Cash drag

A portfolio manager rarely invests every rupee a client hands over. Some of it sits in liquid funds, waiting for a good opportunity or held back for redemptions.

That idle cash still belongs to the client, and it still earns something — usually far less than the equity portion. If a manager reports return only on the money actually invested in stocks, ignoring the cash, the reported number looks better than what the client actually earned on their whole rupee. That gap is the cash drag.

Section 20.2.8 gives the workbook's own worked figures directly. An investor puts Rs 100 lakh into an equity portfolio. The manager invests only Rs 75 lakh in equities; the remaining Rs 25 lakh sits in liquid funds. Over the period, the equity sleeve earns Rs 7.5 lakh, and the liquid fund returns 4%.

• Return ignoring the cash drag = Rs 7.5 lakh ÷ Rs 75 lakh = 10% — the number a manager gets if they only look at the invested sleeve.
• Return adjusting for the cash drag = (10% × Rs 75 lakh) + (4% × Rs 25 lakh) = Rs 7,50,000 + Rs 1,00,000 = Rs 8,50,000, or 8.5% on the full Rs 100 lakh the client actually handed over.

The workbook is explicit that ignoring this mis-states the return, because the capital contribution made by the investor — the whole Rs 100 lakh, not just the invested portion — has to be taken into account when computing performance.

Following the workbook's own worked figures, applied to a second client. Mr Aditya Bose gives his PMS manager Rs 60,00,000. The manager deploys Rs 45,00,000 (75%) into equities and keeps Rs 15,00,000 (25%) in a liquid fund.

Over the year, the equity sleeve returns 12%, earning Rs 5,40,000. The liquid fund returns 4%, earning Rs 60,000.

Reported return, ignoring cash drag = Rs 5,40,000 ÷ Rs 45,00,000 = 12%.

True return, adjusted for cash drag = (Rs 5,40,000 + Rs 60,000) ÷ Rs 60,00,000 = Rs 6,00,000 ÷ Rs 60,00,000 = 10%.

The manager's marketing material quoting "12% return" overstates what Mr Bose actually earned on his money by 2 full percentage points — the cash drag from the 25% sitting uninvested.

Chapter 20 (Performance Measurement and Evaluation of Portfolio Managers), section 20.2.8, gives the Rs 100 lakh / Rs 75 lakh / Rs 25 lakh illustration directly, immediately after annualised return and before the discussion of alpha and beta return. The chapter's own rule — SEBI requires portfolio managers to consider all cash holdings and investments in liquid funds when calculating performance — is stated a few pages later in the same chapter's compliance clarifications. Expect a direct computation of adjusted versus unadjusted return from a stated cash allocation.

• The unadjusted figure is always calculated on the smaller, invested-only base — Rs 75 lakh, not Rs 100 lakh — which is exactly why it looks higher than the true figure.
• Cash drag is not the same as a low-cash-allocation strategy being wrong. Holding cash can be a deliberate, sensible choice; the issue is reporting return that hides the cash's effect, not holding cash itself.
• SEBI's rule requires cash and liquid-fund holdings to be included in performance calculation — reporting only the invested sleeve's return is a compliance failure, not just a stylistic choice.
• The liquid fund's return is usually positive, so cash drag understates the manager's own equity skill only when equities outperform the liquid fund — if equities do worse than the liquid fund in a given period, uninvested cash would actually flatter the whole-portfolio return instead of dragging it down.