The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

TRADING

Trading is the process of executing the orders derived in the portfolio construction step. To trade a list of stocks efficiently, investors must balance opportunity costs and execution price risk against market impact costs. Trading each stock quickly minimizes lost alpha and price uncertainty due to delay, but impatient trading incurs maximum market impact. However, trading more patiently over a longer period reduces market impact but incurs larger opportunity costs and short-term execution price risk. Striking the right balance is one of the keys to successful trade execution.

The concept of “striking a balance” suggests optimization. Investors can use a trade optimizer to balance the gains from patient trading (e.g., lower market-impact cost) against the risks (e.g., greater deviation between the execution price and the decision price; potentially higher short-term tracking error). Such an optimizer will tend to suggest aggressive trading for names that are liquid and/or have a large effect on portfolio risk, while suggesting patient trading for illiquid names that have less impact on risk. A trade optimizer can also easily handle most real-world trading constraints, such as the need to balance cash in each of many accounts across the trading period (which may last several days).

A trade optimizer can also easily accommodate the time horizon of a manager’s views. That is, if a manager is buying a stock primarily for long-term valuation reasons, and the excess return ...