An Application of Transaction Cost in the Portfolio Optimization Process

Abstract

We propose a transaction cost analysis (TCA) portfolio optimization procedure that incorporates transaction costs directly into the problem of the objective function of portfolio optimization. The results show that a fund achieves considerably higher net returns with TCA optimization than with traditional quadratic programming methods that do not directly consider transactions costs. For a large-cap, 50-stock portfolio, the improvement in net returns was on average +4.5 bp to +8.2 bp and as high as +7.6 bp to +13.5 bp. For a large-cap, 100-stock portfolio, the improvement in net returns was on average +3.2bp to +7.0 bp and as high as +5.0 bp to +10.2 bp. These results show that a manager can start with a seemingly suboptimal or inefficient ex ante portfolio in traditional mean variance space and earn higher ex post net returns after accounting for transaction costs.