What Is 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.
- Performance drag is the difference between returns for an investment with associated trading costs and returns for an investment without associated trading costs.
- The costs that cause performance drag can be direct or indirect.
- A single method to mitigate performance drag does not exist.
Understanding 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. This is due to the direct and indirect costs involved in trading a security. Examples of direct costs for security trading are commissions and fees involved in trading. Example of indirect costs for security trading are the opportunity costs to implement a trade as well as delays that might accompany the transaction.
A single method to mitigate performance drag does not exist because it is caused due to a variety of factors. Instead traders employ investment strategies suited to their overall return goals in order to minimize performance drag. For example, delays in implementing a trading order might not be a significant factor for value investing. But it may mean the difference between a profit and loss for momentum trading.
Common Sources of Performance Drag
- Commissions and other transaction costs: Performance drag is most commonly attributed to explicit brokerage commissions. Transaction costs also generally apply when using an online trading platform. 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.
Example of Performance Drag
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 they 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.