LO 66.4: Describe the implications of transaction costs on portfolio construction.

LO 66.4: Describe the implications of transaction costs on portfolio construction.
Transaction costs are the costs changing portfolio allocations, primarily trading commissions and spreads. Transaction costs reduce active portfolio returns relative to those of the benchmark portfolio and are uncertain, although typically less so than alphas. Because of this, transaction costs are an important input into the portfolio optimization process. Including transaction costs in portfolio optimization increases the importance of both precision in estimating alphas and of the choice of scale.
Transaction costs occur at points in time, while the benefits (i.e., additional return) are realized over time. Consider two stocks, one of which will return 2 % over 6 months, at which time it can be replaced by another stock that returns 2 % over 6 months, and another stock which will return 4% over 1 year. Also, assume transaction costs are 1%. The annual returns on the first stock will be approximately (2 % 1%) x 2 = 2 % and the annual returns
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Topic 66 Cross Reference to GARP Assigned Reading – Grinold and Kahn, Chapter 14
on the second stock will be approximately 4% 1% = 3%. With uncertain holding periods across portfolio holdings, the question arises over what period transaction costs should be amortized. Precision in scale is important in addressing the tradeoff between alphas and transaction costs. .Annual transaction costs will be the cost of a round-trip trade divided by the holding period in years.
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