Cash Drag

Cash drag is the amount by which uninvested cash lowers a portfolio's return relative to the return the portfolio's target allocation would have produced. It arises because a portfolio earns the weighted average of what its components earn, and cash has generally earned less than a stock-and-bond mix over long periods. The term is used for a household's own idle balances and also for the cash a fund holds internally to meet redemptions and to bridge the gap between receiving money and investing it, which is one of the reasons an index fund's return can differ slightly from its index. Cash drag is a comparison against a stated target, so it only means something once there is a target to compare against.

Cash drag does not require a decision, and this is the part worth internalizing because it is where most of it comes from. A rollover check arrives as cash and stays cash. Dividends and interest are paid into a settlement account and pool there. A transfer settles on a Tuesday and nobody places the trade. An employer contribution lands in the plan's default holding. In each case the balance quietly earns the sweep rate until someone notices, and the noticing is what is missing rather than the intention.

The size is easy to compute, which distinguishes cash drag from most costs investors worry about. The drag equals the share of the portfolio held in cash multiplied by the difference between the return on cash and the return on the target mix. That formula also shows what governs it. A large cash balance in a period when cash yields nearly as much as bonds costs very little. A modest cash balance during a strong year in the target assets costs a great deal, and the two situations feel identical while they are happening.

There are two separate costs and they answer different questions. The nominal cost is the drag against the target mix, which is what the formula above measures. The real cost is what inflation does to the cash, which is a comparison against prices rather than against the portfolio. They can point opposite ways: in a period when cash yields more than inflation, the real cost is negative while the nominal drag against a rising stock allocation is substantial. A page or a conversation that mixes the two produces an argument that cannot be settled, because the participants are measuring different things.

Inside a fund, the same arithmetic explains part of why a fund's return differs from its index. An index has no cash and no need to meet redemptions; a fund has both. This is one of several contributors to a fund's tracking error, which has its own page and its own set of causes.

The honest qualification is that cash drag is a statement about expectations rather than a guarantee. In any period where cash outperforms the target mix, which happens whenever stocks and bonds both fall, the drag is negative and the cash helped. What makes cash drag worth managing is not that cash always loses but that a balance nobody decided to hold is carrying whatever result the arithmetic produces, in both directions, with no thought behind it.

Measuring cash drag takes three inputs and one multiplication.

1. The cash weight: how much of the portfolio is in cash, as a percentage of the total.
2. What that cash earned over the period, which is the sweep rate or money market yield rather than zero.
3. What the target mix earned over the same period.

Drag equals the cash weight times the difference between the second and third numbers.

A hypothetical example. Camila has a $400,000 portfolio with a target allocation that returned 7 percent over the year. Of that, $28,000 sat uninvested in the settlement account earning 4 percent, so the cash weight is 7 percent and the invested weight is 93 percent.

The portfolio returned 0.93 times 7 percent plus 0.07 times 4 percent, which is 6.51 plus 0.28, or 6.79 percent, against the 7.00 percent the target allocation produced. The drag is 0.21 percentage points.

The formula gives the same answer directly: 7 percent of the portfolio times the 3 percentage point gap between 4 percent and 7 percent is 0.21 percentage points. On $400,000 that is $840 for the year.

Two observations follow. The cost is not the $28,000 sitting still; it is only the gap, so raising what the cash earns shrinks the drag without eliminating it. And the drag compounds, because next year's balance is smaller than it would have been, which is what makes a long-forgotten balance more expensive than an obviously idle one.

Pros

• Cash is the only holding guaranteed to be available at full value when it is needed, which is what prevents a forced sale in a falling market.
• The cost is precisely measurable, so a deliberate cash position can be priced rather than argued about.
• Reducing it is usually free: investing an idle balance costs a trade, not a fee.
• Raising the return on cash, by moving it from a low-yielding sweep to a money market fund or high-yield savings account, shrinks the drag without changing the allocation.

Cons

• It is invisible on a statement, because nothing is charged and no line item appears.
• It compounds, so a balance forgotten for several years costs more than the simple annual figure suggests.
• It scales with the gap between cash and the target mix, which means it is largest in exactly the years the portfolio was doing well.
• It is usually the residue of inattention rather than a considered position, so it carries risk and cost that nobody chose.
• The remedy tempts an overcorrection, and investing money that was genuinely needed within a year in order to eliminate drag is the worse mistake.