Active investors and asset managers — such as hedge funds, mutual funds and proprietary traders — try to predict security returns and trade to profit from their predictions. However, such dynamic trading often entails significant turnover and transaction costs, so active investors must constantly weigh the expected benefit of trading against its costs and risks.
An investor often uses different return predictors (value and momentum predictors are two examples), and these have different prediction strengths and mean-reversion speeds — or, said differently, different “alphas” and “alpha decays.” The alpha decay is important because it determines how long the investor can enjoy high expected returns and, therefore, affects the trade-off between returns and transactions costs. For instance, while a momentum signal may predict a high return on IBM stock over the next month, a value signal might predict that Cisco will perform well over the next year
This paper addresses how the optimal trading strategy depends on securities’ current expected returns, the evolution of expected returns in the future, their risks and correlations, and transaction costs. Our framework constitutes a powerful tool to optimally combine various return predictors taking into account their evolution over time, decay rate, and correlation, and trading off their benefits against risks and transaction costs. Such dynamic trade-offs are at the heart of the decisions of arbitrageurs that help to make markets efficient, as the efficient market hypothesis suggests they should be.
This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.