Dynamic Trading with Predictable Returns and Transaction Costs

47 Pages Posted: 11 Aug 2009 Last revised: 20 Jul 2023

See all articles by Nicolae Garleanu

Nicolae Garleanu

University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: August 2009

Abstract

We derive a closed-form optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal strategy is characterized by two principles: 1) aim in front of the target and 2) trade partially towards the current aim. Specifically, the optimal updated portfolio is a linear combination of the existing portfolio and an "aim portfolio," which is a weighted average of the current Markowitz portfolio (the moving target) and the expected Markowitz portfolios on all future dates (where the target is moving). Intuitively, predictors with slower mean reversion (alpha decay) get more weight in the aim portfolio. We implement the optimal strategy for commodity futures and find superior net returns relative to more naive benchmarks.

Suggested Citation

Garleanu, Nicolae Bogdan and Pedersen, Lasse Heje, Dynamic Trading with Predictable Returns and Transaction Costs (August 2009). NBER Working Paper No. w15205, Available at SSRN: https://ssrn.com/abstract=1444706

Nicolae Bogdan Garleanu (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

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National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

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Copenhagen Business School - Department of Finance ( email )

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Denmark

New York University (NYU) ( email )

Stern School of Business
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Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom