Limina Blog

What is Cash Drag and How to Reduce it?

Produce performance with more confidence and make less mistakes by knowing the state of your data quality.

Kristoffer Fürst

November, 2022

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What is Cash Drag and How to Reduce it?

In this post, we explore what cash drag is and how to maximise your investment level with confidence, in other words, how to avoid cash drag as much as possible. By increasing data quality in the investment decision process, you will be able to enhance performance by improving confidence in your investment decision making.

Portfolio manager held back by his non-invested cash, creating a cash drag on his performance.

What is cash drag?

Performance drag is the difference in return over time between a fully invested portfolio and a non-fully invested portfolio. For example, it could be a passive strategy or index fund following an index, or an actively managed fund following a benchmark.

When the performance drag is caused by a cash reserve being kept, it is referred to as cash drag.

What problems does cash drag create?

As the market increases in value over time, sitting on uninvested cash will directly mean that your portfolio is getting left behind your benchmark. Every dollar not invested is – on average – a missed positive return.

For an index following strategy, cash drag also increases tracking error, which is a measure of financial performance which determines the difference between the return fluctuations of a  chosen benchmark and an investment portfolio.

An example of cash drag in action

As a portfolio manager, you often want to invest right up to the edge of what’s possible. Imagine for a moment that you have 1% in cash. You want to invest that cash pro-rata across your portfolio. But how much of the 1% do you dare deploy?

The decision puts a lot at stake. If you invest too much, you might become a borrower, and that could lead to heavy fines and the need to issue a breach report to your investors. But you can’t afford to invest too little, either. If you leave cash sitting uninvested, you might be missing opportunities to create alpha.

You need to know with total certainty how much you can invest; whether it’s 99% of your cash or 99.9% of it.

Fee pressure has made reducing cash drag even more important

Given the state of the investment industry, peak performance has never been more important. A PWC report predicts fees will continue to decline through to 2025, reinforcing the need to reduce cash drag to improve investment performance.

This trend is increasing competition between asset managers, a reality that makes performance, and reducing cash drag, even more important. If a portfolio manager can be more invested by even a small amount, they may see a one-basis-point increase in return, causing their performance to rise relative to their peers. And a bump in performance increases the chances of higher net new money.

It all comes down to the main goals – deliver outperformance and grow your AuM.

How to reduce cash drag

The hypothetical investment conundrum above illustrates the importance of high-quality portfolio data when attempting to reduce cash drag. It is critical to trust your systems to inform you of the state of your data in real-time, so that you can understand how accurate and complete your data is before making investment decisions.

What is data quality?

So, how is data quality for an asset manager achieved?

  • Complete data – All portfolio events tracked, including both trading and non-trading related records
  • Accurate data – Automated data validation checks
  • Timely data – All portfolio events processed in real-time
Data quality is the intersection of accurate, complete and timely portfolio data.

Quality data reduces cash drag

With the help of real-time data quality visualisation, you can manage your funds conservatively and aggressively at the same time, helping to reduce cash drag. The two philosophies aren’t mutually exclusive. Instead, they unite to demand precision – something portfolio managers can attain through accurate information.Through high-quality, real-time data, this can mitigate significant operational risks. Accurate data protects your cash from overdrafts. At the same time, trust in your portfolio data makes it possible to increase your investment level to the limits, unlocking the potential for additional returns and reducing cash drag.

 Data quality application performing automatic data quality controls to enable portfolio managers to trust their portfolio data.

How to ensure your portfolio managers are looking at high-quality portfolio data

Data quality in an Investment Management Solution (IMS) depends on correct calculations within – as well as on the delivery of – high-quality data from multiple sources. Such sources could be custodians, brokers, index providers, valuation providers, the security master(s) and market data feeds. Some issues can be solved by the IMS itself, while some cannot (at least not in time). It is exactly for this reason that visualising data quality in real-time is paramount for portfolio managers to reduce cash drag through confident, high return investment decisions.

Cash ladder application, showing projected cash day by day in all accounts, all currencies, and from both a trade and settle date perspective.

Summary

Because cash drag can reduce your portfolio returns and have a negative impact on your portfolio performance, by increasing data quality in the investment decision process, you will be able to maximise investment returns through improved decision making. Investing in advanced investment management solutions will enable you to maximise your investment level with confidence, thanks to high-quality data insights that are accurate, complete and timeous.  

If you’re curious to know more about Limina, reach out to our team or explore our solutions and discover the benefits of Limina’s IMS platform.