Working Paper: CEPR ID: DP12737
Authors: Pierre Collin-Dufresne; Kent Daniel; Mehmet Saglam
Abstract: We solve for the optimal dynamic asset allocation when expected returns, volatilities, and trading costs follow aregime switching model. The optimal policy is to trade partially towards an aim portfolio with a given trading speed.In a given state, the aim portfolio is a weighted average of mean-variance portfolios in every state, where the weightis a function of the probability of transitioning to that state, and the state's persistence, risk and trading costs.The trading speed is higher in states that are more persistent, where return volatility is higher and trading costsare lower. It can be optimal to deviate substantially from the mean-variance efficient portfolio (or from the risk-parity allocation) and to underweighthigh Sharpe ratio (high volatility) assets, as well as to trade more aggressively the less liquid assets in anticipation of an increasein their volatility and trading costs. We illustrate our approach in an empirical exercise in which we exploittime-variation in the expected return, volatility, and cost of trading of the value-weighted market portfolio of UScommon stocks. We estimate a regime switching model applied to a dataset of institutional trades, and find thatrealized trading costs are significantly higher when market volatility is high. The optimal dynamic strategysignificantly outperforms a myopic trading strategy in an out-of-sample experiment. The highest gains arise fromtiming the changes in volatility and trading costs rather than expected returns.
Keywords: dynamic portfolio choice; transaction costs; stochastic volatility; price impact; risk parity; mean-variance
JEL Codes: D53; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal dynamic strategy (C73) | significantly outperform myopic trading strategy (G41) |
| market volatility (G17) | realized trading costs (G19) |
| persistent states with greater return volatility (G19) | trading speed (F10) |
| high Sharpe ratio, high volatility assets (G19) | underweighting (D91) |
| less liquid assets (G19) | more aggressive trading (G19) |
| state of the market (G10) | optimal trading strategies (G13) |