The risk of falling short : Implementation Shortfall variance in portfolio construction

Transaction cost variance introduces a risk often neglected in portfolio optimization. We define a mean-variance portfolio optimization problem and show that including a transaction cost variance term significantly impacts the performance of these portfolios. Transaction cost variance is estimated based on a transaction cost model constructed using proprietary data from a large institutional money manager. Using a standard time-series models setup for our returns, we show that considering transaction cost variance leads to better performing portfolios. We further demonstrate the main contribution of transaction cost variance, which we show to have reduced transaction costs significantly