In the first two articles of the smart beta series, I talked about which factors pass the Harvey et al. (2016) smell test of robust research as well as the benefits of combining de-correlated factors together.
Surprisingly, Harvey et al. (2016) and many other papers, don’t include a discussion on the impact of transaction costs on live performance of smart beta strategies.
Yet, this a topic of extreme importance for investors because these strategies' returns aren’t gross of fees as hypothesized by academia.
The first researchers to deal with this issue were Frazzini, Israel and Moskowitz (2014). They attempt at answering the following two questions:
1. Do size, value, momentum and short term reversal survive trading costs?
2. What is the equilibrium capacity of these strategies?
The answer to the above questions from the study is reassuring for investors:
1. With the exception of short term reversal, the well-known factor premia (size, value and momentum) add value after transaction costs
2. And the amount that can be invested is fairly big: $259 billion, $273 billion, $141 billion respectively.
However, this study was critiqued by academics and practitioners given the dataset used to assess the impact of transaction costs (relatively short time series covered and limited to larger stocks).
Last year, another study on the topic was published in the Review of Financial Studies. In fact, Robert Novy-Marx and Mihahil Velikov take the issue to the next level by evaluating a larger set of well-known anomalies over a longer time frame.
The article, 'A Taxonomy of Anomalies and Their Trading Costs', examines the after-transaction cost performance for 23 different factor investing strategies over longer horizons and across various market capitalization classes, an improvement over other studies.
One caveat is that the authors calculate transaction costs using the effective bid-ask spread measure proposed by Hasbrouck (2009).
Hence, considering that the bid/ask spread does not account for the price impact of large trades, it should be interpreted as the cost faced by a small liquidity demander.
They attempt at answering the same questions as Frazzini, Israel and Moskowitz:
1. What are the costs of trading the most important anomalies (read factor premia)?
2. What is the capacity that each of these strategies has to attract new capital before it becomes unprofitable to marginal trading?
Once again, good news for investors:
1. The authors reach a similar conclusion as prior research: size, value and momentum still have positive returns after transaction costs.
2. They calculate $170 billion capacity for size, $50 billion. for value and $5 billion. for momentum. The authors’ estimates generally agree with Frazzini et al (2014) on size and value, but they come up with a much lower estimate for momentum, which aligns with Korajczyk and Sadka (2004).
Once again, when evaluating whether to invest in smart beta products, comprehensive due diligence is a must for investors.
This includes considerations about the impact of transaction costs on the back-tested results presented by academia as well as by the industry.
Dr Elisabetta Basilico CFA is a quant investment expert and consultant who specialises in what she terms ‘turning academic insights into investment strategies.’ She helped several private and institutional clients achieve stable returns and financial prosperity. Follow her at academicinsightsoninvesting.com