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Invisible Costs and Profitability

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Portfolio Construction, Measurement, and Efficiency

Abstract

Treynor, J. (Financial Analysts Journal 27:12–14 (1971)) argues that transaction costs can significantly impede performance. This paper explores the implications of transaction costs for the measured profitability of various asset-pricing anomalies. While standard portfolios yield poor performance for large fund sizes, optimal liquidity-conscious methodologies can substantially improve performance. The decrease in the level of trading costs over time may further increase the attractiveness of these trading strategies. However, the systematic component of transaction costs has increased, elevating portfolio liquidity risk. Furthermore, the lower transaction costs are associated with an increase in trading activity as evidenced by the exponential increase in trading volume and the shortened average investment horizon of institutional investors. The increased arbitrage activity may have improved market efficiency, thereby reducing the ex-ante profitability of some anomalies.

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Notes

  1. 1.

    See, e.g., Kyle (1985), Glosten and Milgrom (1985), Easley and O’hara (1987), Admati and Pfleiderer (1988), and Huberman and Stanzl (2004).

  2. 2.

    See, e.g., Glosten and Harris (1988), Hasbrouck (1991a,b), Breen et al. (2002), and Sadka (2006).

  3. 3.

    See also Chen et al. (2005), Lesmond et al. (2004), Mendenhall (2004), Sadka and Scherbina (2007), Ng et al. (2008), and Chordia et al. (2009).

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Acknowledgements

We would like to thank Robert Korajczyk for helpful comments and Siyi Shen for valuable research assistance.

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Authors and Affiliations

  1. Lerner College of Business and Economics, University of Delaware, Newark, DE, 19716, USA

    Xiaoxia Lou

  2. Department of Finance, Carroll School of Management, Boston College, 140 Commonwealth Ave., Chestnut Hill, MA, 02467, USA

    Ronnie Sadka

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  1. Xiaoxia Lou
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  2. Ronnie Sadka
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Correspondence to Ronnie Sadka .

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  1. McKinley Capital Management, Anchorage, Alaska, USA

    John B. Guerard, Jr.

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Lou, X., Sadka, R. (2017). Invisible Costs and Profitability. In: Guerard, Jr., J. (eds) Portfolio Construction, Measurement, and Efficiency. Springer, Cham. https://doi.org/10.1007/978-3-319-33976-4_6

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