Liquidity is critical to the daily movements of institutional and retail traders, but what about advisors who are picking securities for long-horizon clients? VettaFi contributor Dan Mika spoke with William Knight, a wealth advisor at Pittsburgh-based Legend Financial Advisors, about his strategies around liquidity when working with high net worth clients.
Dan Mika, VettaFi: Walk me through your thought process when you are sitting down with a client, whether they’re high net worth, or they have specific strategies in mind that aren’t a long-term buy-and-hold strategy. How much does the liquidity of the underlying security matter in your selection process whether it’s a stock, a bond, or an ETF?
William Knight, Legend Financial Advisors: Liquidity does play a part in our security selection process, and the reason being will depend upon the client’s cash flow needs. So whether it’s something where we have a monthly distribution that they take for their cash flow needs, or where if it’s a client that has a longer time horizon, maybe it’s five, 10, 20 years. That’ll certainly play a part in terms of the underlying investments we’re selecting.
VettaFi: What goes into the thought process and the actual security selection? Are there certain factors that you look for other than just the bid/ask spread in building a portfolio for clients that need monthly distributions or want to be more active?
Knight: We have a preference for ETFs when it comes to liquidity. When we’re creating portfolios over the past several years, we’ve been using more ETFs as a result, because whether we are rebalancing or trying to find the right security to make a sale to rebalance the portfolio, it gives us more flexibility. It’s typically better for the client because we don’t have any trading fees that are involved. Typically, liquidity isn’t much of a concern, and if that’s ever the case, we can typically work with our custodian to arrange trades with the market makers themselves.
VettaFi: Has there been a scenario where it would be preferable to use something other than ETF, whether for liquidity reasons or something else?
Knight: We would favor a mutual fund if the performance for a particular strategy is superior to what we can find available in an ETF. Health care has been one of those sectors where we’ve had a mutual fund in the portfolios for over the past decade and we really haven’t been able to find anything that has been able to compete with it. There are also situations and the debt side of the market, where for the most part we’ve found more attractive mutual funds relative to ETF counterparts. The floating rate area of bonds is one of those areas in particular.
VettaFi: And are those mutual funds strategies active or passive?
Knight: They are active.
VettaFi: How much do you find that plays into the security selection and the analysis of its liquidity?
Knight: It does play a role, but it hasn’t played a part in causing a constraint. With the mutual funds we’ve utilized, we can sell any day the markets open. It’s not as though there’s a certain lockup period for any of the funds that we’re using.
VettaFi: What are some of your considerations in terms of liquidity when building a portfolio for a client who only has long-term planning horizons and doesn’t have a preference or a need that would require frequent buying and selling?
When it comes to looking at more of the long term, the underlying expense ratio is going to be important. Aside from ETFs which don’t have a trading fee with most ETFs, they have a more attractive expense ratio than mutual funds and in most cases, greater tax efficiency. Those are typically two of the long-term drags on investment returns.
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