E. Qian, R. Hua, and J. Tilney (USA)
Portfolio management, portfolio turnover, transaction cost
We analyze the turnover of quantitatively-managed equity portfolios. We derive an analytic formula for the portfolio turnover, caused by changes in alpha forecasts, of a long short market neutral portfolio. The most critical input to this analytic solution is the cross-sectional correlation between two sets of consecutive forecasts. Other influencing factors include the targeted tracking error of the portfolio, the number of stocks in the investable universe, and the average stock specific risk. We next focus on the common practice of ignoring small trades and analyze its impact on portfolio's alpha exposure. We find that one can reduce portfolio turnover by 50% and yet achieve 70% of incremental alpha exposure. For long only portfolios, we use Monte Carlo simulation to calculate their turnovers, which are generally lower than that of the long-short portfolios. Qualitatively, the reduction in long-only turnover compared to the long short turnover increases as the targeted tracking error, the number of securities, or the benchmark concentration increases. We construct an empirical model for this reduction based on the percentage of zero-weight securities in the long-only portfolio.
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