Portfolio Construction in the Presence of Transaction Costs

Authors: Cheung, W., Hofmeyr, A. and Vandermark, S.

Publisher: Lehman Brothers


As we demonstrate in our research into capacity constraints , transaction costs (TC) can significantly undermine the net alpha of an investment strategy. While execution costs are inevitable, we can minimise their effect through transaction-cost-aware portfolio construction. In the recommended framework, we not only consider TC in portfolio construction, but also in trading.

In this article, we:  Show that transaction cost estimates are important in determining portfolio weights  Formalise the problem through identifying two dimensions of TC-incurred inefficiency that can be addressed through a TC-aware optimisation – mean bias inefficiency and execution efficiency  Explore how trading strategy can influence transaction costs and risks  Discuss an iterative process for TC-aware portfolio construction  Explain how this framework allows for non-optimised methods of portfolio construction.

Source: Manual