Cash drag: what 5% cash does to an equity fund's return

A small slice with a visible effect

Most equity funds do not invest every rupee in shares. A slice sits in cash or short-term instruments, because investors redeem, new money arrives, and a manager may wait for a price. That slice earns a cash-like return rather than an equity return, and the difference shows up in the fund's number.

This post puts that effect into arithmetic you can check. For how much cash funds actually hold, see cash levels in equity funds.

The arithmetic

Assume, for illustration, that shares in the portfolio return 12% in a year and cash returns 6%.

• Fully invested (100% shares): 12.0%
• 5% in cash: 0.95 × 12% + 0.05 × 6% = 11.4% + 0.3% = 11.7%
• 10% in cash: 0.90 × 12% + 0.10 × 6% = 10.8% + 0.6% = 11.4%

Each 5 points of cash costs about 0.3 percentage points in a 12% year. On a holding of ₹10 lakh, 0.3 points is ₹3,000. A modest drag, but it happens every year the equity part earns more than cash.

It cuts the other way in a falling year

Now suppose shares fall 10% and cash still earns 6%.

• Fully invested: −10.0%
• 5% in cash: 0.95 × (−10%) + 0.05 × 6% = −9.5% + 0.3% = −9.2%
• 10% in cash: 0.90 × (−10%) + 0.10 × 6% = −9.0% + 0.6% = −8.4%

The cash cushions the fall by 0.8 points at 5% and 1.6 points at 10%. So a cash slice is a trade: it gives up some of a good year to lose less in a bad one.

All inputs are assumed. Actual cash returns and share returns vary, and the gap between them is what drives the result. If cash earned more than shares in a year, the sign flips.

Why the effect is small but not trivial

Two fund managers with the same stock picks can post different returns purely because of cash. Over 15 or 20 years, a persistent 0.3-point gap compounds: on ₹10 lakh at roughly 12%, it is the difference between about ₹54.7 lakh and ₹52.6 lakh after 15 years. Treat these as rough figures from rounded growth factors. For comparison, the expense ratio gap is usually the larger drag.

Reading it on a fund page

• Look at the stated mandate. A fund that can hold a lot of cash by design, such as a flexi or balanced style, is not the same as one meant to stay nearly fully invested.
• Compare with peers, not zero. If most funds in a category hold 3–6%, a fund at 5% is typical.
• Check how it changed. A cash level that rises sharply may show a view on markets, or may show heavy redemptions.
• Do not double count. Fund returns already include the effect of cash. You do not adjust for it again.
• Know what you want. If you hold a fund for equity exposure, high cash dilutes it. If you want a smoother ride, it may help. Portfolio return is a weighted average in the same way, across holdings as well as across funds.

The takeaway

Cash is not idle; it earns something. But it earns less than equity in good years and more in bad ones, so it works as a small shock absorber that costs a little when markets rise. Knowing the sums helps you read a fund's return for what it is made of.

This post is educational, not financial advice. All returns are assumptions for illustration, not forecasts or any fund's record.