Optimal Portfolio Rebalancing with Transaction Costs

Abstract

Research has proven the optimality of a no-trade region around an investor's desired asset proportions to assure that trading occurs only when asset proportions drift outside this region, and then only to bring proportions back to the boundary of the no-trade region, not to the target proportions. Because current solution methods are complex, managers typically rely on ad hoc heuristics that are either calendar-based or volatility-based and whose performance against an optimal strategy is unknown. The authors characterize the size and shape of the no-trade region as a function of key problem parameters and compare the performance of different rebalancing strategies. The analysis suggests that extraction of key features associ-ated with optimal rebalancing allows development of more tractable rebalancing heuristics that enhance the effectiveness of optimal rebalancing.