Dynamic Trading with Predictable Returns and Transaction Costs

Nicolae Gârleanu, Lasse Heje Pedersen

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Abstract

We derive a closed-form optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal strategy is characterized by two principles: (1) aim in front of the target, and (2) trade partially toward the current aim. Specifically, the optimal updated portfolio is a linear combination of the existing portfolio and an “aim portfolio,” which is a weighted average of the current Markowitz portfolio (the moving target) and the expected Markowitz portfolios on all future dates (where the target is moving). Intuitively, predictors with slower mean-reversion (alpha decay) get more weight in the aim portfolio. We implement the optimal strategy for commodity futures and find superior net returns relative to more naive benchmarks.
Original languageEnglish
JournalJournal of Finance
Volume68
Issue number6
Pages (from-to)2309–2340
ISSN0022-1082
DOIs
Publication statusPublished - Dec 2013

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