Transaction Costs

This tutorial shows how to incorporate transaction costs (TC) into the MeanRisk optimization.

TC are fixed costs incurred when buying or selling an asset.

By using the transaction_costs parameter, you can add linear TC to the optimization problem:

\[total\_cost = \sum_{i=1}^{N} c_{i} \times |w_{i} - w\_prev_{i}|\]

with \(c_{i}\) the TC of asset i, \(w_{i}\) its weight and \(w\_prev_{i}\) its previous weight (defined in previous_weights). The float \(total\_cost\) is impacting the portfolio expected return in the optimization:

\[expected\_return = \mu^{T} \cdot w - total\_cost\]

with \(\mu\) the vector af assets expected returns and \(w\) the vector of assets weights.

the transaction_costs parameter can be a float, a dictionary or an array-like of shape (n_assets, ). If a float is provided, it is applied to each asset. If a dictionary is provided, its (key/value) pair must be the (asset name/asset TC) and the input X of the fit method must be a DataFrame with the assets names in columns. The default is 0.0 (no transaction costs).

Warning

According to the above formula, the periodicity of the transaction costs needs to be homogenous to the periodicity of \(\mu\). For example, if the input X is composed of daily returns, the transaction_costs need to be expressed as daily costs.

This means that you need to convert this fixed transaction costs into daily costs. To achieve this, you need the notion of expected investment duration. This is crucial since the optimization problem has no notion of investment duration.

For example, let’s assume that asset A has an expected daily return of 0.01% with a TC of 1% and asset B has an expected daily return of 0.005% with no TC. Let’s assume both assets have the same volatility and a correlation of 1.0. If the investment duration is only one month, we should allocate all the weights to asset B. However, if the investment duration is one year, we should allocate all the weights to asset A.

Example:

• Duration = 1 months (21 business days):

  • 1 month expected return A ~= -0.8%

  • 1 month expected return B ~= 0.1%

• Duration = 1 year (252 business days):

  • 1 year expected return A ~= 1.5%

  • 1 year expected return B ~= 1.3%

So in order to take that duration into account, you should divide the fix TC by the expected investment duration.

Data

We load the S&P 500 dataset composed of the daily prices of 20 assets from the S&P 500 Index composition starting from 1990-01-02 up to 2022-12-28. We select only 3 assets to make the example more readable, which are Apple (AAPL), General Electric (GE) and JPMorgan (JPM):

import numpy as np
from plotly.io import show

from skfolio import MultiPeriodPortfolio, Population, Portfolio
from skfolio.datasets import load_sp500_dataset
from skfolio.model_selection import WalkForward, cross_val_predict
from skfolio.optimization import MeanRisk, ObjectiveFunction
from skfolio.preprocessing import prices_to_returns

prices = load_sp500_dataset()
prices = prices[["AAPL", "GE", "JPM"]]

X = prices_to_returns(prices)

Model

In this tutorial, we will use the Maximum Mean-Variance Utility model with a risk aversion of 1.0:

model = MeanRisk(objective_function=ObjectiveFunction.MAXIMIZE_UTILITY)
model.fit(X)
model.weights_

array([6.17733231e-01, 3.78775541e-09, 3.82266765e-01])

Transaction Cost

Let’s assume we have the below TC:

• Apple: 1%

• General Electric: 0.50%

• JPMorgan: 0.20%

and an investment duration of one month (21 business days):

transaction_costs = {"AAPL": 0.01 / 21, "GE": 0.005 / 21, "JPM": 0.002 / 21}
# Same as transaction_costs = np.array([0.01, 0.005, 0.002]) / 21

First, we assume that there is no previous position:

model_tc = MeanRisk(
    objective_function=ObjectiveFunction.MAXIMIZE_UTILITY,
    transaction_costs=transaction_costs,
)
model_tc.fit(X)
model_tc.weights_

array([4.11868007e-01, 1.40979621e-07, 5.88131852e-01])

The higher TC of Apple induced a change of weights toward JPMorgan:

model_tc.weights_ - model.weights_

array([-2.05865225e-01,  1.37191866e-07,  2.05865087e-01])

Now, let’s assume that the previous position was equal-weighted:

model_tc2 = MeanRisk(
    objective_function=ObjectiveFunction.MAXIMIZE_UTILITY,
    transaction_costs=transaction_costs,
    previous_weights=np.ones(3) / 3,
)
model_tc2.fit(X)
model_tc2.weights_

array([0.33333336, 0.3333332 , 0.33333345])

Notice that the weight of General Electric becomes non-negligible due to the cost of rebalancing the position:

model_tc2.weights_ - model.weights_

array([-0.28439988,  0.3333332 , -0.04893332])

Multi-period portfolio

Let’s assume that we want to rebalance our portfolio every 60 days by re-fitting the model on the latest 60 days. We test the impact of TC using Walk Forward Analysis:

holding_period = 60
fitting_period = 60
cv = WalkForward(train_size=fitting_period, test_size=holding_period)

As explained above, we transform the fix TC into a daily cost by dividing the TC by the expected investment duration:

transaction_costs = np.array([0.01, 0.005, 0.002]) / holding_period

First, we train and test the model without TC:

model = MeanRisk(objective_function=ObjectiveFunction.MAXIMIZE_UTILITY)
# pred1 is a MultiPeriodPortfolio
pred1 = cross_val_predict(model, X, cv=cv, n_jobs=-1)
pred1.name = "pred1"

Then, we train the model without TC and test it with TC. The model trained without TC is the same as above so we can retrieve the results and simply update the prediction with the TC:

pred2 = MultiPeriodPortfolio(name="pred2")
previous_weights = None
for portfolio in pred1:
    new_portfolio = Portfolio(
        X=portfolio.X,
        weights=portfolio.weights,
        previous_weights=previous_weights,
        transaction_costs=transaction_costs,
    )
    previous_weights = portfolio.weights
    pred2.append(new_portfolio)

Finally, we train and test the model with TC. Note that we cannot use the cross_val_predict function anymore because it uses parallelization and cannot handle the previous_weights dependency between folds:

pred3 = MultiPeriodPortfolio(name="pred3")

model.set_params(transaction_costs=transaction_costs)
previous_weights = None
for train, test in cv.split(X):
    X_train = X.take(train)
    X_test = X.take(test)
    model.set_params(previous_weights=previous_weights)
    model.fit(X_train)
    portfolio = model.predict(X_test)
    pred3.append(portfolio)
    previous_weights = model.weights_

We visualize the results by plotting the cumulative returns of the successive test periods:

population = Population([pred1, pred2, pred3])
fig = population.plot_cumulative_returns()
show(fig)

If we exclude the unrealistic prediction without TC, we notice that the model fitted with TC outperforms the model fitted without TC.