Dynamic Trading with Predictable Returns and Transaction Costs

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.