Transaction costs matter - So cost mitigation strategies should be employed

Transaction costs matter and are often not given enough focus when looking at strategy comparisons. A key reason for the decline in performance between backtested results and live returns is associated with not properly accounting for transaction costs. Of course, this is part of the larger issue that backtested numbers do not often match live performance. Nevertheless, we will focus on the issue of transaction costs.

To address this issue, investors need to focus on two questions: 1. what are at the true transaction costs of the strategy? and 2. what are the transaction cost mitigation strategies that can employed to reduce costs? Overall, transaction costs will lead to lower net Sharpe ratios, but an appropriate accounting of cost will lead to better live strategy performance.

There are three factors that impact performance from backtested results, model drag, structural issues, and transaction costs. Model drag is a function of the sample tested versus the live market regime. Structural issues include the ability to short and the cost of borrowing. Transaction costs are the bid-ask spread and liquidity concerns. 

Cost mitigation can be divided into four different strategies: rebalancing, banding, liquidity focus, and screening.

A good paper on how to deal with transactions is "Comparing Cost-Mitigation Techniques". This paper looks at each of the four major cost mitigation strategies and finds they have variable ability to boost returns. In general, using banding or holding position longer before action is the most appropriate cost mitigation strategy. However, the appropriate cost mitigation is a function of the type of strategy employed and the universe of stocks used for a given strategy. These cost mitigation strategies have less impact on large cap stocks while having a strong impact on micro caps. 

Using screening techniques will have a strong impact on returns by filtering which stocks to add to the portfolio and cut costs. For example, the size effect tied with momentum will have a strong impact on returns. Match a strategy with a filter will support better Sharpe ratio.

One of the key concerns when investing in new quant managers is the expected difference between backtested results and live returns. Addressing transaction costs is an important technique for reducing the difference between this potential drop in performance. How cost mitigation strategies are employed is one way to differentiate between managers.