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Managing Stock Portfolio Trading Frictions

Posted in Equity Premium

What is the best way to suppress trading frictions for active, long-term stock portfolios? In their September 2018 paper entitled "Comparing Cost-Mitigation Techniques", Robert Novy-Marx and Mihail Velikov compare three approaches to suppression of trading frictions for long-term stock factor premium capture strategies:

  1. Limiting selection to stocks that are cheap to trade.
  2. Rebalancing infrequently.
  3. Imposing a penalty for opening a new position compared to maintaining an established position (banding).

They also evaluate indirect suppression of trading frictions from exploiting a secondary premium (stock sort) that sometimes delays or even cancels trades targeting the primary premium. They consider three stock universes: large (top 90% of total market capitalization); small (the next 9%); and, micro (the next 0.9%). They estimate trading frictions as effective bid-ask spreads. Their test portfolios are long-short extreme fifths (quintiles) of stocks sorted on seven stock/firm variables as specified in widely cited academic literature: accounting (failure probability and net stock issuance); defensive (beta and idiosyncratic volatility); and, momentum (conventional, unexpected earnings and earnings announcement). Using specified data during January 1975 through December 2016, they find that:

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