How Trading Costs Erode Factor Returns

When choosing a factor-based strategy, advisors should carefully scrutinize the fund’s construction rules (e.g., the number of securities held) and implementation strategy (e.g., the frequency of rebalancing and the use of patient, algorithmic trading).

To understand the importance of this issue, let’s go back to our book, “Your Complete Guide to Factor-Based Investing,” in which Andrew Berkin and I laid out five criteria that must be met before considering investing in a factor. The factor must show evidence of being a unique/independent source of risk that has generated a premium that is:

  • Persistent – It holds across long periods of time and different economic regimes.
  • Pervasive – It holds across countries, regions, sectors and even asset classes.
  • Robust – It holds for various definitions (for example, there is a value premium, whether it is measured by price-to-book, earnings, cash flow or sales).
  • Investable – It holds up not just on paper but also after considering actual implementation issues, such as trading costs.
  • Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.

We then laid out the evidence that, among the “zoo” of equity factors documented in the academic literature, only a handful pass all the tests: market beta, size, value, momentum and profitability/quality. It is particularly important to consider transactions costs (investability) because market impact costs may substantially erode a strategy's expected excess returns. Transactions costs are impacted by not only turnover (due to the need to rebalance portfolios) but also concentration of turnover and thus demands on liquidity.

Feifei Li, Tzee-man Chow, Alex Pickard and Yadwinder Garg contribute to the literature with their study “Transaction Costs of Factor-Investing Strategies,” which appears in the Spring 2019 issue of the Financial Analysts Journal. The authors evaluated 15 popular factor investing strategy implementations and identified how index construction methods, when thoughtfully designed, can reduce market impact costs.