Research: Robert Korajczyk, Finance
finance scholar examines impact of trading costs on stock
The stock market,
always an object of fascination for researchers, shows predictable
patterns of return over time.
Over the short
term - say, a week or a month - returns are likely to reverse,
while over a medium time frame - three months to a year -
they are likely to regain momentum in their original direction.
Over the long term - three to five years- stock returns tend
to show reversals once again.
In a hypothetical
world of zero-cost portfolio trading, then, an investor holding
long positions of winning stocks and short positions of underperformers
would achieve superior returns over an intermediate horizon,
researchers have shown.
But what impact
do trading costs have on these strategies? And does this observation
hold true for portfolios regardless of their size? Kellogg
Professor Robert A. Korajczyk and his co-researcher Ronnie
Sadka, PhD '03, decided to find out.
"There's a long
literature that seems to indicate there are opportunities
for investors following momentum-based strategies. But none
of these have taken into account the costs of implementing
those strategies," says Korajczyk, the Harry G. Guthmann Distinguished
Professor of Finance and the Kellogg School's senior associate
dean of curriculum and teaching.
Korajczyk and Sadka,
a professor at the University of Washington, looked at how
trading costs affect the profitability of investment strategies
that rely on these patterns of momentum. They focused in particular
on how large a momentum-based fund would have to be before
the cost of trading drives profits to zero. Their findings
were published in a June 2004 article in the Journal of
The trading of
large institutional portfolios leads to price impact, with
the purchase of large amounts of stock pushing up the price
and the sale of large amounts pushing down the price. When
transaction costs are not figured in, the size of the profits
can be misleading. "If you think you're going to get 10 percent
on the trade, but your trading pushes the price up by 5 percent,
then you're only really getting a 5 percent return," Korajczyk
Trading costs can
have an even larger effect on smaller, less liquid stocks.
These costs can wipe out a small-capitalization-focused fund's
profits when a momentum-based strategy is applied.
"It was surprising
how rapidly the profits went away when they were based on
traditional strategies," Koraj-czyk says. "You get to a $10
million to $20 million fund and they just disappear because
of the adverse effect of price impact. They were touted as
being very profitable but were not, after accounting for the
cost of trading. However, we found with a tweak of the strategy,
we could trade much larger portfolios before profits were
Korajczyk and Sadka
discovered alternative strategies that provide greater profits:
in particular, one that tilts portfolios in favor of stocks
that are more liquid, and away from those that are less liquid.
"When a stock is
illiquid, there are more frictions to trading," Koraj-czyk
says. "You can't just buy or sell an indefinite quantity at
some fixed price. In the case of an illiquid stock, it could
be that there aren't many shares being traded, so your trading
has a large impact on the price. It's not like going into
a currency market, where you could buy tens of millions in
a currency and it wouldn't change the exchange rate very much."
The findings are
likely to be of particular interest to professional money
managers trading larger portfolios, Korajczyk says.
"A naively implemented
momentum-based strategy will not be successful at very large
investment sizes," he says. "Thinking more carefully about
how the difficulty of trading assets intermingles with trading
strategies can help you implement the strategy at a more significant