Cash drag adjusted return

A portfolio manager rarely invests every rupee the moment it comes in. Some money often sits in a liquid fund or a bank account, waiting to be deployed, earning a much lower return than the main investment strategy.

This uninvested cash is a drag on the portfolio's overall performance, because it earns less than the equity or other assets the client actually signed up for. A cash drag adjusted return properly accounts for this idle cash, instead of pretending the whole corpus was invested at the equity return alone.

Ignoring the cash component when computing a return mis-states the portfolio's actual performance, because it can make the manager look better, if only the invested portion's return is reported, or simply be inaccurate about what the investor's full corpus actually earned.

The correct approach blends the return on the invested portion with the return on the uninvested cash portion, weighted by how much money sat in each. At the end of the reporting period, the fund manager still has to report the return on the entire portfolio, cash drag included — there is no option to report only the invested slice's return to investors.

Cash-drag-adjusted return = (Invested % x Invested return) + (Cash % x Cash/liquid fund return)

An investor puts Rs 100 lakh into an equity portfolio. The manager actually invests only Rs 75 lakh in equities and leaves Rs 25 lakh in liquid funds. Over the period, the equity portion earns Rs 7.5 lakh, and the liquid fund portion earns 4%.

Ignoring the cash drag, equity return only:

Rs 7.5 lakh / Rs 75 lakh = 10%

Cash-drag-adjusted return:

(10% x Rs 75 lakh) + (4% x Rs 25 lakh) = Rs 7,50,000 + Rs 1,00,000 = Rs 8,50,000

Rs 8,50,000 / Rs 1,00,00,000 = 8.5%

The investor's true return, on the full Rs 100 lakh actually handed over, is 8.5%, not the 10% that only counted the invested portion — a 1.5 percentage point difference caused entirely by the uninvested Rs 25 lakh.

Chapter 16 (Portfolio Performance Measurement and Evaluation), section 16.2.8, works through the Rs 100 lakh, Rs 75 lakh equity, Rs 25 lakh liquid fund example above. Expect a question that gives you the invested amount, the uninvested amount, and the returns on each, and asks you to calculate the blended, cash-drag-adjusted return on the full corpus.

• Never compute the return only on the invested portion when uninvested cash exists — the workbook is explicit that this mis-states the true return on the investor's full corpus.
• The uninvested cash still earns some return, typically from a liquid fund, so the drag is a matter of a lower return dragging the average down, not a zero return.
• At reporting time, the manager must disclose the return on the whole portfolio including the cash drag — reporting only the equity-invested return is not an acceptable substitute.