Portfolio Construction with Transaction Costs

Bernd Scherer

11.1 TRANSACTION COSTS

So far we have assumed that all positions within a given portfolio can be created from cash at zero transaction cost. This assumption will be relaxed in this chapter, where we focus on the costs associated with buying and selling securities. Although we use standard mean–variance optimisation to describe investors’ preferences, the analysis can be extended to any other objective function treated in this book. It is well known that the average active investor will, by definition, exhibit zero alpha before costs and underperform after costs (see Sharpe 1991). Hence, the inclusion of transaction costs in the portfolio construction process is material and has attracted increasing attention.

Transaction costs come in many forms. In general, we can identify three sources.

Brokerage commission. This reflects the mechanics of order processing and is an explicit fee charged by the broker to handle the trade. Commissions have been under constant pressure and reflect only a very small part of transaction costs.

Bid–ask spread. The bid–ask spread reflects the costs of buying a security and immediately selling it. Economically, we expect the bid–ask spread to rise