The Price of Transaction Costs

Excerpt

Capturing the systematic premia is the main aim of many quantitative traders. However, investors tend to overlook an important factor when backtesting. Trading costs are an essential part of every trade, and yet even when we consider them, we often only use an approximation. The recent article from Angana Jacob (SigTech) looks into how heavily trading costs affect the overall return of various strategies and analyzes multiple ways of implementing trading costs into the trading rules themselves.

Firstly, the author distinguishes between explicit and implicit components of the costs of a systematic trading strategy. The fees known in advance are categorized as the explicit components. On the other hand, the less visible and harder to estimate costs are categorized as implicit. Further, the author divides the implicit costs into three groups: Instant impact, Temporary impact, and Permanent impact. And because the implicit costs are often much greater than the explicit costs, the paper focuses mainly on instant impact costs, their influence on the strategy’s return, and possible ways to minimize them.

The article also debates the pros and cons of frequent rebalancing. If an investor rebalances their strategy too often, they might have the advantage of increased reactivity; however, the transaction costs may overpower the rebalancing premia. This is shown in an example of FX Short-term Value Strategy.

Additionally, Global Tactical Asset Allocation Strategy (GTAA), which is rebalanced daily, shows an even more extreme example of the price of transaction costs. The author improves the GTAA strategy by slowing the rebalancing by employing a threshold and increasing the lookback window in the return estimation for the mean-variance optimization.

Author: Angana Jacob

Title: How to control the hidden costs of systematic investing

Link: https://hubs.la/Q018FFD40

Abstract:

“Any backtest is only as good as the information put into it. And yet when it comes to trading costs it is often assumed that an approximation is accurate enough to account for real world trading frictions. In reality, the impact of trading costs can be similar in magnitude, or even outweigh, the systematic premia they aim to capture. Additionally, trading costs assume greater significance in a low-return environment as they effectively represent a greater proportion of potential return available.“

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