Updated: Nov 19, 2019
The optimisation of a portfolio is subject to various constraints depending on the investor’s requirement for liquidity, the length of time for which an investor is willing to remain invested in a particular security before realising the returns, the tax treatment of returns etc.
Liquidity refers to the marketability of an asset; how quickly can it be converted to cash. It includes two parameters:
Market Breadth: Measured by the cost that is incurred while executing a transaction due to liquidity conditions on the counter, also known as impact cost.
Market Depth: Measured by the size of the transaction needed to bring about a unit change in the price. If the stock is highly liquid and has a large number of buyers and sellers, purchasing a bulk of shares will not result in noticeable stock price movements.
Higher the demand and supply of the security, higher the trading volume and lower the liquidity risk.
Usually, investors with low risk appetite and high liquidity requirements may choose to invest for a shorter horizon. Longer investment horizons offer higher risk adjusted returns due to high volatility and illiquidity.
Investors may also be sensitive to the tax treatment of the securities they invest in. Tax code may lead to a trade-off between diversification, tax needs and liquidity. In India due to higher net returns, tax free bonds, that usually have a long tenor (typically 15 to 20 years), may be sold at a premium but they are relatively thinly traded in India creating liquidity issues. The investment policy statement between the portfolio manager and investor should hence specify each of these constraints for formulation of an appropriate portfolio management strategy.