Cash Drag: Definition & Portfolio Impacts
In investment portfolios, cash plays a crucial role in managing day-to-day operations like controlling inflows and outflows and collecting income sources like dividends. However, holding too much can negatively impact portfolio performance compared to benchmarks. This is called cash drag.
What is Cash Drag?
Cash drag is a form of a performance drag, referring to the negative impact that excess cash can have on a company or fund’s financial performance.
For individuals, cash drag refers to holding a portion of a portfolio in cash rather than investing it in the market. Here, it’s a form of opportunity cost.
Because cash typically has very low or even negative returns after considering the effects of inflation, portfolios could earn a better return by investing cash in the stock market or in other outperforming assets.
What is Performance Drag?
Performance drag refers to any reduction in the performance of an investment. A variety of factors can contribute to performance drag including taxes on investment returns, transaction and management fees, and holding cash in an investment account, and can negatively impact overall performance.
Understanding Cash Drag
Cash is useful in portfolios for its liquidity, low transaction costs and stability, but holding too much of a cash position in your brokerage can lessen long-term returns.
For mutual funds and exchange-traded funds (ETFs), cash positions are held to facilitate redemptions and pending investments. Since the underlying asset classes of a mutual fund — stocks and bonds — tend to have better long-term returns than cash, a permanent cash allocation reduces the performance of the fund.
Cash drag is typically more pronounced among actively managed mutual funds compared to index funds because index funds tend to remain fully invested whereas active mutual funds require more held in cash in order to cover transaction costs.
For example, if one held $10,000 extra cash in a high-yield savings account, they would earn an annualized 3% return (based on interest rates), equalling just over $13,000 after 10 years.
On the other hand, if you invested that $10,000 in an S&P 500 index fund (average annual return of 10.67%), after ten years the total returns would be over $27,000.
Benefits of Cash Positions
Some investors decide to hold cash to pay for account fees and commissions, as an emergency fund or to help diversify other portfolio holdings.
Cash doesn’t have to be a drag on long or short-term returns. Investors with less cash flow may prefer to keep more held in cash.
Managing Cash Drag
The best way to manage cash drag is to reduce the amount of excess cash on hand. This can be done through a variety of strategies, including investing in growth opportunities, reducing expenses, and increasing revenue.
Investing in growth opportunities is one effective way to reduce cash drag. This can include investing in new projects, acquiring other businesses or expanding into new markets. A company can generate returns and increase its financial strength by putting excess cash to work.
Reducing expenses is another effective strategy for reducing cash drag. This can include cutting costs, minimizing credit card debt, streamlining operations or reducing waste. By reducing expenses, a company can free up cash that can be used for investment and growth.
Increasing revenue is another strategy for reducing cash drag. This can be done through various means, including expanding into new markets, offering new products or services or improving marketing efforts. By increasing revenue, a company can generate more cash that can be invested in growth opportunities.
Invest Excess Cash in Contemporary Art
Contemporary Art has outperformed the S&P 500, yielding an annualized return of 13.8% from 1995 to 2021 compared to the S&P 500’s 10.2%, compared to 3% on cash held in a high-yield savings account.
To manage cash drag, investing in blue-chip Contemporary Art can help to enhance long-term returns while also diversifying your portfolio to hedge against inflation and economic downturns.
- Read More: Has High Inflation Impacted the Art Market?
Historically, fine art was reserved for those able to dole out millions of dollars for a piece of artwork. Today, Masterworks allows investors to purchase fractionalized shares of iconic art pieces, democratizing the art market and improving the liquidity of each investment piece.
The Bottom Line
Cash drag can significantly impact a portfolio’s financial performance, but it can be effectively managed through various strategies. Individuals can increase their financial strength by reducing the amount of excess cash on hand and sticking to a long-term investment strategy.
The information in this article is provided for educational purposes only. This information should not form the basis of an investment decision, and should not be construed as investment advice.