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Transaction cost research involves the measurement of the cost of executing an order m a security on a post-trade basis, and the estimation of that cost in expected terms for pre-trade analysis, often relating that expectation to some measure of risk.1 A typical goal of such work is to provide guidance as to how to manage those costs within a trading strategy, including the choice of strategy itself.
Today, 98% of large institutions and 88% of medium-sized institutions globally are consumers of transaction cost research. Apart from the regulatory mandate of best execution, the widespread adoption of this research can be explained by the following simple fact: 40% of market participants believe that alpha is lost primarily through trading costs, while 14% attribute the loss of alpha to bad timing of thentransactions.2 In an environment where 100 basis points difference in alpha can make a hero out of a portfolio manager, an average oneway cost of 25 basis points on a portfolio turned over annually robs 50% of that return.
This type of thinking highlights the new challenge of transaction cost analysis. That challenge is to proactively lower transaction costs by helping portfolio managers and traders choose how to construct portfolios and leverage trading strategies. We begin with an old observation: investment performance reflects two factors, the underlying investment strategy of the portfolio manager and the execution costs incurred in realizing those objectives. In the simplest case, transaction cost analysis is limited to the idea that costs simply eliminate part of the notional or "paper" return to an investment strategy, and therefore, costs should be controlled at the level of the trading desk only. In contrast to this mindset, research on how to generalize and solve the asset-allocation problem in the presence of transaction costs dates all the way back to 1970.3 The focus in most of the published papers has been on technical formulations and the mechanics of problem solving.4 Illustration of the link between transaction costs to the fundamental law of active management, as well as to the joint optimization of positions and trades, has been a fairly recent development, however/ Data on the usefulness of transaction cost analysis in portfolio construction also are lacking, because reliable...