| Abstract: |
This paper derives in closed form the optimal dynamic portfolio policy when
trading is costly and security returns are predictable by signals with
different mean-reversion speeds. The optimal updated portfolio is a linear
combination of the existing portfolio, the optimal portfolio absent trading
costs, and the optimal portfolio based on future expected returns and
transaction costs. Predictors with slower mean reversion (alpha decay) get
more weight since they lead to a favorable positioning both now and in the
future. We implement the optimal policy for commodity futures and show that
the resulting portfolio has superior returns net of trading costs relative to
more naive benchmarks. Finally, we derive natural equilibrium implications,
including that demand shocks with faster mean reversion command a higher
return premium. |