20 – M4 L3a 162 Real World Constraints Transaction Costs V2

Another real-world constraint is the total transaction cost, the implicit and explicit costs of making trades. Transaction costs add up and are often a substantial contributor to the success or lack of success of a trading strategy. Most people immediately think of commissions, the explicit cost, as the transaction cost. However, for an institutional market participant, the commission is usually by far the smallest component of the true transaction cost. The biggest component, the implicit component, is what is called the market impact. Institutions need to make large trades. Market impact is the effect that a market participant has when he or she buys or sells an asset. It is the extent to which buying or selling moves the price against the buyer or seller. More buying will move the market price upward. More selling will move the market price downward. For instance, if a fund is trying to sell a large block of shares to an investment bank, then the larger the block of shares, the more risk the investment bank is taking in holding the opposite side of the trade. So, the investment bank would ask for a better deal in the form of a lower price, which would then diminish the profit of the fund. To avoid adversely moving the market price, they will likely slice the trade into smaller blocks. Then we’ll trade those blocks over time. Taking more time to trade all blocks also entails the risk that the market price will move over that time. So to summarize, real-world transaction costs can diminish the performance of an alpha factor. So, we want some way to evaluate an alpha factors potential impact on a portfolio’s total transaction cost.