Capturing the systematic premia is the main aim of many quantitative traders. However, investors tend to overlook an important factor when backtesting. Trading costs are an essential part of every trade, and yet even when we consider them, we often only use an approximation. The recent article from Angana Jacob (SigTech) looks into how heavily trading costs affect the overall return of various strategies and analyzes multiple ways of implementing trading costs into the trading rules themselves.
Firstly, the author distinguishes between explicit and implicit components of the costs of a systematic trading strategy. The fees known in advance are categorized as the explicit components. On the other hand, the less visible and harder to estimate costs are categorized as implicit. Further, the author divides the implicit costs into three groups: Instant impact, Temporary impact, and Permanent impact. And because the implicit costs are often much greater than the explicit costs, the paper focuses mainly on instant impact costs, their influence on the strategy’s return, and possible ways to minimize them.
The article also debates the pros and cons of frequent rebalancing. If an investor rebalances their strategy too often, they might have the advantage of increased reactivity; however, the transaction costs may overpower the rebalancing premia. This is shown in an example of FX Short-term Value Strategy.
Additionally, Global Tactical Asset Allocation Strategy (GTAA), which is rebalanced daily, shows an even more extreme example of the price of transaction costs. The author improves the GTAA strategy by slowing the rebalancing by employing a threshold and increasing the lookback window in the return estimation for the mean-variance optimization.
Author: Angana Jacob
Title: How to control the hidden costs of systematic investing
Link: https://hubs.la/Q018FFD40
Abstract:
“Any backtest is only as good as the information put into it. And yet when it comes to trading costs it is often assumed that an approximation is accurate enough to account for real world trading frictions. In reality, the impact of trading costs can be similar in magnitude, or even outweigh, the systematic premia they aim to capture. Additionally, trading costs assume greater significance in a low-return environment as they effectively represent a greater proportion of potential return available.“
As always we present several interesting figures:
Notable quotations from the academic research paper:
“In order to construct robust investment strategies, it is essential that asset managers accurately incorporate all trading costs including commissions, slippage, bid-ask spreads and market impact into their backtesting process.
The overall cost of a systematic trading strategy comprises explicit and implicit components. The explicit component is typically known in advance of trading such as agency commissions and fees.
Implicit costs are less observable, harder to estimate and can be of a higher magnitude than the explicit costs.
Implicit cost = Instant impact + Temporary impact + Permanent impact
The remainder of this paper focuses primarily on instant impact, the effect this impact can have on the total return of a systematic strategy and potential ways to mitigate it.
The higher rebalancing frequency has the advantage of increased reactivity but the sheer number of trades creates an annualised cost of 1.5% loss in returns. On a cumulative basis over a decade, the strategy’s total return net of costs (1.6% total) ends up a tiny fraction of its hypothetical gross return with zero costs (17.1% total).
The GTAA strategy analyzes short-term performance across different liquid markets/asset classes and allocates to the instruments that have outperformed on a risk-adjusted basis. The strategy employs daily rebalancing based on a mean variance optimisation. This strategy demonstrates an even more extreme example of the impact of transaction costs on the total return. By properly accounting for costs, a convincing backtest becomes a clear loss-making proposition. Though the strategy invests in highly liquid instruments with transaction costs of low single digit basis points, the fast reversal of daily positions erodes up to 6.2% a year (from the no-cost backtest annualised return of 3.9%) and 62% cumulatively over a decade.
The GTAA strategy was improved (as shown in Fig 3) using more thoughtful construction: 1) by slowing the rebalancing through employing a threshold and 2) by increasing the lookback window in the return estimation for the mean-variance optimisation. The longer lookback window smooths the signal and reduces the wild swings in its position weights, thereby making a substantial difference to trading costs (0.5% annualised difference between a no-cost backtest vs including costs).”
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