DEFINITION of Performance Drag
Performance drag refers to the difference between the return on an investment assuming there are no costs associated with it and the return on the investment after deducting costs associated with it. The costs that cause performance drag and negatively affect the performance of an investment include items such as paying taxes on investment returns, paying for transaction costs and fees related to maintaining an investment or account and/or holding cash in a portfolio rather than investing the entire value of the portfolio. Performance drag is essentially unavoidable.
BREAKING DOWN Performance Drag
For many traders, the actual return of an asset is sharply different than what would be recognized if all transaction costs were removed. For example, let's assume an investor pays $30 in brokerage commissions to buy 100 shares of ABC Company at an entry price of $24 per share and another $30 to sell those shares. In this case, the investor needs the stock's price to rise 2.5% so that he or she can recover the commissions paid to do the trades (a $0.60 rise on 100 shares will equal the $60 that the investor needs to recoup the commissions. $0.60 is equal to 2.5% of the $24 purchase price). The 2.5% cost of the transaction will cause the investor's total return to drag behind the change in the price of the asset, resulting in performance drag.
Common Sources of Performance Drag
Commissions and other transaction costs. Performance drag is most commonly attributed to explicit brokerage commissions, such as the $30 fee in the example above. Transaction costs also generally apply when using an online trading platform, such as TD Ameritrade. Outside of these explicit costs, there are many other implicit costs to trading, such as timing, bid-ask spreads and other opportunity costs that can cause the return of an investment to lag behind the return seen in the market.
Advisor fees, expense ratios and account maintenance fees. There are a host of fees associated with maintaining an investment account. Advisor fees must be paid when hiring an advisor to manage a portfolio. A management fee or expense ratio must be paid to the manager of the mutual fund, exchange traded fund or separately managed account holdings. Maintenance fees are paid to a custodian or bank to maintain client accounts.
Cash. "Cash drag" is a common source of performance drag in a portfolio. It refers to holding a portion of a portfolio in cash rather than investing this portion in the market. Because cash typically has very low or even negative real returns after considering the effects of inflation, most portfolios would earn a better return by investing all cash in the market. However, some investors decide to hold cash to pay for account fees and commissions, as an emergency fund or as a diversifier of other portfolio investments.
Taxes. Applicable taxes are an additional source of performance drag.