Title | Implementation shortfall |
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Course | Asset Pricing |
Institution | University of Exeter |
Pages | 3 |
File Size | 66.3 KB |
File Type | |
Total Downloads | 20 |
Total Views | 137 |
Implementation shortfall...
5.3 Implementation Shortfall We have seen how transaction costs affect your trading and your profits from trading but also what it means to trade optimally. Implementation Shortfall: the costs of trading and not trading
Paper portfolio: your desired portfolio if trading costs were zero
Performance of paper portfolio: compute return and re-adjust the portfolio in real time as if you can trade any number of shares at the mid quote (middle of the bid-ask spread) this is the best case scenario, you can do whatever you want
Real-life performance differs from that of the paper portfolio because: 1. In real life, you incur transaction costs 2. In real life, you change your trading pattern, possibly causing missed opportunities to trade because net of transaction costs the trades don’t make sense
Implementation shortfall (IS) is a measure that captures both of these costs.
It is the sum of the transaction costs (TC) and The cost of not trading, i.e., opportunity cost (OC) : IS = TC+OC
Computing implementation shortfall (Perold (1988)): IS = performance of paper portfolio – performance of real portfolio
Suppose the paper portfolio promises you 30% return on your initial assets under management. But in the real-life portfolio you only get a 20% return. The difference is your IS
The opportunity cost can be inferred, OC = IS – TC.
Using implementation shortfall to improve trading
Tracking whether your trading ideas are being successfully implemented:
A hedge fund is not interested in making money in principle, but in practice A large shortfall drives a wedge between the two Study why you have a large IS- is it high TC or is it high OC. If it is high then on paper you should be making money but in practice you are not. Then you can ask how can you reduce the shortfall to increase your returns. Suppose IS is not high then maybe you should come up with better ways to improve your paper portfolio because the problem is not that there is a big difference between the paper and the real-life portfolio, the problem is that your paper portfolio is not good enough to generate the high returns that you are seeking
Studying your performance and IS can help focus your efforts on:
improving your trading implementation or the strategy’s alpha signals. How can you use IS and paper-portfolio returns to determine this?
How do you reduce your shortfall?
IS=TC+OC By trading faster and being first to the market before it moves away from you? (Reduce OC). You will likely incur higher TC (trade-off) Or by trading more slowly and minimizing your price impact and other trading costs? (reducing TC) but you will have more missed opportunities to trade How do you know whether a change worked? Just ask if in reducing TC did IS actually go down but did OC go up by more or less e.g. if TC go down by £100m and OC only increase by £50 then you have still increased profits. IS falls by £50. How fast to trade therefore depends on the relative importance of TC and OC: strategies in illiquid markets tend to have large TC, implying that you optimally trade slowly, whereas strategies with a large alpha decay (the trading opportunity disappears quickly) have large OC, implying that you optimally trade fast...