Funding Conditions, Transaction Costs and the Performance of Anomalies

Transaction costs have declined over time but they can increase considerably when funding liquidity becomes scarce, investors’ fears spike or other frictions limit arbitrage. We estimate bid-ask spreads of thousands of firms at a daily frequency and put forward these large movements for several of these episodes in the last 30 years. The trading cost of three-quarters of the firms is significantly impacted by funding liquidity and increases on average by 24%. While small firms and high volatility firms have larger transaction costs, the relative increase in trading costs in crisis times is more pronounced in large firms and low-volatility firms. The gap between the respective trading costs of these high- and low-quality groups also increases when financial conditions deteriorate, which provides evidence of flight to quality. We build anomaly-based long-short portfolios and estimate their alphas adjusted for rebalancing costs based on our security-level transaction cost estimates to show that only three anomaly strategies related to unexpected earnings, sales growth and price per share yield a significant positive profit. Strategies reducing the turnover only marginally add to the actual alpha-producing characteristics