Performance Drag

Performance Drag

A situation in which an index fund does not perform exactly the same as the index it is supposed to follow. Performance drag occurs when the fund does not precisely track the underlying index; that is, it occurs when the fund includes other investments. Commonly, performance drag can occur when the money manager allocates part of the fund to cash and cash equivalent to improve its liquidity. However, high performance drag may indicate that the index fund is not much of an index fund at all. See also: Closet index fund.

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Performance drag. Performance drag describes a situation in which an investment -- such as an index mutual fund or exchange traded fund (ETF) -- lags behind the index that it is designed to track. Performance drag can occur for a variety of reasons.

One example, known as cash drag, occurs when a fund allocates a portion of its portfolio to cash, causing its performance to underperform its underlying index. Cash drag may especially affect open-end index funds, which may need cash to buy back shares that investors want to sell.

Performance drag is illustrated by a fund's tracking error -- a calculation of how much an index-tracking investment deviates from its underlying index.