INCORPORATING TRANSACTION COSTS

Transaction costs can be generally divided into two categories: explicit (such as bid-ask spreads, commissions and fees), and implicit (such as price movement risk costs9 and market impact costs10).

The typical portfolio allocation models are built on top of one or several forecasting models for expected returns and risk. Small changes in these forecasts can result in reallocations that would not occur if transaction costs are taken into account. In practice, the effect of transaction costs on portfolio performance is far from insignificant. If transaction costs are not taken into consideration in allocation and rebalancing decisions, they can lead to poor portfolio performance.

This section describes some common transaction cost models for portfolio rebalancing. We use the mean-variance framework as the basis for describing the different approaches. However, it is straightforward to extend the transaction cost models into other portfolio allocation frameworks.

The earliest, and most widely used, model for transaction costs is the mean-variance risk-aversion formulation with transaction costs.11 The optimization problem has the following objective function:

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where TC is a transaction cost penalty function, and λTC is the transaction cost aversion parameter. In other words, the objective is to maximize the expected portfolio return less the cost of ...

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