NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Dynamic Trading with Predictable Returns and Transaction Costs

Nicolae B. Garleanu, Lasse H. Pedersen

NBER Working Paper No. 15205
Issued in August 2009
NBER Program(s):   AP

We derive a closed-form optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal strategy is characterized by two principles: 1) aim in front of the target and 2) trade partially towards the current aim. Specifically, the optimal updated portfolio is a linear combination of the existing portfolio and an "aim portfolio," which is a weighted average of the current Markowitz portfolio (the moving target) and the expected Markowitz portfolios on all future dates (where the target is moving). Intuitively, predictors with slower mean reversion (alpha decay) get more weight in the aim portfolio. We implement the optimal strategy for commodity futures and find superior net returns relative to more naive benchmarks.

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This paper was revised on December 16, 2013

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Document Object Identifier (DOI): 10.3386/w15205

Published: "Dynamic Trading with Predictable Returns and Transaction Costs" (with Lasse Heje Pedersen). Journal of Finance, vol. 68 (2013), issue 6, pp. 2309-2340.

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