The risk of falling short: Implementation Shortfall variance in portfolio construction *

Abstract

Transaction cost variance introduces a risk often neglected in portfolio optimization. Adopting a mean-variance portfolio optimization problem, we show that including a transaction cost variance term can significantly impact the associated portfolios' performances. Transaction cost variance is estimated based on a transaction cost model constructed using proprietary data from a large institutional investment manager company. Using a standard time-series model setup for returns, we show that considering transaction cost variance leads to improved net risk-adjusted performance.

Keywords: Portfolio optimization, Implementation Shortfall, Time-series models. JEL Classification: C01, C32, C51, C52, C61, G11, G12

JEL Classification: C01, C32, C51, C52, C61, G11, G12