Reasons why there is cloth on the handle for dao.
1. To wipe blood from the hand during battle and stop your hand from slipping.
2. Wrapping the cloth in your hand before you handle your dao stops the weapon from flying out of your hand. Just imagine you are in battle, you are on horseback, etc. you are fighting maybe for hours -- blood and sweat are slippery, our grip becomes weak and that there is constant impact on your weapon/handling ... or you just get clumsy when exhausted.
3. With the dao 'flag' in our hand, my teacher told me there was a method of thrusting with the dao and letting the handle go (but still having a grip on the cloth), thus allowing for a few extra inches to an attack -- and grabbing the handle afterward. Don't have the balls to try this one yet
Remember that most sword fights would only last a matter of a few moves and that the dao is not really 'swung' around in combat so the flag wouldn't really come into play as a method of distraction. However, flags and tassels are used as part of showmanship in contemporary wushu today.