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Book Preview – Chapter 4

| | Posted in: Big Ideas

Here is this Friday’s installment of Avoiding Investment Strategy Flame-outs, a short book we are previewing for subscribers. Chapter previews will continue for the next five Fridays.

Chapter 4: “Accounting for Implementation Frictions”

“Investment frictions (costs) include such burdens as broker transaction fee, bid-ask spread, impact of trading (for large trades), borrowing cost for shorting, cost of leverage, costs of data, software and hardware for research, fund loads, cost of advisory services and cost of an investment manager.

“These costs vary considerably by category of investor (retail or institutional), over time, across countries and across types of assets. For example:

“Transaction fees vary by broker.

“Transaction fees are generally higher percentage-wise for small trades than large trades, and therefore for investors with small accounts than those with large accounts. Sophisticated traders may be able to suppress frictions via broker arrangements and order placement algorithms.

“Market liquidity tends to be lower in emerging markets than developed markets, generally indicating higher bid-ask spreads and impacts of trading in emerging markets.

“Both transaction fees and bid-ask spreads were generally much higher in past decades than now due to regulatory changes (ending of fixed commissions and decimalization) and technological advances (lower cost of execution and lower barrier to entry for discount brokers). This variation is problematic for long backtests.

“Frictions are generally higher percentage-wise for option trades than equity trades of similar sizes. Frictions for futures trades are comparatively low.

“Frictions for aesthetic assets such as art and wine are very large compared to those for financial assets.

“Cost of an investment manager subsumes the other costs (perhaps with economies of scale) but adds incremental fees for administration and management.

“Realistic modeling of frictions is often very difficult, especially for samples spanning long time periods. Many researchers set a goal of analyzing gross risk premiums or anomalies and therefore ignore frictions in measuring returns and alphas (returns adjusted for widely accepted risk factors). However, research findings based on net results may differ substantially from those based on gross results, to the extent of rendering realistic implementations unprofitable. The following sections cover some considerations and approaches for modeling trading frictions.”

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