Model Selection with Transaction Costs

60 Pages Posted: 17 Mar 2021

See all articles by Andrew L. Detzel

Andrew L. Detzel

University of Denver - Daniels College of Business

Robert Novy-Marx

Simon Business School, University of Rochester; National Bureau of Economic Research (NBER)

Mihail Velikov

Pennsylvania State University

Date Written: March 16, 2021

Abstract

Failing to account for transaction costs materially impacts inferences drawn when evaluating asset pricing models, biasing tests in favor of those employing high cost factors. Ignoring transaction costs, the Hou, Xue, and Zhang (2015) q-factor model and the Barillas and Shanken (2018) six-factor model models have high maximum squared Sharpe ratios and small alphas across 120 anomalies. They do not, however, come close to spanning the achievable mean-variance efficient frontier. Accounting for transaction costs, the Fama and French (2015, 2018) five-factor model has a significantly higher squared Sharpe ratio than either of these alternative models, while variations employing cash profitability perform better still. More generally, these results highlight the importance of incorporating real-world concerns into financial research.

Keywords: Factor Models, Trading Costs, Mispricing

JEL Classification: G11, G12, G14

Suggested Citation

Detzel, Andrew L. and Novy-Marx, Robert and Velikov, Mihail, Model Selection with Transaction Costs (March 16, 2021). Available at SSRN: https://ssrn.com/abstract=3805379 or http://dx.doi.org/10.2139/ssrn.3805379

Andrew L. Detzel (Contact Author)

University of Denver - Daniels College of Business ( email )

2101 S. University Blvd
Denver, CO 80208
United States

HOME PAGE: http://portfolio.du.edu/adetzel

Robert Novy-Marx

Simon Business School, University of Rochester ( email )

Rochester, NY 14627
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Mihail Velikov

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

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