When investors put money into a mutual fund, they expect every rupee to be actively invested in the market. However, asset management companies (AMCs) often keep a portion of the portfolio in cash or cash equivalents, adjusting this allocation based on market conditions. This raises an important question for investors: does cash serve as a safety net, or does it pose a performance risk?
“Holding a high level of cash in a mutual fund portfolio on a prolonged basis will impact the performance. In an upwards trending market, cash holding will pull down the performance of the fund and in a volatile or falling market, cash holding will help in exploiting market opportunities and reducing the magnitude of fall,” Pallav Agarwal, Certified Financial Planner, Bhava Services LLP shared with ETMutualFunds.
Echoing similar opinion, another expert also shares that holding cash in an equity mutual fund typically reduces returns because cash generates lower yields compared to equities.
Chakrivardhan Kuppala, Cofounder & Executive Director, Prime Wealth Finserv while sharing an example of how keeping cash in the portfolio impacts the performance. According to Kuppala, if 5% of the portfolio remains in cash while the market rises 15%, the fund automatically underperforms by nearly 0.75%
“However, cash serves important purposes in the Indian context: it allows managers to meet redemptions without liquidating equities at unfavourable prices and provides flexibility to deploy during market corrections. Research on Indian equity funds indicates no consistent link between high cash and poor performance outcomes depend on whether managers deploy cash effectively during downturns,” he added.
According to the last available data as on July 31, 2025, mutual funds increased their overall cash allocation by Rs 2,884 crore in July to Rs 2.06 lakh crore, after cutting exposure for two straight months.
In July, Nifty50 and BSE Sensex dropped down by nearly 3% and mutual funds increased their cash allocation. On the other hand, in May and June, the benchmark indices went up by nearly 1.50% and by up to 3% respectively and the monthly shows that mutual fund houses have reduced their exposure for two consecutive months.
An old report by ETMutualFunds showed that according to the October 2024 portfolio two prominent fund houses moved in opposite directions when Nifty50 was down by 9% from its September month end peak. According to the report, Quant Mutual Fund was buying the dip while PPFAS Mutual Fund was seen raising cash in its portfolios.
Now the important thing to know is in rising markets, can excess cash holdings drag down returns or during volatile or falling markets, does cash allocation help reduce downside risk?
The expert, Chakrivardhan Kuppala firmly says that yes, in rising markets, cash dilutes performance since it doesn’t participate in equity gains. For instance, Indian mutual funds with higher cash levels in 2024 underperformed peers during sustained rallies.
On the other hand, Agarwal also says that yes, in a strong rising market, excess cash holdings for a prolonged period will drag down the returns and similarly in volatility or falling markets, cash allocation will help reduce the fall in NAV.
Every mutual fund scheme holds a portion of their portfolio in cash be it an actively managed fund or passive funds. We considered SBI Large Cap Fund and SBI Nifty Index Fund for understanding the cash level an active and a passive fund holds.
Since January 2025, SBI Large Cap Fund had between 4-6% in cash and cash equivalents and only in May it had 1.59% in cash and cash equivalents. On the other hand, SBI Nifty Index Fund had between 0.04% to 0.68% in cash and cash equivalents but in February, the fund had (0.20%) in cash and cash equivalents.
Based on the data, do actively managed funds and passive funds differ in their approach to cash allocation? The experts say that yes both these types of funds differ in approach to cash allocation? The experts say that yes both these types of funds differ in their approach to cash allocation because of their nature.
According to Agarwal, active funds have more flexibility in terms of cash holdings and can use this for delivering a better performance if timed well whereas a passive fund needs to be fully invested, otherwise its tracking error will increase, and it will not mirror the return of the underlying index, hence defeating its objective.
On similar lines, Chakrivardhan Kuppala says that passive funds in India, such as index funds and ETFs, typically maintain cash levels of 1–2% or less, as their mandate requires full replication of the benchmark and active funds, by contrast, treat cash as a tactical allocation tool.
“Managers may increase cash to 8 – 12% when valuations appear stretched, or reduce it when deploying into equities. This discretion creates flexibility, but also adds performance risk: if markets rally while while active funds balance flexibility with potential cash drag,” he adds