Liquidity Risks, Transaction costs and Online Portfolio Selection

Abstract

The performance of online (sequential) portfolio selection (OPS), which rebalances a portfolio in every period (e.g. daily or weekly) in order to maximise the portfolio's expected terminal wealth in the long run, has been overestimated by the ideal assumption of unlimited market liquidity or no market impact cost. Therefore, a new transaction cost factor model that considers both market impact costs, estimated from limit order book (LOB) data, and proportional transaction costs has been proposed in this paper to measure existing OPS strategies performance in a more practical way as well as to develop a more effective OPS method. Backtesting results from the historical LOB data of NASDAQ-traded stocks show both the performance deterioration of existing OPS methods by the market impact costs and the superiority of our proposed OPS method in the environment of limited market liquidity.

Keywords: Online Portfolio Selection, Transaction Cost, Market Impact Cost, Liquidity Risks, LOB

JEL Classification: G11, C63