cash without significant loss in value. At one extreme, cash and overnight money market funds provide immediate access. At the other, stakes in private companies or long-lock private equity funds may take years to exit.

Even traditionally liquid markets can become illiquid under stress. In March 2020, U.S. Treasuries — normally the most liquid securities — saw bid-ask spreads multiply and trading stall until the Federal Reserve intervened. Liquidity is context-dependent: in calm markets, assets may trade in seconds; in crises, they may only sell at a steep discount or not at all.

Liquidity is valuable but comes at a cost. Highly liquid assets tend to offer lower returns, while investors in illiquid assets often expect higher returns as compensation — the illiquidity premium. Private equity funds have historically delivered 3–4% higher annual returns than public markets in exchange for multi-year lock-ups. The challenge is finding the right balance through thoughtful liquidity budgeting.

Source: Bloomberg, MPI, measuring returns from 12/31/14 through 12/31/24. “Private Equity” represented by the Preqin Private Equity Index as of 9/30/24. “Large Caps” represented by the MSCI ACWI NR Index, “Small Caps” represented by the MSCI ACWI Small Cap NR. Private Credit refers to the Preqin Private Debt Index, Agg Bond refers to the Bloomberg US Aggregate Bond Index, and High Yield refers to the ICE BofA US High Yield TR Index. Past performance does not guarantee or indicate future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index.

What Is a Portfolio Liquidity Budget?

A liquidity budget is a strategic plan for how much of a portfolio can be allocated to various liquidity categories, aligned with an investor’s needs. It defines an “illiquidity cap” — the maximum portion of the portfolio in hard-to-sell assets — based on cash needs, risk tolerance, and time horizon.

Without a budget, investors risk either overcommitting to illiquids and being forced to sell in distress, or over-indexing to cash and missing return opportunities. The budget should be dynamic, revisited when circumstances change.

Long-horizon investors with stable inflows can take on more illiquidity; those with large near-term liabilities should hold more liquid reserves. Leading endowments exploit their time horizon to harvest the illiquidity premium, but they also set discipline. For example, some maintain illiquid allocations anywhere from 10% to 80%, depending on inflows, spending, rebalancing needs, and capital call patterns.

Source: BlackRock as of 6/24/25. 290 advisors responded to the question “what % of a $5M+ portfolio would you invest in private markets?”

Classifying Assets by Liquidity Profile

A practical step is to bucket assets by time-to-cash under normal conditions:

• T+0 (Immediate Liquidity): Cash, bank deposits, overnight instruments, Treasury bills.

• T+2: Publicly traded stocks, bonds, ETFs, and mutual funds, generally settling in two days.

• 30–90 Days: Periodic liquidity, such as hedge funds, interval funds, and some private debt or real estate funds with redemption windows.

• 1–3 Years: Moderate illiquidity, e.g., private credit funds, closed-end funds nearing maturity.

• 3+ Years: High illiquidity, e.g., private equity, venture capital, infrastructure, direct holdings.

Not all alternatives are equally illiquid; a quarterly redemption REIT is not the same as a decade-long private equity fund. Allocations to each tier must align with the liquidity budget.

Market Liquidity Across Conditions

Liquidity changes with market conditions:

• Normal: Ample buyers, tight spreads, easy execution near fair value.

• Stressed: Wider spreads, cautious buyers, redemption gates, and asset sales at discounts.

• No-Bid: Severe crises where markets freeze — e.g., early 2009 secondary bids for private equity fell to ~35% of NAV.

Budgets should be stress-tested to ensure obligations can be met even if normal liquidity evaporates.

Matching Liquidity to Obligations

Liquidity serves three main purposes:

1. Operational Spending: Regular withdrawals such as endowment payouts or pension benefits.

2. Capital Calls: Contractual obligations to private funds, often arriving during market stress.

3. Rebalancing and Opportunities: Maintaining target allocations or seizing attractive investments in dislocations.

Best practice is to cover at least 1–2 years of spending and expected capital calls with ultra-liquid assets. Cambridge Associates suggests ensuring that, even after a severe market downturn, liquid assets still cover at least three times annual needs. Mapping obligations against sources — cash, Treasuries, sellable public assets — ensures a reliable buffer.

Source: Cambridge Associates LLC

Illiquidity Caps and Practical Takeaways

Setting an illiquidity cap involves scenario modeling. In downturns, falling public markets and ongoing private calls can sharply increase the portfolio’s illiquid percentage (the denominator effect).

Large endowments often hold 20–40% in illiquids; family offices sometimes more. Optimal ranges vary:

• Hold at least one year of obligations in ultra-liquid assets.

• Pass the “3× coverage” test in a stress scenario.

• Adjust for withdrawal flexibility — fixed obligations require more liquidity.

• Include limits in policy, monitor uncalled commitments.

Discipline prevents liquidity shortfalls and supports long-term strategy.

Source: Cambridge Associates LLC

Tools for Liquidity Management

Two tools can supplement liquidity planning:

• Credit Lines: Useful for short-term bridging but unreliable in crises unless committed; best as secondary buffers.

• Derivative Overlays: Futures or swaps can adjust exposures without selling assets, but add leverage and complexity. Best for experienced teams with pre-approved policies.

These tools complement but do not replace real balance-sheet liquidity.

Conclusion

Liquidity is not the same as cash — but it must be managed just as carefully. By classifying assets, aligning them with obligations, setting prudent illiquidity caps, and stress-testing for adverse conditions, investors can keep their portfolios resilient through downturns and agile in seizing opportunities.

A robust liquidity budget helps avoid forced sales, maintains strategic flexibility, and can turn crises into moments of strength.