Working Paper: NBER ID: w15205
Authors: Nicolae B. Garleanu; Lasse H. Pedersen
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.
Keywords: dynamic trading; predictable returns; transaction costs; portfolio strategy
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| transaction costs (D23) | optimal updated portfolio (G11) |
| current Markowitz portfolio (G11) | aim portfolio (G11) |
| expected Markowitz portfolios on future dates (G17) | aim portfolio (G11) |
| alpha decay (Y60) | trading aggressiveness (F12) |
| aim portfolio (G11) | trading behavior (G41) |