Model Comparison with Transaction Costs

Failing to account for transaction costs materially impacts inferences drawn when evaluating asset pricing models, biasing tests in favor of those employing high cost factors. Ignoring transaction costs, the Hou, Xue, and Zhang (2015) q-factor model and the Barillas and Shanken (2018) six-factor model models have high maximum squared Sharpe ratios and small alphas across 120 anomalies. They do not, however, come close to spanning the achievable mean-variance efficient frontier. Accounting for transaction costs, the Fama and French (2015, 2018) five-factor model has a significantly higher squared Sharpe ratio than either of these alternative models, while variations employing cash profitability perform better still. More generally, these results highlight the importance of incorporating real-world concerns into financial research.

Keywords: Factor Models, Trading Costs, Mispricing

JEL Classification: G11, G12, G14

Suggested Citation: Suggested Citation

Detzel, Andrew L. and Novy-Marx, Robert and Velikov, Mihail, Model Comparison with Transaction Costs (March 16, 2021). Journal of Finance, Forthcoming, Proceedings of Paris December 2021 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3805379 or http://dx.doi.org/10.2139/ssrn.3805379