Portfolio Optimization and the Cost of Trading

Abstract

This article illustrates the effects of incorporating transaction cost estimates into mean-variance portfolio construction. It begins with an examination of single-period 130/30 portfolios and a two-year monthly rebalancing exercise for a market-neutral strategy, both for the Russell 2000 Value universe. Accounting for trading costs ex ante delivers superior net returns, broader diversification, lower turnover, and a portfolio robust to noisy alpha signals, relative to standard mean-variance stock selection and portfolio construction. Global portfolios then are analyzed, for three time periods preceding and spanning the current financial crisis. Shifts in regional weights are explainable by trading costs, and differences in portfolio composition are dramatic relative to “paper portfolios.” These findings imply substantial shifts in investment strategy. Overall, the results confirm that mitigation of transaction costs, leading to improvement in realized returns and better alignment of return with risk, begins at the portfolio construction stage and therefore should not be controlled only at the level of trading desks.