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May 5, 2009

Managing Portfolio Liquidity: Position Level Calculation

Liquidity is a critical, yet often overlooked, risk constraint.  The reason it is frequently ignored is because position size is throttled by heuristics and mental calculation instead of having a repeatable method to factor liquidity into how the fund sizes positions.  Alpha Theory has developed a simple calculation to help determine portfolio liquidity constraints.

Start by determining the minimum and maximum position size you will allow for your portfolio.  If you don't have those pre-defined, see why it is important here.  We'll start by assuming a minimum position size of 1% and a maximum of 10%.  Then determine how many days you are willing to trade to get out of a position, we'll assume 5 and what percentage of the volume you are willing to be, we'll assume 20%.  Now we can calculate a minimum liquidity and preferred liquidity for the portfolio:

5 Days to Exit Position
x
20% of Daily Volume
x
1% and 10% Minimum and Maximum Position Sizes
x
\$500 M Fund Value
=
\$5 M Minimum Liquidity and \$50 M Preferred Liquidity

Liquidity is measure by a stocks average dollar volume (average daily volume x stock price)

Now we have defined a spectrum of liquidity for our portfolio.  We cannot invest in an asset that trades less than \$5 M per day and we are not concerned about liquidity for any asset that has over \$50 M of average dollar volume.

For that assets that fall in between, we can derive a maximum position size we are willing to take given the stocks average dollar volume.  For instance, we are considering putting Stock ABC in our portfolio and it trades \$25 M per day, which is above our minimum but not quite at our preferred.  To determine the maximum position size we are willing to take for Stock ABC:

\$25 M Liquidity (Average Dollar Volume)
/
\$500 M Fund Value
/
20% of Daily Volume
/
5 Days to Exit Position
=
5% Maximum Position Size

This is an important calculation that should be part of any portfolio risk control arsenal and the Liquidity Derived Maximum Position should be known for every investment prior to beginning the research process.  No need to do work on a name that you can't add to the portfolio anyway