Definition
Cash Drag
Cash drag is the small performance shortfall an index fund or ETF suffers from holding uninvested cash, which earns less than the index when markets rise and contributes to tracking error.
Indian index funds keep some cash to meet redemptions, pay expenses and handle dividend timing, and this idle balance fails to fully participate in market gains. Over time, cash drag is a component of both tracking error and tracking difference versus the benchmark.
Managers minimise cash drag using techniques like holding liquid ETFs or index futures to equitise cash so it tracks the market until deployed. The drag is usually small for large, well-managed funds but can be more noticeable in funds with volatile flows or in fund of funds structures.
Related terms
- Tracking ErrorTracking error is the standard deviation of the difference between an index fund or ETF's returns and its benchmark index's returns, measuring how consistently the fund follows the index.
- Tracking DifferenceTracking difference is the actual cumulative return gap between an index fund or ETF and its benchmark over a period, typically negative because of fees and costs.
- Liquid ETFA liquid ETF is an exchange-traded fund that invests in very short-term money-market and overnight instruments, used by traders to park idle cash and even as collateral or margin.
- Index FundAn index fund is a passively managed mutual fund that aims to replicate the performance of a market index by holding the same securities in the same proportions, at low cost.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.