Cash Management for Index Tracking

Although all standard equity indexes have a zero weight in cash, managers running index-tracking portfolios often find that maintaining a positive cash holding is cost-efficient. This practice saves significantly on transaction costs because temporary cash inflows and outflows can be absorbed into the cash inventory. In this paper, a mean–variance framework is used to analyze the cash management problem for an index-tracking portfolio. The theoretical model is based on passive index tracking, but it has implications for any portfolio manager with an equity benchmark and random cash inflows and outflows.