Journal of Banking and Finance 94 (2018) 131–151

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Journal of Banking and Finance

journal homepage: www.elsevier.com/locate/jbf

Portfolio selection with proportional transaction costs and

predictability
Xiaoling Mei a, Francisco J. Nogales b,∗
a
Department of Finance, School of Economics & Wang Yanan Institute for Study in Economics (WISE), Xiamen University, China
b
Department of Statistics & UC3M-BS Institute of Financial Big Data, Universidad Carlos III de Madrid, Spain

a r t i c l e i n f o a b s t r a c t

Article history: We consider the portfolio selection problem for a multiperiod investor who seeks to maximize her utility
Received 21 July 2016 of intermediate consumption facing multiple risky-assets and proportional transaction costs in the pres-
Accepted 23 July 2018
ence of return predictability. With the presence of transaction costs, this problem is very difficult to solve
Available online 27 July 2018
even numerically due to the curse of dimensionality. In this paper, we propose first several suboptimal
JEL classification: rebalancing policies that are based on optimizing simple quadratic programs for a mean-variance investor
G11 who faces proportional transaction costs. Then, we propose some feasible rebalancing and consumption
policies that can be easily computed even for many risky assets, for an investor with power utility, based
Keywords: on the proposed suboptimal policies. Finally, we show how to compute upper bounds and use them to
Investment analysis
study how the certainty equivalent losses of consumption, associated when using the approximate poli-
Portfolio optimization
cies, depend on different problem parameters.
Dynamic portfolio choice
Information relaxations © 2018 Published by Elsevier B.V.

1. Introduction Constantinides (1979) studies a general discrete-time model and

Dynamic portfolio choice is one of the most important prac-
tical problems in finance since the work of Merton (1971), who
analyzed an investor who wishes to maximize her utility of con-
sumption, and has access to multiple risky-assets with a constant
investment opportunity set.1 Merton’s policy indicates that an in-
vestor should continuously rebalance her portfolio weights in order
to hold a fixed proportion of her wealth on each of the risky assets.
However, continuously portfolio rebalancing requires the payment
of high transaction costs. Since Merton’s seminal work, researchers
have tried to characterize the optimal portfolio policy in the pres-
ence of transaction costs.
The case with a single-risky asset and proportional trans-
action costs is now well understood. Magill and Constan-
tinides (1976) consider proportional transaction costs and conjec-
ture that for a finite-horizon continuous-time investor, the op-
timal trading policy can be characterized by a no-trade interval:
if the portfolio weight on the risky asset is inside this interval,
then it is optimal not to trade, and if the portfolio weight is out-
side, then it is optimal to trade to the boundary of this interval.
∗
Corresponding author.
E-mail addresses: luciamay@xmu.edu.cn (X. Mei), nogales@uc3m.es,
fcofavier.nogales@uc3m.es, fjnm@est-econ.uc3m.es (F.J. Nogales).
1
Merton also studied the case where the investor has logarithmic utility in the
presence of predictability.
demonstrates the optimality of the no-trade interval policy with
CRRA power utility of intermediate consumption and a single risky
asset. Constantinides (1986) considers an infinite horizon problem
with proportional transaction costs, and computes approximately-
optimal no-trade intervals by assuming the investor’s consump-
tion rate is a fixed proportion of her wealth, a condition that
is not satisfied in general. Davis and Norman (1990) address the
same problem, establish analogous results on the no-trade interval,
and provide a numerical method to calculate the optimal policy.
Muthuraman (2007) develops an efficient computational scheme
for the same problem.
The case with multiple-risky assets and proportional transac-
tion costs is generally intractable analytically. With a constant
opportunity set, (Akian et al., 1996) prove the existence and
uniqueness of the optimal portfolio policy for a CRRA investor
who has power utility with relative risk aversion between zero
and one, and where risky-asset returns are uncorrelated. They
also present some numerical results for the two uncorrelated
risky assets case. Liu (2004) considers a constant absolute risk-
aversion (CARA) investor who has access to unconstrained borrow-
ing and faces uncorrelated risky-asset returns. He shows analyti-
cally that there exists a box-shaped no-trade region and numeri-
cally solves the case of two risky assets with a small correlation
value. Muthuraman and Kumar (2006) propose an efficient nu-
merical approach to compute the no-trade region for an infinite-
horizon CRRA investor who makes decisions continuously.

https://doi.org/10.1016/j.jbankfin.2018.07.012
0378-4266/© 2018 Published by Elsevier B.V.
132 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151
When we add predictability, the case with multiple-risky as-
sets and proportional transaction costs is much more difficult to
solve, and only a small number of papers deals with this prob-
lem. Balduzzi and Lynch (1999) study the impact of return pre-
dictability on the utility cost and obtain the optimal rebalancing
rules for a single-risky asset case. They show the costs of ignor-
ing predictability can be substantial for a CRRA investor with a
finite life. Lynch and Tan (2010) analyze numerically the model
with two risky assets and predictable returns for a multiperiod
CRRA investor who maximizes her power utility of intermediate
consumption. Using numerical dynamic programming, they show
that for each state, there is a quadrilateral-shaped no-trade re-
gion that confines the transaction. Their numerical methods are
based on a grid discretization of the state space, and then their ap-
proach could run into the curse of dimensionality with more risky
assets. Brown and Smith (2011) provide several heuristic trading
strategies for a finite-horizon discrete-time investor facing propor-
tional transaction costs and multiple risky assets in the presence
of return predictability. They evaluate the optimality of the pro-
posed heuristics based on upper bounds obtained through a dual
approach. The dual method based on information-relaxation is ini-
tially developed in Brown et al. (2010) and it provides a technique
to construct valid dual bounds for any approximated solution.
The aforementioned papers show that, for a CRRA power util-
ity investor facing a small number of risky assets (up to two), the
model that incorporates return predictability with transaction costs
generally admits only a numerical solution. With more risky assets,
only an approximate solution can be obtained due to the curse of
dimensionality. Gârleanu and Pedersen (2013), hereafter G&P, con-
sider a more analytically tractable framework that allows them to
achieve a closed-form solution for the optimal portfolio policy in
the presence of quadratic transaction costs. Specifically, their in-
vestor maximizes the present value of the mean-variance utility
of her wealth changes at multiple time periods, has access to un-
constrained borrowing, and faces multiple risky assets with pre-
dictable price changes. With the quadratic utility, quadratic trans-
action costs and no portfolio constraints, the model is formulated
as a linear quadratic control problem which is straightforward to
solve. However, the quadratic form in G&P model is not able to
characterize the trading strategies of an investor who incurs pro-
portional transaction costs. Meanwhile, the mean-variance frame-
work also ignores consumption, which is a key element in practice.
In this paper, we consider a dynamic portfolio-selection prob-
lem in a discrete-time, finite-horizon setting. In our model,
the investor maximizes her expected CRRA utility of interme-
diate consumption. We further assume that she faces mul-
tiple risky assets with predictable returns and without con-
straints on borrowing, and incurs proportional transaction costs.
We propose several approximate trading strategies that are based
on solving simple quadratic programs and evaluate the sub-
optimality of these strategies through the dual approach proposed
by Brown et al. (2010). In order to propose these approximate
strategies, we first approximate our model for a CRRA power util-
ity investor with the same mean-variance problem considered in
G&P. But instead of considering a model with an infinite invest-
ment horizon and quadratic transaction costs, we considered a
more realistic framework with a finite investment horizon and pro-
portional transaction costs. We then find some approximate solu-
tions that induce a lower utility loss for the mean-variance prob-
lem. Finally, we adapt these approximate solutions to the CRRA
framework. Our numerical experiments suggest that these adapted
approximate strategies perform reasonably well in practice.
We make three contributions to the dynamic portfolio-choice
and transaction cost literature. Our first contribution is to provide
several approximate trading strategies for a mean-variance utility
investor who faces proportional transaction costs and predictabil-
ity. Specifically, these approximate trading strategies are proposed
using the tractable mean-variance framework by G&P and can be
conveniently computed by solving simple quadratic programs.
Our second contribution is to show how to adapt the strate-
gies to a framework based on a CRRA power utility. To do this,
we consider an investor who wishes to maximize her CRRA util-
ity of intermediate consumption with predictable returns, in the
presence of proportional transaction costs. We compute numeri-
cally the corresponding upper bounds to the certainty equivalent
of the investor and show that the certainty equivalent losses from
using these approximate policies are reasonably small.
Finally, we show that the multiperiod portfolio selection prob-
lem with multiple risky assets in the presence of predictability
and proportional transaction costs can be tackled through the use
of the duality method developed in Brown et al. (2010) based
on information relaxation. This method can be used to compute
dual bounds on the optimal value function by introducing proper
penalty functions. We show these dual bounds can improve signif-
icantly the bounds computed when no penalty function is consid-
ered.
Our work is related to Brown and Smith (2011) and
Mei et al. (2016). Like (Brown and Smith, 2011), we propose some
approximate trading strategies for a multiperiod investor with
CRRA power utility, but instead of approximating the dynamic pro-
gramming recursion (the continuation value functions) of the pri-
mal problem, we approximate the primal problem for each period
with a quadratic program that can handle problems with more
risky assets. In addition, we consider an investor that maximizes
her power utility of intermediate consumption while (Brown and
Smith, 2011) consider an investor who maximizes her utility of ter-
minal wealth. Mei et al. (2016) consider a mean-variance investor
who faces general transaction costs and constant investment op-
portunity set. For the case with proportional transaction costs, they
give closed-form expressions for the no-trade region. In this pa-
per, we propose the approximate trading strategies based on their
analysis on no-trade regions, but we consider a more realistic case
where there is predictability.
The remainder of this paper is organized as follows. In
Section 2, we introduce the dynamic portfolio selection frame-
work in the presence of proportional transaction costs and pre-
dictability. In Section 3, we describe our approximate trading poli-
cies for a mean-variance investor and evaluate these approximate
strategies under the mean-variance framework. Section 4 describes
how to adapt these approximate strategies to a CRRA power utility
framework and evaluates numerically these strategies. The evalua-
tion is based on information relaxations that allow to obtain dual
bounds. Section 5 concludes. Appendix A contains the figures and
tables. Appendix B contains the derivation of the aim portfolio,
which is a weighted average of the current Markowitz portfolio
and the expected future Markowitz portfolios. Appendix C contains
the derivation of the penalty function. In Appendix D we describe
how to approximate the consumption for at each period for the
model with transaction costs.
2. General framework
We now describe the basic portfolio selection problem of an
investor with a finite life of T periods who needs to decide the
portfolio weights for N risky assets. Assume time is discrete and
indexed as t = 0, 1, . . . , T with t = 0 being the initial time and
t = T being the terminal time. There is also a risk-free asset be-
ing traded in the market and the risk-free rate Rf is assumed to
be constant over time. Let Pt, i be the price of asset i at time t,
from time t − 1 to t, the risky asset returns are stochastic and de-
Pt,i
noted by Rt = [Rt,1 , . . . , Rt,N ], where Rt,i = Pt−1,i ≥ 0 is the gross re-
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151 133

turn on asset i. Based on the asset returns up to t, the investor risky-asset weight is the ratio of these two, the transaction costs
then determines the decision vector xt = [xt,1 , . . . , xt,N ], where xt, i then becomes
is the weight of the ith asset held in period t. Throughout this   
 xt−1,+ − νt 
manuscript, we will use xt to denote the sequence of decision vari- T˜Ct = 
K xt −
.
 (3)
ables [x0 , . . . , xt−1 ] and x to denote the full sequence of decisions 1 − ct − Lc,t
1
[x0 , . . . , xT −1 ].
We assume there is no margin requirements imposed for bor- We set τi,c = κi so that the cost of liquidating the entire holding of
rowing on margin or shorting. Moreover, we will focus on the spe- risky asset i equals the cost of rebalancing the risky-asset holding
cial case where transaction cost for each period is proportional to to zero. In this sense, our τ i, c choice balances the cost of liquidat-
the amount of trade. This type of transaction cost is realistic to ing the risky assets with the cost of rebalancing.
model small trades, where the transaction costs come from the Let Ct denote the total consumption, that is Ct = ct Wt . We as-
bid-ask spread and other brokerage fees. Let xt,+ be the vector of sume that the investor’s objective is to maximize the expected util-
allocation to the risky assets inherited from period t, that is ity of the intermediate consumption over all the periods:

xt · Rt+1 
T −1 
xt,+ = , max E0 ρ t+1Ut (Ct ) , (4)
R p,t+1 {ct ,xt }t=0
T −1
t=0
where · denotes the component-wise product and R p,t+1 is the
portfolio return defined as where ρ ∈ (0, 1) is the discount factor and Ut is the power utility
function
R p,t+1 = xt Rt+1 + [1 − xt e − K (xt − xt−1,+ )1 ]R f ,
1 −γ
Ct −1
with e a vector of ones with length N. The term K (xt − xt−1,+ )1 Ut = , (5)
is the proportional transaction costs that the investor incurs. 1−γ
Here K is a N × N diagonal matrix with elements in the di- with relative risk-aversion parameter γ ≥ 1. In (4), E0 ( · ) denotes
agonal diag(K ) = [κ1 , · · · , κN ]. Each κ i denotes the proportional the conditioned expectation on the information at the beginning
transaction-cost rate parameter for asset i. Following Lynch and of initial period.
Tan (2010), we assume the following law of motion for investor’s Moreover, let {Ft }t=0 T −1
denote the filtration generated by the
wealth in the presence of transaction costs: risky asset returns and other state variables. We let each Ft rep-
Wt+1 = Wt (1 − ct )R p,t+1 , (1) resents the set of events that describes the investor’s state of in-
formation at the beginning of period t, and further we require
where Wt is investor’s wealth at t, and ct is the fraction of Ft ⊆ Ft+1 for all t < T so the investor does not ignore the past.
wealth consumed at t. Similar to Balduzzi and Lynch (1999); Let P (u ) ⊆ P0 × · · · × PT −1 denote the set of all feasible action
Lynch (2001) and Lynch and Tan (2010), the above law of mo- sequences x = [x0 , · · · , xT −1 ] for any given scenario of state vari-
tion indicates that the transaction cost at t is Wt (1 − ct )K (xt − able u. We assume each xt satisfies the nonanticipativity constraints
xt−1,+ )1 and is paid by costlessly liquidating the risk-free asset. such that the decision choice xt for each period t must depend only
Moreover, it also implicitly assumes that consumption at each pe- on the information known at the beginning of t, and we denote
riod is obtained by liquidating the ith risky assets and the risk-free by PF the set of nonanticipative feasible policies. With all of these
asset in the proportions xi,t−1,+ and (1 − xt−1 
,+
e ).2 definitions, we can now introduce the proposed dynamic portfolio-
When rebalancing rules may be sensitive to the cost differen- choice problem:
tial associated when using the risky assets rather than the risk-
less one for consumption, we can introduce the proportional cost 
T −1 1 −γ
Ct

of τ i, c to liquidate the risky asset i for consumption, following the max E0 ρ t+1 (6)
(c,x )∈PF 1−γ
procedure described in Lynch and Balduzzi (20 0 0). Letting Lc, t be t=0

the cost incurred from liquidating risky assets for consumption at t,

paid from the money market account, the law of motion for wealth
s.t. Wt+1 = Wt (1 − ct )R p,t+1 , (7)
becomes:
Wt+1 = Wt (1 − ct )R˜ p,t+1 .
The portfolio return R˜ p,t+1 now is given by: ct ≥ 0. (8)

R˜ p,t+1 = xt Rt+1 + (1 − xt e − T˜Ct − Lc,t )R f ,
N
where the liquidation costs for consumption Lc,t = i=1 τi,c νi,t , and
ν i, t ≥ 0 is the component of consumption at t obtained by liquidat-
ing the risky asset i. Let νt = [ν1,t , · · · , νN,t ] be the vector formed
by the component of consumption at t. Since we assume the liqui-
dation cost can be paid costlessly from the money market account,
then νi,t ≤ xt−1,+ . Note that the pre-rebalancing portfolio risky-
asset weights at t now depend on the consumption decision at t.
After consumption, the holding of risky assets can be expressed by
the vector xt−1,+ − νt and the portfolio value is 1 − ct − Lc,t , each
expressed as a fraction of wealth Wt . Because the pre-rebalancing
(2) In the presence of liquidation costs for consumption, we replace
R p,t+1 with R˜ p,t+1 in (7).
Note in the proposed model, the investor has access to uncon-
strained borrowing to facilitate the adaption of the approximate
strategies from mean-variance.3 Several comments are in order.
When we allow the presence of predictability, the proposed opti-
mization problem can be formulated as a stochastic dynamic pro-
gram where the state variables include the current wealth level,
the portfolio position and the market state variables. Note that for
a power utility, the wealth level Wt can be factored out for each
period and if St denotes the vector of state variables, the Bellman
equation for each period faced by the investor can be written as:

2
The liquidation for consumption may be costless given the availability of money
market bank accounts and given that equities pay dividends. For the case when the
sum of risky assets dividends exceeds the consumption out of the risky asset, a
dividend reinvestment plan can be used to costlessly reinvest the excess dividend
in the risky asset.
3
We can also consider the case when the investor faces constraints on borrowing
or when margin requirements are imposed for borrowing on margin or shorting.
In this case, we simply need to add the corresponding margin constraints to the
optimization model.
134 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151

a straightforward and simplified consideration given that the op-

φt (St , xt−1,+ )1−γ
timal investment strategies for an investor who maximizes mean-
1−γ
variance utility and CRRA power utility are both confined by a no-
c 1 −γ (1 − ct )1−γ 
1−γ 1−γ 
= max t
+ E φt+1 St+1 , xt,+ R p,t+1 ,
(ct ,xt )∈Pt (xt−1 ) 1−γ 1−γ
for t = 0, · · · , T − 1. Note the above equation can be solved by
a backward iteration, starting with t = T − 1 and φT −1 = 1. In
Section 2.1, we introduce the model for the market state variables
St . Note that solving the dynamic program requires discretizing the
state variables and the iteration in (9) involves the expectation of
φt+1 , while the dimension of the state space leads to the curse of
dimensionality especially when there are more than two risky as-
sets. In Section 3.1, we introduce the G&P framework that allows
us to propose the trading strategy when there are many risky as-
sets.
2.1. Predictability model
Like in Campbell and Viceira (1999), we assume the dynamics
of asset returns and state variables follow a restricted first-order
vector auto-regression model (VAR) which has also been broadly
analyzed in Balduzzi and Lynch (1999), Lynch and Tan (2010),
Brown and Smith (2011) and Gârleanu and Pedersen (2013).
More specifically, we assume the risky asset returns can be pre-
dicted by the log of dividend-price ratio, which is also the only
state variable needed to forecast the risky asset dynamics.4 Let rt
be a vector consisting of log risky asset returns, rt = log(Rt ), Dt
the predictive variable (dividend yield) and dt = log(1 + Dt ). As in
Campbell and Viceira (1999), rt and dt follow the next VAR model
(expressed in terms of percentages):
rt+1 = Ar + Br dt + et+1 ,
dt+1 = ad + bd dt + t+1 ,
where Ar is a N × 1 vector, ad is a scalar, B is a N × 1 vector and
bd is a scalar. Moreover, [et+1 ; t+1 ] is a i.i.d. vector of mean-zero
disturbances with constant covariance matrix e . Without loss of
generality, the mean of {dt }t=0
T −1
can be normalized to 0 and the
variance to 1. Finally, we assume the volatility of both returns and
dividend yield is constant over time.
3. The mean-variance approximation
In this section we propose several methods for constructing fea-
sible suboptimal trading strategies for a CRRA investor with ob-
jective (6). To avoid solving the dynamic program in (9) which
may result in the curse of dimensionality, we propose to consider
T −1  
suboptimal strategies of the mean-variance framework and then
adapt them to the more general power utility framework. This is
4
Our results can be extended to any predictability model that admits discretiza-
tion for the state variables. For example, we can also assume the risky asset returns
follow the model considered in Gârleanu and Pedersen (2013) where the excess re-
turns are captured by the following model:
rt+1 = B ft + ut+1 ,
ft+1 = − ft + t+1 .
Here, ft is a vector consisting K factors that predict returns, B is an N × K matrix of
factor loadings, and ut+1 is the unpredictable zero-mean noise term with variance-
covariance matrix . Meanwhile, the return-predicting factor ft is known at time t
and follows the model specified in the second expression, where
ft+1 = ft+1 − ft γ
is the change in the factors,  is a K × K matrix of mean-reversion coefficients for
the factors, and t+1 is the shock affecting the predictors with variance vart (t+1 ) =
(9) trade region in the presence of predictability, and also that the
form of the no-trade region under mean-variance framework is
easier to derive. Meanwhile, taking into account that the optimal
consumption is not derivable in (6), we also provide approximate
consumption strategies in Section 4. Together with the adapted ap-
proximate trading strategies, we evaluate the performance of the
suboptimal consumption and investment policies. Specifically, we
first gauge the performance of suboptimal investment strategies
under the mean-variance framework, and then compare to that
in the power utility framework. Note that the performance esti-
mates of these strategies can be obtained through simulation and
these estimates provide lower bounds to the mean-variance utility.
To test the sub-optimality of the approximate strategies, we also
compute valid upper bounds by relaxing future information, as de-
scribed in Sections 3.3 and 4.2.
3.1. Mean-variance framework
As discussed in Section 2, problem (6)–(8) is difficult to solve
even numerically when there are more than two risky assets.
Heuristic trading strategies are proposed based on solving sim-
pler optimization problems, see Brown and Smith (2011), for
an investor who maximizes CRRA utility of terminal wealth.
Haugh et al. (2016) also propose heuristics for a similar problem
where the agent is required to pay capital gains taxes on her in-
vestment gains. These heuristic strategies facilitate the investor to
solve the dynamic program more efficiently through an approxi-
mation in the continuation value function under a power utility.
(10) But compared with the power utility framework, the frame-
work proposed by G&P is analytically more tractable. Specifi-
cally, with the focus on price changes (rather than returns) and
(11) quadratic transaction costs, the closed-form expressions for the op-
timal number of shares can be obtained based on their frame-
work. With proportional transaction costs and constant opportu-
nity set, (Mei et al., 2016) study analytically the properties of op-
timal trading strategies and provide closed-form expression for
the no-trade regions. With a constant investment opportunity set,
they also show that the certainty equivalent loss incurred from
using a mean-variance utility, instead of a CRRA utility of inter-
mediate consumption, is very small. This implies that the op-
timal policy based on a quadratic utility like that specified in
Gârleanu and Pedersen (2013) provides a good approximation for
the optimal policy implied by a CRRA utility in the presence of
transaction costs. Specifically, the objective function for an investor
with mean-variance utility can be written as
 γ 
max E0 ρ (xt μt − xt xt ) − ρ K (xt − xt−1 )1 ,
t+1  t
x∈PF 2
t=0
(12)
where xt denotes the number of shares with the initial holding
x−1 = 0, μt is the conditional expectation of price change, is
the covariance matrix of price changes, assumed to be constant,
and γ is the absolute risk-aversion parameter. Similarly, it can be
formulated as a stochastic dynamic program with state variables
consisting in the current number of shares in risky assets and the
expected price changes conditional at the information in current
period. In particular, the value function for the last period is:
VT −1 (xT −2 , μT −1 ) = ρ T (xT −1 μT −1 − x xT −1 )
2 T −1
. −ρ T −1 K (xT −1 − xT −2 )1 , (13)
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151
and from (13), we can define the value functions for previous pe-
riods recursively according to the Bellman equation:
γ derived in Gârleanu and Pedersen (2013).
Vt (xt−1 , μt ) = max ρ t+1 (xt μt − xt xt )
xt ∈Pt (xt−1 ) 2
−ρ t K (xt − xt−1 )1 + Et [Vt+1 (xt , μt+1 )],
for t = 0, · · · , T − 1. Although the numerical solution is also diffi-
cult to obtain when there are more than two risky assets, we only
need to track the wealth change at each period instead of tracking
the evolution of total wealth under the G&P framework. Moreover,
unlike the model with power utility, the focus on price changes
implies that there is no need to track the risky-asset price evo-
lution. Hence, instead of considering the power utility framework,
in this section, we propose trading strategies based on the G&P
framework, and later, in Section 4 we propose to adapt them back
to the CRRA utility framework.
3.2. Approximate trading strategies
To avoid the difficulties we may find when solving the port-
folio optimization model with predictability and transaction costs,
we propose several trading strategies to approximate the optimal
trading strategy in (12). These strategies provide a first step ap-
proximation for the suboptimal trading strategies of model (6)–(8).
For simplicity, and following G&P framework, we assume that the
dynamic of price changes follows the model specified in (10) and
(11). Analogously, the same procedure can be applied to derive the
approximate strategies for the case with a different predictability
model.
3.2.1. Simple policy
First, we consider a deterministic approximation that ignores
model predictability and simply follows the optimal trading strat-
egy recommended by a deterministic model. In this model, the
investor ignores the innovations in the predictability model. The
model becomes a deterministic problem which can be solved us-
ing quadratic programming:
T −1 
 
γ
max ρ t+1 (xt μ˜ t − xt xt ) − ρ t K (xt − xt−1 )1 ,
{xt }t=0
T −1 2 
t=0
where μ ˜ t is the expectation of price changes conditional to the
initial stage, that is μ
˜ t = E0 (μt ). The corresponding simple policy is
defined as the solution to the deterministic portfolio problem (14).
Note that this simple policy will perform well in practice when the
volatility in the predictability model is small.
3.2.2. Linear policy
Second, we consider the linear approximation where the in-
vestor trades linearly towards a next-period aim portfolio. This
trading strategy falls into the category of linear decision rules
where the rebalancing rule is a linear function of past-return pre-
dicting factors.
In the absence of transaction costs, it is known that the optimal
policy at each period is the Markowitz portfolio (see, for example,
Campbell and Viceira (2003) and references therein). In the pres-
ence of transaction costs, the investor trades partially to it in order
to economize on trading.
With quadratic transaction costs, Gârleanu and Peder-
sen (2013) show that the investor trades partially at each period
to an aim portfolio which is a weighed average of the current
and future Markowitz portfolios when she is an infinite-horizon
investor and faces predictability. They also give an explicit ex-
pression of the next-period optimal number of shares, which is
a linear combination of the existing position and the next-period
aim portfolio. With a finite horizon and a constant investment
135
opportunity set, Mei et al. (2016) show the optimal policy is to
trade to an aim portfolio at each period, similar to the result
With proportional transaction costs, both Calafiore (2009) and
Skaf and Boyd (2010) use linear decision rules to address dynamic
portfolio choice problems without return predictability. They show
through examples that, imposing affine restrictions on the decision
variables, they can largely improve the flexibility and can reduce
the complexity of the solution, at the cost of a reasonable loss of
optimality. With predictability, Moallemi and Sağlam (2017) pro-
pose a class of linear rebalancing rules for dynamic portfolio op-
timization problems that allow for various types of transaction
costs and also trading constraints. Besides computational tractabil-
ity, they show through an example of portfolio execution that the
linear rebalancing policies can achieve near optimal performance.
For those reasons, with proportional transaction costs, we pro-
pose to consider a linear rebalancing approximation, similar to that
of the model with quadratic transaction costs: the investor has an
aim portfolio at each period, and she chooses to trade partially to
this aim portfolio, following the linear policy in Gârleanu and Ped-
ersen (2013). Specifically, we define the aim portfolio for period
t < T as
aimt = z Markowitzt + (1 − z )Et (aimt+1 ), (15)
√
γ −γ ρ −λ(1−ρ )+ (γ ρ +λ(1−ρ ))2 +4λγ ρ 2
where z = γ +c and c = 2ρ . At t =
T − 1, the aim portfolio is the optimal portfolio in the absence of
transaction cost, that is,
aimT −1 = (γ )−1 μT −1 .
Finally, the proposed linear policy is:
c c
xt = (1 − )xt−1 + aimt . (16)
λ λ
In Gârleanu and Pedersen (2013), λ denotes the quadratic transac-
tion cost parameter. Since we use (16) as an approximation to the
model with proportional transaction costs, we propose to calibrate
λ such that the total utility is maximized. With the dynamics of
price changes specified in (10) and (11), the aim portfolio for each
(14) period is
 
aimt = (γ )−1 Ar + Br ad gt (bd ) + bTd −1−t dt
+z(γ )−1 Br [dt ft (bd ) − ad ht (bd )], (17)
where
ft (bd ) = (1 − z )bd ft+1 (bd ) + 1 − bTd −1−t
−t−2
T
ht (bd ) = bid + bd (1 − z )ht+1 (bd )
i=0
gt (bd ) = bTd −t−2 + gt+1 (bd )
with fT −1 = 0, hT −1 = 0 and gT −1 = 0. In (10)-(11), normalizing dt
leads to ad = 0 in Equation (17).
3.2.3. No-trade region policy
Third, we consider the no-trade region approximation where,
in each period, the investor’s portfolio choice is confined by a
no-trade region. With proportional transaction costs, it is already
known that the optimal trading strategy at each period is confined
by a no-trade region. For an investor who maximizes CRRA utility
of intermediate consumption and incurs proportional transaction
costs, Lynch and Tan (2010) show computationally that the optimal
rebalancing rule is confined by a parallelogram-shaped no-trade
region centered at a “target portfolio”, which is the optimal portfo-
lio when there is no transaction costs in the model when returns
are i.i.d. When there is predictability, Lynch and Tan (2010) and
136 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151

Muthuraman and Kumar (2006) show that it is a convex quadri- 1

lateral that confines the transaction at each period. In addition,
Mei et al. (2016) give explicitly the expression of the no-trade re-
gion under a mean-variance framework, showing similar properties
for the no-trade region to those analyzed in Lynch and Tan (2010).
Specifically, they express the no-trade region in the form of a par-
allelogram with the Markowitz portfolio in the center:
1 1−ρ
K −1 (xt − Markowitz )∞ ≤ .
ργ 1 − ρ T −t
Note this region contrasts with that in Lynch and Tan (2010), who
show the Markowitz portfolio is contained in the no-trade region
but is no longer the center of it. Combining the similarity of the
solution of both the mean-variance framework and the power util-
ity one, we propose to consider an approximate trading strategy
such that at each period, the investment is confined by a no-trade
region which depends on relevant model parameters.
To do that, note that in a dynamic setting when asset returns
are predictable, the Markowitz portfolio at each period is no longer
the target portfolio for a long-term investor. Hence, to complement
the no-trade region strategy, we suggest to adapt the aim portfolio
specified in the linear policy as the center of the no-trade region
at each period. Equivalently, it means we approximate the target
portfolio of an investor who incurs proportional transaction costs
by the aim portfolio of that facing quadratic transaction costs.
T −1  
Specifically, we consider the investor’s target position as the
center of the no-trade region. But instead of trading linearly to-
wards the aim portfolio, the investor will trade to the boundary of
the no-trade region centered at the aim portfolio. Moreover, fol-
lowing Mei et al. (2016) and Lynch and Tan (2010), we assume the
size of the no-trade region shrinks when the number of remaining
periods increases. For each period, we propose the no-trade region
policy as the solution to the following optimization problem:
min (xt − xt−1 ) (xt − xt−1 )
xt
1 1−ρ
s.t. K −1 (xt − aimt )∞ ≤ , and where we do not require x to be nonanticipative (to allow for
ργ 1 − ρ T −t
where aimt denotes the aim portfolio for each period, defined in
Eq. (17), and xt−1 is the position from previous period.
3.2.4. Rolling optimize-and-hold policy
Finally, we consider an approximate policy that assumes the in-
vestor follows a buy-and-hold strategy at each stage. With this as-
sumption, we can derive explicitly the expression of a no-trade re-
gion at each period with a distinct center, other than the previ-
ously specified aim portfolio.
Under proportional transaction costs, the previously proposed
aim portfolio may cause overtrading and may deviate from the
“true aim portfolio”at each period. Hence, taking into account that
the optimal rebalancing policy for the model with constant invest-
ment opportunity set is a buy-and-hold strategy, we now propose
a rolling optimize-and-hold approximation under predictability in as-
set returns.
Specifically, we assume that at each period, the investor chooses
trades to maximize the expected mean-variance utility at next pe-
riod, taking transaction costs into account, but assuming that there
will be no opportunities to adjust the portfolio until time T − 1.
Although this assumption assumes there are no opportunities to
adjust the portfolio until the end, at each period the investor will
rebalance according to a state-dependent no-trade region, which is
centered at a target portfolio.
Therefore, at each period, the investor selects her portfolio by
solving the following optimization problem:
min (xt − xt−1 ) (xt − xt−1 )
xt
s.t. K −1 (xt − xCt )∞ ≤ , (19)
ργt
where xCt = (γt )−1 μt with
1 − ρ T −t
γt = (1 + ρ + · · · + ρ T −1−t )γ = γ, (20)
1−ρ
μt = μt + ρμt+1|t + · · · + ρ T −t μT −1|t . (21)
In (21), each μt+ j|t refers to the mean price changes for period
t + j conditioned on the information at period t. Note that the cen-
ter of the no-trade region xCt is a linear combination of all future
optimal portfolios conditional to the current period in the absence
of transaction costs.
3.3. Evaluation
In this section, we analyze the empirical performance of the
proposed feasible policies. For each policy, we compare the cer-
tainty equivalent return with the upper bounds obtained from per-
fect hindsight solutions, assuming the investor knows all future val-
ues of market state variables before making any investment de-
cisions. Specifically, given the convexity of the objective function
in (12), it is straightforward to show that
 γ
max E0 ρ t+1 (xt μt − xt xt ) − ρ t K (xt − xt−1 )1
x∈PF 2
t=0

T −1  γ 
≤ E0 max ρ t+1 (xt μt − xt xt ) − ρ t K (xt − xt−1 )1 . (22)
x 2
t=0
We obtain an estimate of the upper bound given on Eq. (22) using
simulation, where in each trial, we solve the following determinis-
tic problem
T −1 
 
γ
max ρ t+1 (xt μt − xt xt ) − ρ t K (xt − xt−1 )1 ,
x 2
t=0
perfect hindsight). The estimate of the upper bound is then ob-
tained by averaging the optimal values from the above problems
across all sample paths.
Following Lynch (2001), we use discrete approximations of the
uncertainties to calculate expectations. We first approximate the
market state variable using a grid with 19 points. The disturbances
[et+1 ; t+1 ] in (10) and (11) are approximated using a Gaussian
quadrature approach with three points per asset.5 Note that for the
model with N risky assets, the joint distribution for returns and the
market state variable is approximated using a N + 1 dimensional
grid with a total of N3 × 19 elements. We use this discrete approx-
imation scheme to calculate the expectations in the optimization
problems for the heuristic trading strategies in Section 3.2.
To evaluate the performance of each feasible policy, we first
generate M paths of sample returns and dividend yields from the
grids according to the probabilities of the discrete approximations.
As in DeMiguel et al. (2007), we compute the certainty-equivalent
(CEQ) return which is defined as the risk-free rate that an investor
is willing to accept rather than adapting a particular risky portfo-
lio strategy in each sample path. Specifically, for each policy, the
certainty-equivalent return is defined as
γ
CEQ = r̄ p,c − σ̄ 2 ,
2
5
We choose 19 grid points for the dividend yield and 3 grid points for the stock-
return innovations since Balduzzi and Lynch (1999) find that the resulting approx-
imation is able to capture important dimensions of the return predictability in the
data. Moreover, we also experimented with larger numbers of quadrature points for
(18) the innovations, with essentially the same results, suggesting the same conclusion
as in Balduzzi and Lynch (1999).
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151
where r̄ p,c and σ̄ 2 are the mean and variance of portfolio return,
respectively, net of proportional transaction costs of each sample
path. Moreover, we also compute the portfolio turnover to get a
sense of the amount of trading required to implement each port-
folio strategy. The turnover is defined as the average sum of the
absolute value of the trades across the N available assets:
T −1 N
1 
Turnover = (|xi,t − xi,t−1 | ).
T (Ubounds − Uheuristic )/Ubounds . The Third row gives the turnover of each pol-
t=0 i=1
We assume the predictability models for dividend yield and
price changes are given by (10) and (11) and that the initial div-
idend yield is neutral (i.e., d1 = 0). Finally, we assume that the in-
vestor has an initial wealth of 1 dollar. With these assumptions,
the absolute risk-aversion parameter under the mean-variance
framework, described in Section 3.1, is equivalent to the relative
risk-aversion parameter under the power utility framework.
As an illustrative example, we consider a model with two risky
assets,6 following the same example in Lynch and Tan (2010),
where we consider the 12-month dividend yield on the value-
weighted New York Stock Exchange (NYSE) index as a proxy for
the predictive variable D. For the first risky asset, we consider
the monthly rate of return on the value-weighted NYSE index,
while for the second risky asset we consider the high BM port-
folio which is formed from the 6 value-weighted portfolios SL,
SM, SH, BL, BM and BH.7 The parameters for the predictabil-
ity model in (10) and (11) are estimated using ordinary least
squares (OLS) with Ar = [0.83; 0.54], Br = [0.47; 0.30], ad = 0, bd =
0.98, the state covariance matrix for both risky assets is =
[0.0 054 0.0 037; 0.0 037 0.0 030] and volatilities for both assets are
σ1 = 7.37% and σ2 = 5.52%, respectively. The risk-free rate is esti-
mated by mean the of 1-month T-bill rate over this period, which
gives a value of 0.056%.
3.3.1. The base case scenario
For our base case scenario, we consider a time horizon of
6 months, that is T = 7. We assume an absolute risk-aversion
parameter γ = 5, a matrix of proportional transaction cost K =
[0.0 050 0; 0 0.0 050], an annual discount rate ρ = R1 , and that the
f
investor starts with holding zero shares in both assets.
For the simple policy, the expectation is μ ˜ t = E0 (μt ) = Ar +
Br bt−1
d
d1 , where the innovation term t+1 has zero mean and vari-
ance 1 − b2d . Note that the higher bd , the lower volatility in dt .
For the linear policy, the value of λ is calibrated such that it pro-
vides the maximum value of total utility. Fig. A.1 depicts the total
utility of the linear policy for different values of δ when the other
model parameters are fixed. In Gârleanu and Pedersen (2013), the
value of λ is calibrated for each asset, which turns out to be
around 10−7 . In our example, we change the value of λ from 0 to
10, with the parameters specified above, and hence the total utility
varies from 4.53 × 10−3 to 5.19 × 10−3 , and reaches its maximum
around λ = 5.28.8
6
Our approximate trading strategies can also be applied to the case with many
risky assets using a similar procedure: evaluate the approximate strategies by dis-
cretizing the state variable space for each of the assets. An example with more risky
assets is given in Section 4.3.3.
7
Following Lynch and Tan (2010), the low and high BM portfolios are formed
from the 6 value-weighted portfolios SL, SM, SH, BL, BM, and BH from Fama and
French (1993) and Davis et al. (20 0 0). The notation S(B) indicates that the firms in
the portfolio are smaller (larger) than 50% of NYSE stocks. The notation L indicates
that the firms in the portfolio have BM ratios that place them in the bottom 3
deciles for all stocks; analogously, notation M indicates the middle 4 deciles and H
indicates the top 3 deciles. The high BM portfolio is an equal-weighted portfolio of
SH and BH.
8
We consider monthly asset returns with unconditional mean [0.83%; 0.54%].
Starting with [0; 0], this policy indicates a movement towards the aim portfolio
at each period which does not vary significantly, resulting in an average total utility
137
Table A1
Certainty-equivalent Returns - The Base Case. This table shows the
certainty-equivalent returns for an investor with objective (12) based on
the proposed approximate policies. Column 2–5 show the returns ob-
tained based on the simple policy(S-P), the linear policy(L-P), the no-trade
region policy(NTR-P) and the rolling optimize-and-hold policy(ROH-P) re-
spectively. The last column denotes the upper bounds to the return ob-
tained based on perfect hindsight solution. The values of the returns are
reported in the first row and the second row shows the correspond-
ing gaps respect to the upper bounds (in %). The gaps are computed by
icy.
Policies S-P L-P NTR-P ROH-P Bounds
CEQ 0.0083 0.0086 0.0089 0.0089 0.0091
CEQ Loss (in %) 7.95 3.89 0.92 1.49
Turnover 0.0461 0.0867 0.0505 0.0504 0.0427
Finally, for the no-trade region policy and the rolling optimize-
and-hold policy, the center of the no-trade region can be calculated
based on the conditional mean at each period.
For the base case scenario, the certainty-equivalent returns for
the feasible policies and the associated upper bounds are reported
in Table A.1. It gives the certainty-equivalent returns obtained
based on the simple policy (S–P), the linear policy (L–P), the no-
trade region policy (NTR-P) and the rolling optimize-and-hold policy
(ROH-P), respectively. The last column of this table denotes the up-
per bounds to the certainty-equivalent returns obtained based on
a perfect hindsight solution. The values of the certainty-equivalent
returns, reported in the first and second rows, show the corre-
sponding gaps (certainty-equivalent return losses) which are com-
puted by (C Ebounds − C Eheuristic )/C Ebounds . We observe that the return
loss associated when adopting the simple policy (that is, the rela-
tive difference between the certainty equivalent return of the sim-
ple policy and the upper bound obtained from perfect hindsight
solution (22)) is as much as 7.95%. This return loss is relatively
high because for the simple policy, the existence of predictabil-
ity is completely ignored in the model, hence the trading strategy
at each period lacks information updated from previous periods,
which results in a high return loss.
Regarding the linear policy, which relies on both the previous
stage portfolio and an aim portfolio, we find that the certainty-
equivalent loss is over 3.8%, which is also high compared with
NTR-P and ROH-P. The result indicates that for the linear policy,
the strategy penalizes transactions in terms of a quadratic form.
With proportional transaction costs, the investor is motivated to
make more transactions compared to the other strategies, which
can also be verified by the high turnover given in Table A.1.
The no-trade region policy, on the other hand, outperforms the
other proposed strategies with an associated return loss less than
0.92%. This result indicates that, compared with the simple policy,
the no-trade region policy takes the aim portfolio as the center
of the no-trade region, using updated information from previous
period; while compared with the linear policy, the existence of a
no-trade region confines the amount of transaction, implying then
a more conservative trading strategy.
Finally, the return loss associated when adopting the rolling
optimize-and-hold policy is 1.19%, which also shows a low loss com-
pared to the simple policy and the linear one, and a slightly higher
loss than that of the no-trade region policy. This shows that, con-
fining transactions with a no-trade region that updates periodically
helps to correct the over-trading in the linear policy. Nevertheless,
assuming no trades until the last period may cause large deviation
around 10−3 over all the sample paths. Alternatively, if we annualize the parame-
ters, the corresponding total utility changes from 0.112 to 0.132, indicating a more
significant change.
138 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151
Fig. A1. Utility of Linear Policy depending on λ This figure shows the utility of the linear policy for different values of λ. In this figure, we consider proportional transaction
costs parameter κ = 0.005, a discount factor R1 , a risk-aversion parameter γ = 5, and an investment horizon T = 7.
f
from the true center of the no-trade region, this strategy obtain
higher losses than those in NTR-P.
Fig. A.2 shows the trading trajectories of the proposed strate-
gies and the perfect insight policy. It shows that the simple policy
deviates highly from the rest of the policies due to the lack of in-
formation update. The linear policy tends to trade closely to the
aim portfolio aimt at each period, resulting in a higher turnover
compared to other strategies. Finally, the no-trade region policy and
the rolling optimize-and-hold policy are confined by the same no-
trade region in the last period, with the latter being slightly more
conservative in terms of turnover.
3.3.2. Comparative statics for other scenarios
We analyze empirically how the certainty-equivalent return
loss associated with all the proposed policies depend on the
transaction-cost parameter, the risk-aversion parameter and the
slope in the predictability model for the dividend yield. Table A.2
reports the return loss considering an investing horizon of T = 6
months and Table A.3 shows the corresponding turnover.
First, we find that regardless of the value of bd , the certainty-
equivalent returns decrease monotonically for all policies as κ in-
creases. This is intuitive since the same amount of transaction may
result in lower return when κ is higher. Moreover, we find that
the relative return loss associated with all the approximate poli-
cies does not depend on the risk-aversion parameters.
Regarding each policy, we observe the certainty-equivalent
return loss associated with ignoring uncertainty in the predictabil-
ity model (i.e., the simple policy) is high for all the considered
parameters especially when bd is small (i.e., high volatility in
dividend yield). Taking into account that a higher bd indicates a
lower volatility in the dividend yield, we observe the return loss
in the simple policy decreases dramatically when we increase
bd from 0.75 to 0.98. For example, for an investor with γ = 5
and κ = 0.0050, the return loss reduces from 22.62% to 7.95%.
The main reason is that the conditional mean μ ˜ t in the simple
policy can approximate future means better when there is lower
volatility in the dividend yield. Moreover, we also find the return
loss associated with the simple policy decreases as κ increases.
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151 139

Table A2
Certainty-equivalent Returns: mean-variance utility. This table shows the certainty-
equivalent returns of an investor with objective function (12) based on the proposed
heuristic policies. The first three columns give the values of bd , the risk-aversion pa-
rameter γ and the proportional transaction costs parameter κ . Columns 4–7 show
the returns obtained based on the simple policy(S-P), the linear policy(L-P), the no-
trade region policy(NTR-P) and the rolling optimize-and-hold policy(ROH-P), respec-
tively. The last one column shows the upper bounds to the return obtained based
on perfect hindsight. In each row, the value of CEQ returns and the corresponding
gap (in %) with respect to the upper bound is reported.

Parameters Policies Bounds

bd γ κ S-P L-P NTR-P ROH-P Upper Bound

0.75 3 0.0020 0.0204 0.0262 0.0276 0.0270 0.0279

26.75% 5.92% 0.97% 3.05%
0.0050 0.0183 0.0225 0.0235 0.0229 0.0237
22.60% 5.18% 1.05% 3.42%
0.0100 0.0150 0.0173 0.0179 0.0175 0.0182
17.54% 4.95% 1.87% 3.85%
5 0.0020 0.0123 0.0158 0.0166 0.0162 0.0168
26.76% 5.94% 0.97% 3.04%
0.0050 0.0112 0.0137 0.0143 0.0139 0.0144
22.62% 5.17% 1.06% 3.40%
0.0100 0.0092 0.0106 0.0109 0.0107 0.0111
17.58% 4.94% 1.88% 3.84%
7 0.0020 0.0088 0.0112 0.0118 0.0116 0.0119
26.72% 5.91% 0.96% 3.06%
0.0050 0.0080 0.0098 0.0103 0.0100 0.0104
22.58% 5.19% 1.06% 3.42%
Fig. A2. Heuristic Trading trajectories. This figure shows the trading trajectories of 0.0100 0.0066 0.0076 0.0079 0.0077 0.0080
the proposed heuristic strategies and that of the perfect hindsight, when T = 3 and 17.59% 4.93% 1.88% 3.84%
there are two securities. The dark parallelograms denote the no-trade regions of 0.98 3 0.0020 0.0173 0.0180 0.0187 0.0186 0.0189
NTR-P while the green ones are those of the ROH-P. Dark points inside the no-trade 8.17% 4.63% 0.89% 1.36%
regions denote aim portfolios of the linear policy and the center of the no-trade 0.0050 0.0138 0.0144 0.0149 0.0148 0.0150
region; green points are the center of no-trade regions obtained by Eq. (19). (For 7.95% 3.90% 0.92% 1.49%
interpretation of the references to color in this figure legend, the reader is referred 0.0100 0.0110 0.0115 0.0117 0.0117 0.0119
to the web version of this article.) 7.42% 3.24% 1.42% 1.54%
5 0.0020 0.0104 0.0108 0.0112 0.0112 0.0113
8.18% 4.64% 0.89% 1.36%
0.0050 0.0083 0.0086 0.0089 0.0089 0.0090
This is because a higher κ leads to less transactions in risky assets, 7.95% 3.89% 0.92% 1.49%
implying predictability plays a less important role. 0.0100 0.0066 0.0069 0.0070 0.0070 0.0071
In contrast to the simple policy, the aim portfolio in the lin- 7.43% 3.23% 1.41% 1.54%
7 0.0020 0.0074 0.0077 0.0080 0.0080 0.0081
ear policy takes into account the information updated from previ-
8.17% 4.64% 0.89% 1.35%
ous period, resulting in a relatively lower return loss for all the 0.0050 0.0059 0.0062 0.0064 0.0063 0.0064
parameters. When fixing other parameters, the aim portfolio at 7.96% 3.89% 0.92% 1.50%
each period gives a better approximation if we consider a lower 0.0100 0.0047 0.0049 0.0050 0.0050 0.0051
volatility in the dividend yield (higher bd ), implying a lower return 7.42% 3.25% 1.40% 1.54%

loss. However, as mentioned in the base case scenario, this pol-

icy forces the investor to make more transactions compared with
other policies, attaining the highest turnover amongst all the pro-
conservative trading strategy than the no-trade region policy, im-
posed policies. Furthermore, when transaction becomes more ex-
plying a lower turnover and a higher deviation from the perfect
pensive (higher κ ), part of the return loss is compensated by a less
hindsight. Similar to the no-trade region policy, this policy per-
turnover in the linear policy, which explains the decreasing return
forms better when transactions become cheaper or when there is
loss in κ .
lower volatility in the predictor.
Next, we find that the return loss associated with the no-trade
To conclude, the no-trade region policy and the rolling
region policy increases as κ increases for both values of bd . That
optimize-and-hold one perform very well in practice for all the
means, as shown in Table A.3, an expensive transaction implies less
values of κ (the return loss is below 4% for all the values of κ
trading at each period, decreasing more the investor’s turnover.
when bd = 0.75 and below 2% when bd = 0.98) while the simple
Moreover, with a higher κ , the no-trade region at each period ex-
policy attains higher return losses, followed by the linear policy
pands such that the investor has smaller incentive to trade. These
because of the higher turnover.
two reasons imply a higher rate of decrease in turnover compared
Based on the above robustness checks, the benefits of the pro-
to the perfect hindsight assumption, causing an increase in the re-
posed approximation can be summarized as follows:
turn loss. Finally, it is worth noting that the return loss is relatively
low in all cases, with the highest loss less than 2% and a slightly
better performance when there is a lower volatility in the dividend 1. For the simple policy, if there is low volatility in the dividend
yield. yield, the performance is very reasonable in practice.
Regarding the rolling optimize-and-hold policy, it achieves good 2. For the linear policy, it has lower return losses than the simple
performance in terms of relatively low return losses. However, the policy but higher losses than the no-trade region policy and the
loss is slightly higher than that associated with the no-trade region rolling optimize-and-hold one, regardless of the volatility in the
policy in all cases. This is because the center of the no-trade region dividend yield. The loss can be as low as 3% when the transac-
at each period depends directly on the assumption that there is no tion is expensive and is always below 6%. So it is a good ap-
trade in future periods. This assumption implicitly suggests a more proximation to the optimal solution.
140 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151

Table A3 4.1. Adapting mean-variance framework to the CRRA framework

Portfolio Turnovers depending on different parameters. This table reports the port-
folio turnover of the proposed heuristic policies. The first three columns give
the values of bd , the risk-aversion parameter γ and the proportional transaction Under the G&P framework, the proposed feasible policies in
costs parameter κ . Columns 4–7 show the turnover obtained based on the sim- Section 3.2 provide suboptimal number of shares that the investor
ple policy(S-P), the linear policy(L-P), the no-trade region policy(NTR-P) and the needs to hold for each period. Moreover, we assumed there is no
rolling optimize-and-hold policy(ROH-P), respectively. The last one column gives the risk-free asset and consumption. In order to make the proposed
turnover obtained based on perfect hindsight.
trading strategies more realistic, we introduce several assumptions
Parameters Policies Upper Bounds to adapt the feasible policies to the power utility framework.
bd γ κ S-P L-P NTR-P ROH-P Perfect hindsight

0.75 3 0.0020 0.0895 0.2017 0.1639 0.1439 0.1430 4.1.1. Approximating consumptions
0.0050 0.0844 0.1479 0.1231 0.1155 0.1340 We consider two proposals to approximate the consumption.
0.0100 0.0758 0.1470 0.0920 0.0863 0.1211
The first proposal assumes that the investor’s consumption to
5 0.0020 0.0537 0.1210 0.0984 0.0864 0.0858
0.0050 0.0506 0.1008 0.0763 0.0693 0.0804 wealth ratio for each period, ct , is given by the model without
0.0100 0.0455 0.1007 0.0572 0.0518 0.0727 transaction costs. Note that in the presence of transaction costs,
7 0.0020 0.0384 0.0865 0.0703 0.0618 0.0613 the optimal consumption is no longer affine in total wealth, which
0.0050 0.0362 0.0788 0.0557 0.0495 0.0574
is in contrast to the model without transaction cost. However,
0.0100 0.0325 0.0787 0.0418 0.0370 0.0519
0.98 3 0.0020 0.0951 0.1530 0.0991 0.0986 0.1066
Sefton and Champonnois (2015) show that the investor consumes
0.0050 0.0900 0.1420 0.0836 0.0833 0.0984 at a constant rate along the optimal path in the limit case.9 More-
0.0100 0.0814 0.1252 0.0719 0.0719 0.0864 over, given risky asset return dynamics in (10) and (11), the opti-
5 0.0020 0.0571 0.0918 0.0595 0.0592 0.0639 mal consumption in the absence of transaction costs can be easily
0.0050 0.0540 0.0852 0.0502 0.0500 0.0591
computed numerically using dynamic programming by discretizing
0.0100 0.0488 0.0798 0.0432 0.0431 0.0518
7 0.0020 0.0408 0.0656 0.0425 0.0423 0.0457 the market state variables.
0.0050 0.0386 0.0609 0.0359 0.0358 0.0422 Note that this approximation is different from the idea of con-
0.0100 0.0349 0.0590 0.0309 0.0309 0.0370 sidering a simple investment policy approximation, where the op-
timal portfolio weights are taken from the problem without trans-
action costs. First, the simple trading strategy often does not per-
3. For the no-trade region policy, it performs constantly well for form well since it leads to continuously rebalancing which re-
all the cases, where the associated return losses are relatively sults in high transaction costs. Second, there is extensive literature
low. The associated return losses for all cases is relatively low. showing the portfolio weight of each asset belongs to a no-trade
It can be used as a robust approximation for the optimal solu- region policy in the presence of proportional transaction costs,
tion in the presence of proportional transaction cost and pre- but no such region applies to investor’s optimal consumption. Fi-
dictability. The gap between its certainty-equivalent return and nally, as pointed out by Liu (2004), the optimal consumption for
the upper bound is small for all the cases. the model with proportional transaction costs of an investor with
4. For the rolling optimize-and-hold policy, it is again a robust ap- CARA preference is affine in the dollar amount invested in the
proximation for the optimal solution in the presence of propor- risk-free asset and nonlinear in the dollar amounts in risky as-
tional transaction costs and predictability. It has lower turnover sets. Hence, considering a simple consumption policy is equivalent
compared to the no-trade region policy, and the gap between to approximating a nonlinear function with a linear one within a
its certainty-equivalent return and the corresponding upper small interval. That implies, the assumed constant consumption to
bound is again small for all the cases. wealth ratio is still a conservative and reasonable choice.
The second proposal to approximate the optimal consumption
is based on the Bellman equation an investor has to solve at each
4. The CRRA framework
period:
We now adapt each of the approximate trading strategies, pro-
posed for the mean-variance problem in Section 3, to the frame- φt (St , xt−1,+ )1−γ
work with CRRA power utility. Campbell and Viceira (2003) show 1−γ
that when the risky asset returns are lognormal, the portfolio c 1 −γ (1 − ct )1−γ 
1−γ 1−γ 
choices resulting from the power utility and mean-variance frame- = max t
+ E φt+1 St+1 , xt,+ R p,t+1 .
(ct ,xt )∈Pt (xt−1 ) 1 − γ 1−γ
works are consistent. In the absence of transaction costs, the in-
vestor trades off mean against variance for a single period in both (23)
cases. In the presence of transaction costs, Mei et al. (2016) show
that the certainty equivalent loss from adapting the mean-variance For a discretized state variable space at each period, the approx-
framework is typically smaller than 0.5% for the case with a con- imate investment strategies for each sample path can be com-
stant investment opportunity set. puted and stored. Starting from the last
 period where φT −1 = 1,we
In this section, we consider an investor who maximizes her

1−γ 1−γ
compute the expectation term bt : E φt+1 St+1 , xt,+
ˆ ˆ Rˆ at p,t+1
CRRA utility of intermediate consumption by investing in a risk-
free asset and N risky assets in the presence of predictability, and each node based on the discrete approximation, where φˆ and
subject to proportional transaction costs (i.e, with preferences (6)– Rˆ p,t+1 denote the values obtained based on the approximate in-
(8)). In Section 4.1, we obtain several approximate solutions for vestment policy. Consequently, we propose to use an approxima-
the portfolio optimization problem (6)–(8) by adapting the pro- tion of the optimal consumption by simply maximizing the follow-
posed feasible policies proposed based on the G&P framework. We
also propose alternative suboptimal consumptions in Section 4.1.1.
9
By aggregating the proposed approximations for consumption and They consider a continuous dynamic portfolio problem of an investor who max-
imizes her welfare from a consumption stream for the case where risky assets re-
trading strategies together, we can then evaluate the performance turns are predictable in the presence of transaction costs. In the limit case, they
of these strategies through upper bounds based on an information show that an investor will consume at rate (R f − ρ )/γ where γ is the absolute
relaxation procedure, introduced in Section 4.2. risk aversion coefficient.
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151 141

ing univariate function at each node for every period: account that it is very difficult to solve numerically the original
c 1 −γ (1 − ct )1−γ 
model, we complement these proposed feasible policies with up-
max t
+ bˆ t (24) per bounds on the certainty equivalent based on the dual approach
ct 1−γ 1−γ which will be explained in the next section.
which implies
1 4.2. Obtaining upper bounds
cˆt = 1 /γ
. (25)
1 + bˆ t
Therefore, we can obtain the approximated optimal consumptions Given the suboptimal policies for the portfolio optimization
based on a “pseudo-dynamic programming”approach at each node problem (6)–(8), we can evaluate their performance using simu-
for every period. Note when values of state variables are not on lation by generating different sample paths and averaging utilities.
the grid, the consumptions can be obtained using interpolation. These averages provide unbiased lower bounds to the optimal util-
ity U∗ . When considering these suboptimal policies, it would be
4.1.2. Wealth dynamics helpful to know how much better we could possibly do. In other
To simplify the framework adaptation, we assume that the in- words, we will use the optimal utility U∗ to evaluate the optimality
vestor has an initial wealth of $1 invested in the risk-free as- of the suboptimal policies. However, because the optimal utility U∗
set. With this assumption, the absolute risk aversion parameter in is unavailable, we propose to develop an upper bound to U∗ .
model (12) under the mean-variance framework equals the relative One simple way to obtain an upper bound is to consider the
risk aversion parameter in (6)-(8) for the power utility framework. same problem (6)–(8) but to ignore the existence of transaction
f
Hence, for each period, the amount of money invested in risk-free costs. That is, if Vt denotes the optimal value function at t for
asset is problem (6)–(8) in the absence of transaction costs, then
ˆ t (1 − cˆt ) − W
Wt f = W ˆ t (1 − cˆt )K (xˆt − xˆt−1,+ )1 ,
ˆ t (1 − cˆt )xˆt Pt − W
Vt∗ (ct−1 , xt−1 ) ≤ Vt f (ct−1 , xt−1 ),
where cˆt is the approximated consumption to wealth ratio in
where Vt∗ (ct−1 , xt−1 ) denotes the optimal value function at t. How-
Section 4.1.1 and xˆt = xt ./Pt is the number of shares that the in-
ever, Vt∗ generally provides a weak upper bound for U∗ , especially
vestor can hold when the price is Pt instead of $1. Here ./ refers to
when transaction costs are substantial.
the component-wise division of two vectors. The investor’s wealth
ˆ t+1 in each period is the sum of the total holding across the risky Alternatively, if we consider an information relaxation, where G
W
is a relaxation of filtration F defined in Section 2, such that the
assets and risk-free asset, i.e.,
decision maker knows future values of the state variables under G,
W ˆ t (1 − cˆt )xˆt Pt+1 ,
ˆ t+1 = W f R f + W then it can be easily shown that
t

and for each approximate policy, the power utility is 

T −1  
T −1 

T −1 1 −γ ˆ 1 −γ  E0 Ut (xt ) ≤ max E0 Ut (xt ) . (28)
t+1 cˆt Wt x∈PG
U h = E0 ρ . (26) t=0 t=0
1−γ
t=0
Note that the upper bound in (28) is easy to compute via simula-
To evaluate the expectation, we first generate a scenario tree with tion: we can estimate the expected value of the right hand side by
M sample paths for the risky asset returns. Starting with any given randomly generating the state variables and returns, and solving
initial dividend yield d1 , we generate nd different values for d2 T −1
an inner problem based on maximizing t=0 Ut (x ) and assuming
based on (11) and save the realizations for the values of  2 . The that the investor knows the future values of the state variable in
first period risky asset returns R1 can be generated based on (10). each realization.
For each subsequent time period at each node, we repeat the pro- However, the utility obtained by the above information re-
cess until we reach the final time t = T − 1. laxation also provides a weak upper bound to U∗ , especially
Assume, without loss of generality, the initial price for each when we consider perfect information relaxation where all ac-
risky asset is $1. Taking into account Pt+1 = Pt Rt+1 at each period, tions are selected with full knowledge of the future state variables.
the scenario tree for the price Pt can also be generated based on In Brown et al. (2010), they show that the previous upper bound
the scenario tree of risky asset returns. In each sample path, we can be improved by the dual approach that consists of simultane-
compute the power utility for each feasible policy as ously relaxing future information on state variables and imposing
T −1 1 −γ ˆ 1 −γ
 cˆt,(m )Wt,(m )
a penalty function. Based on weak duality, they prove that incor-
U(hm ) = ρ t+1 , porating a proper-selected action-dependent function π (x), which
1−γ
t=0 penalizes the policies that violate nonanticipativity constraints in
for m = 1, 2, · · · , M. Note that in each sample path, for any value the RHS of (28) in each realization, will significantly improve the
of state variables that are not on the grid, the consumption can be performance of the bound given in (28). Especially,
computed based on interpolation. With M sample paths, an unbi-
ased estimate of the utility given in (26) can be obtained by aver-  T
−1   
T −1   T
−1 
aging the values of U(hm ) . Let U h be E0 Ut (xt ) ≤ E0 max Ut (xt ) − π (x ) ≤ max E0 Ut (xt ) .
x∈P x∈PG
t=0 t=0 t=0
M h
m=1 U(m ) Moreover, they show that an ideal penalty function π (c, x) in each
Uh = , (27)
M scenario follows
then, the certainty equivalent for each feasible policy can be de- T −1 
   ∗ 
fined as
1
π ∗ (x ) = ∗
E Vt+1 (xt )|Gt − E Vt+1 (xt )|Ft , (29)
CE (U h ) = ((1 − γ )U h ) 1−γ . t=0

Finally, note that given each feasible policy provides an approxi- where Gt is a relaxation of filtration Ft such that Ft ⊆ Gt in each
mation to the optimal solution for the portfolio optimization prob- period. If Gt denotes perfect information relaxation, the investor
lem with CRRA power utility, the corresponding certainty equiva- determines the actions with full knowledge of future state vari-
lent is clearly a lower bound to that of the true model. Taking into able values. However, also note that it is not practical to obtain Vt∗
142 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151

in (29). A natural idea is to approximate the above penalty func- where ∇ I˜t (y˜ t∗ ) denotes the gradient of the reward function for each
tion with a proper Vˆt such that: period with respect to the decision vector ct and xt . Consequently,
T −1 
   if we solve the following deterministic problem
πˆ (x ) = Vˆt+1 (xt ) − E Vˆt+1 (xt )|Ft . (30) T −1
 1 −γ 
Ct
t=0 max ρ t+1 − ∇ I˜t (y˜ t∗ )(yt − y˜ t∗ ) , (35)
c,x 1−γ
In this case, the upper bound to the optimal value function V1∗ is t=0
then given by
 s.t. Wt+1 = Wt (1 − ct )R p,t+1 ,

(36)

T −1
Vub := E0 max Ut (xt ) − πˆ (c, x ) . (31) ct ≥ 0
x∈P ( u )
t=0 p
in each sample path and let U(m ) be the corresponding optimal
Then, to obtain an unbiased estimate for the previous expecta- M p
m=1 U(m )
tion, we simulate M sample paths of the state variables and dis- objective function for m = 1, 2, · · · , M and U p = M , then U p
turbances, and solve the following maximization problem by as- will be a convenient upperbound to the
 utility of heuristic policy
suming the investor knows the future values of state variables in U h compared to Vf and E0 T −1
U ( x ) . Finally, if we consider the
t=0 t t
each sample path,
certainty equivalent
T −1
    1
max Ut (xt ) + Et Vˆt+1 (xt ) − Vˆt+1 (xt ) .
x
t=0
The expected value in (31) is then estimated by taking the average
of the optimal objective function value of problem (32) over all
sample paths.
Note that in (31), each Ut (xt ) term is generally concave in the
decision variables x, and it leads to convexity in the original DP de-
fined by (9). However, objective function (32) may not be concave
after taking into account the penalty function, and consequently,
it cannot be solved conveniently in practice. A solution is to find
an approximation of Vˆt+1 to guarantee the convexity of (31). For
instance, Brown and Smith (2014) consider penalties based on the
first-order approximation of Vˆt (xt−1 ) to have a convex structure.
To summarize the procedure, a convenient penalty function can
be constructed by a convex approximation of the approximated
value function Vˆt . In this paper, we propose a penalty function
πˆ (c, x ) in (31) such that at each period, the following reward func-
tion is considered:
1 −γ
Ct
I˜t (ct , xt ) = ρ t+1 , (33)
1−γ
subject to the law of motion for investor’s wealth which is defined
in (1) but without transaction costs. The reason is that, first, the
associated utility for the model with reward function I˜t (ct , xt ) is
greater than that for the original model (that is, it is a relaxation
of the original model). And second, if Vˆt (ct−1 , xt−1 ) is the opti-
mal value function corresponding to the proposed reward func-
tions, then it is also an approximation to the optimal function
Vt∗ (ct−1 , xt−1 ) of the original model. For those reasons, we can de-
fine the penalty function as
T −1 
  
π ( c, x ) = Vˆt+1 (ct , xt ) − Et Vˆt+1 (ct , xt ) .
t=0
To guarantee the convexity, and following Brown and
Smith (2014), we consider the first-order linear approxima-
tion of Vˆt so that the resultant penalty function is linear in the
decision variables. If y˜t∗ = (c˜t∗ , x˜t∗ ) denotes the optimal policy for
the no-transaction costs problem with reward function (33) and
∗
W˜ t the corresponding wealth at each period, we can then obtain
the gradient penalty as follows10 ,
T −1

π˜ (c, x) = ∇ I˜t (y˜ t∗ )(yt − y˜ t∗ ),
t=0
10
When we take first order approximation of the approximate value  function
T
Vˆt+1 (ct , xt ), the term which is constant in actions t=1 Vt+1 (y
ˆ ˜t∗ ) − Et Vˆt+1 (y˜t∗ ) is
omitted from the penalty function π (c, x). When we calculate the upper bound for
each scenario, we add the realized values for this term after (34), which serves as
a control variate, see Brown and Smith (2014).
(32) CE (U p ) = ((1 − γ )U p ) 1−γ ,
then, it is clearly a convenient upper bound to the certainty equiv-
alent provided by the approximate policies.
4.3. Numerical results
In this section, we analyze empirically the certainty equivalent
losses associated when adapting the proposed policies, as well as
how these losses depend on the model parameters. Because we
consider a “two-folded approximation” for the model with inter-
mediate consumption, we evaluate the performance of the pro-
posed investment rule and suboptimal consumption strategy sepa-
rately. We first assess the certainty equivalent losses of the subop-
timal investment strategies by considering an investor with CRRA
utility of terminal wealth. Specifically, the upper bound for the
certainty equivalent with terminal wealth is computed based on
the procedure similar to the one described in Section 4.2. Then,
to show how much better each of the heuristic strategies perform
compared to the policy that completely ignores transaction costs,
we also report the certainty-equivalent returns of terminal wealth
of an investor considering the frictionless model, but deducting
transaction costs from the wealth at each period. Finally, we com-
pare the associated certainty equivalent losses of the heuristic in-
vestment policies with the suboptimal consumption strategy based
on the model with intermediate consumption.
In all cases, we begin by solving the dynamic program for the
model without transaction costs. After repeatedly generating ran-
dom sequences of market states and returns, we determine se-
quence of trades selected by the proposed heuristics and further
adapt them to the CRRA framework in each trial. For purpose of
simplification, note that the sequence of consumption is also de-
termined based on the model without both transaction costs and
liquidation costs. We also solve the inner problem (35) in the
same scenario and calculate the corresponding certainty equivalent
of each heuristic. We repeat the simulation process 10 0 0 times.
Moreover, we consider two risky assets with the same model pa-
rameters used in Section 3.3 for monthly returns in the base case.
To gauge the robustness of the proposed trading strategies, we
then evaluate the performance of those strategies using models
with longer investment horizon and more risky assets. Finally, to
assess the impact of liquidation costs for consumption, we com-
(34) pare separately the certainty equivalent consumption and level
of consumption for the model with and without liquidation cost
when fixing a trading strategy.
 4.3.1. The base case scenario
For our base case scenario, we consider the same parameters
used in Section 3.3.1. That is, the investor has a relative risk-
aversion parameter γ = 5, an initial wealth of $1 invested in the
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151
Fig. A3. Comparison of heuristic and boundsThis figure shows the comparison of utilities of an investor following a frictionless strategy (the strategy that ignores transaction
costs), a no-trade region approximate trading strategy, and the upper bound obtained based on the gradient-based penalty function. The parameters are the ones specified
in the base-case scenario. .
risk-free asset, faces proportional transaction costs of 50 basis
points for both assets, rebalances her portfolio once per month,
and has an investment horizon of T = 7. Note that with cT = 1, we
only need to solve a six period problem for the feasible policies to
evaluate a T = 7 problem.
For the model with utility of terminal wealth, we find that
the certainty equivalent losses associated when adapting the sim-
ple policy (S-P), the linear policy (L-P), the no-trade region pol-
icy (NTR-P) and the rolling optimize-and-hold policy (ROH-P) are
4.51%, 3.01%, 2.30% and 2.57%, respectively, whereas that of the
strategy that ignores transaction costs is as high as 7.79%. Fig. A.3
shows the certainty-equivalent comparison between the no-trade
region policy and the lower and upper bounds for each trial of
the simulation. Note the big gap in losses implies the benefits of
considering the heuristic trading strategies rather than completely
ignoring the existence of transaction costs.
Moreover, note that these losses can be decomposed in two
parts: the loss from considering suboptimal trading strategies and
that from adapting mean-variance framework to the CRRA utility
framework. For the first part, note that the insights are similar to
those in Section 3.3: the no-trade region policy is the best approx-
imate feasible solution to the original model among all the poli-
cies, followed by the rolling optimize-and-hold policy. However,
the second part of the loss does not increase proportionally to the
first part, indicating a policy with high certainty equivalent loss in
mean-variance framework may perform better under power utility.
Additionally, the extra loss caused by adapting the mean-variance
framework is relatively small when we consider a shorter horizon,
143
which is consistent with the conclusion in Mei et al. (2016) for the
model without predictability.
Regarding the loss associated when considering simultaneously
the suboptimal trading strategies and the linear consumption pol-
icy, we observe that similar to the model with utility in terminal
wealth, the no-trade region policy outperforms the other policies
with associated loss around 3.6%, indicating an increased loss in
percentage caused by the suboptimal consumption policy.11
4.3.2. Comparative statics for other scenarios
In this section, we analyze empirically how the certainty equiv-
alent losses associated when ignoring volatility in the dividend
yield (i.e., with the simple policy), trading linearly (i.e, with the lin-
ear policy), the no-trade region policy and the rolling optimize-and-
hold policy depend on the proportional transaction costs rate κ , the
risk-aversion parameter γ and the slope of dividend bd .
We examine first the losses associated when adapting subopti-
mal investment policies for an investor who maximizes her CRRA
utility of terminal wealth. As expected, Table A.4 shows that there
are big gaps in certainty equivalent between the strategy based
on ignoring transaction costs and the proposed investment strate-
11
We also evaluate the certainty equivalent losses of a heuristic-based consump-
tion approximation, resulting in higher losses compared to the consumption policy
recommended by the model in the absence of transaction costs in all cases (be-
cause the former policy relies on the proposed approximate strategies, which will
typically result in a large gap especially when the approximate strategies do not
perform well in practice.)
144 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151

Table A4
Certainty-equivalent wealth: CRRA utility of terminal wealthThis table shows the
certainty-equivalent annualized wealth of an investor with CRRA utility of terminal
wealth based on the proposed heuristic policies for different values of bd , the risk-
aversion parameter γ , and the proportional transaction cost rate κ , which are given in
the first three columns. Columns 4–7 show the certainty equivalent based on the sim-
ple policy(S-P), the linear policy(L-P), the no-trade region policy(NTR-P) and the rolling
optimize-and-hold policy(ROH-P), respectively. The last two columns shows the lower
and upper bounds to the return obtained based on frictionless model and perfect hind-
sight. In each row, the value of the CEQ returns and the corresponding gap with respect
to the upper bound (in %) is reported.

Parameters Policies Bounds

bd γ κ S-P L-P NTR-P ROH-P Lower Upper

0.75 3 0.0020 1.1984 1.2646 1.2875 1.2608 1.1904 1.3301

9.91% 4.92% 3.20% 5.21% 10.50%
0.0050 1.1199 1.2152 1.2641 1.2199 1.1080 1.3089
14.44% 7.16% 3.42% 6.80% 15.35%
0.0100 1.1272 1.1811 1.2258 1.1899 1.0597 1.2874
12.44% 8.26% 5.18% 7.53% 17.69%
5 0.0020 1.1229 1.1931 1.2026 1.1842 1.1116 1.2336
8.97% 3.28% 2.52% 4.01% 9.89%
0.0050 1.1181 1.1707 1.1809 1.1663 1.0935 1.2206
8.40% 4.09% 3.26% 4.49% 10.41%
0.0100 1.0964 1.1492 1.1716 1.1419 1.0580 1.2192
10.07% 5.74% 3.92% 6.36% 13.24%
7 0.0020 1.1101 1.1544 1.1656 1.1506 1.1007 1.1867
6.45% 2.72% 2.24% 3.04% 7.27%
0.0050 1.0850 1.1010 1.1109 1.1047 1.0402 1.1463
5.35% 3.95% 3.09% 3.72% 9.26%
0.0100 1.0471 1.0505 1.0564 1.0518 0.9557 1.0975
4.59% 4.28% 2.12% 4.16% 12.92%
0.98 3 0.0020 1.1679 1.1991 1.2038 1.2015 1.1463 1.2314
5.16% 2.63% 2.25% 2.43% 6.91%
0.0050 1.1492 1.1677 1.1855 1.1747 1.1106 1.2048
4.62% 3.08% 2.46% 2.51% 7.81%
0.0100 1.1130 1.1264 1.1285 1.1267 1.0464 1.1660
4.54% 3.40% 3.23% 3.37% 10.26%
5 0.0020 1.1580 1.1882 1.1935 1.1911 1.1426 1.2208
5.14% 2.67% 2.24% 2.44% 6.42%
0.0050 1.0884 1.1055 1.1136 1.1107 1.0521 1.1398
4.51% 3.01% 2.30% 2.57% 7.79%
0.0100 1.0475 1.0580 1.0616 1.0599 0.9871 1.0965
4.47% 3.51% 3.19% 3.34% 9.98%
7 0.0020 1.0837 1.0915 1.0988 1.0979 1.0978 1.1187
3.13% 2.43% 1.78% 1.86% 5.02%
0.0050 1.0774 1.0828 1.0913 1.0905 1.0402 1.1115
3.07% 2.58% 1.82% 1.89% 6.38%
0.0100 0.9911 0.9995 1.0046 1.0043 0.9270 1.0354
4.28% 3.47% 2.98% 3.01% 10.47%

gies. Basically, the former results in very small net returns espe-
cially when κ is high due to higher transaction costs compared to
the suboptimal investment strategies. Similar to the case with the
mean-variance utility, there are higher losses associated with the
trading strategies when the assets returns are more predictable.
In addition, the certainty equivalent losses associated when using
NTR-P and ROH-P generally increase as proportional transaction
cost rates get higher. However, unlike the mean-variance frame-
work, the certainty equivalent return losses decrease as the in-
vestor gets more averse of risk. This is intuitive taking into account
that the investor prefers to trade less, and meanwhile to invest
more into the risk-free asset as she gets more risk averse. More-
over, note that the return losses of the proposed trading strate-
gies under the mean-variance framework may differ from that un-
der the power utility framework due to the nonadditivity of the
adaptation process. Finally, the extra losses obtained when adapt-
ing the no-trade region policy to the power utility framework is
no more than 3.4% percent, which is in line with the conclusion
in Mei et al. (2016), who show a less than 0.5% loss for a model
with i.i.d. returns.
Table A.5 shows the certainty equivalent consumptions and as-
sociated losses after incorporating the approximate consumption
policy into the model with CRRA utility of intermediate consump-
tion. Note that the losses in this table can be decomposed into
three parts that are not additive: the loss from choosing the sub-
optimal policy under the mean-variance framework, the loss from
adapting the mean-variance framework to CRRA utility with ter-
minal wealth, and that from augmenting the suboptimal consump-
tion policy. When looking at the gap between the certainty equiv-
alent of upper bounds, compared to the model with zero-penalty,
the upper bound is significantly improved after considering the
gradient-based penalty in all cases.
Similar to the model with mean-variance utility, a higher pro-
portional transaction cost rate κ is always associated with a higher
certainty equivalent loss for both NTR-P and ROH-P. There are
mainly two reasons for this performance. First, the loss in mean-
variance utility increases with κ due to the high rate of decrease
in turnover, and second, the procedure we have used to augment
the proposed policy to finance intermediate consumption requires
a large amount of trading on risky assets, and thus large transac-
tion costs.
Moreover, we find the losses decrease as risk aversion pa-
rameter γ increases. As it plays no role in the certainty equiv-
alent loss of the proposed approximate strategies under the
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151 145

Table A5
Certainty-equivalent consumption: CRRA utility of intermediate consumption. This table
shows the certainty-equivalent consumption of an investor with CRRA utility of intermedi-
ate consumption based on the heuristic policies for different bd , γ , and proportional trans-
action cost rate κ , which are given in the first three columns. Columns 4–7 show the cer-
tainty equivalent based on the simple policy(S-P), the linear policy(L-P), the no-trade region
policy(NTR-P) and the rolling optimize-and-hold policy(ROH-P), respectively. The last two
columns show the upper bounds to the certainty equivalent obtained based on the perfect
information relaxation with and without penalty function. In each row, the value of the CEQ
consumption and the corresponding gap with respect to the upper bound with penalty func-
tion (in %) is reported.

Parameters Policies Upper Bounds

bd γ κ S-P L-P NTR-P ROH-P Penalty No-penalty

0.75 3 0.0020 0.0532 0.0561 0.0571 0.0562 0.0595 0.0656

10.41% 5.56% 4.09% 5.77% 12.31%
0.0050 0.0499 0.0529 0.0548 0.0534 0.0592 0.0660
15.74% 10.61% 7.57% 9.89% 11.50%
0.0100 0.0519 0.0537 0.0553 0.0545 0.0604 0.0663
13.94% 11.09% 8.39% 9.89% 10.20%
5 0.0020 0.0846 0.0889 0.0906 0.0898 0.0938 0.1061
9.81% 5.24% 3.45% 4.27% 13.16%
0.0050 0.0839 0.0881 0.0893 0.0889 0.0934 0.1057
10.17% 5.67% 4.54% 5.12% 13.12%
0.0100 0.0821 0.0868 0.0886 0.0879 0.0927 0.1067
11.43% 6.27% 5.42% 5.21% 15.10%
7 0.0020 0.0987 0.1027 0.1034 0.1022 0.1071 0.1241
8.71% 4.11% 3.52% 4.68% 15.77%
0.0050 0.0986 0.1021 0.1028 0.1022 0.1075 0.1248
8.27% 5.32% 4.48% 4.90% 13.83%
0.0100 0.0989 0.1022 0.1028 0.1021 0.1080 0.1225
8.43% 5.37% 4.80% 5.47% 13.40%
0.98 3 0.0020 0.0535 0.0552 0.0560 0.0553 0.0578 0.0648
7.44% 4.62% 3.15% 4.32% 12.11%
0.0050 0.0541 0.0566 0.0564 0.0562 0.0589 0.0663
8.15% 3.95% 4.24% 4.58% 12.56%
0.0100 0.0525 0.0546 0.0542 0.0539 0.0568 0.0640
7.57% 3.87% 4.58% 5.10% 12.67%
5 0.0020 0.0862 0.0882 0.0899 0.0891 0.0924 0.1054
6.71% 4.55% 2.72% 3.58% 14.07%
0.0050 0.0863 0.0878 0.0886 0.0880 0.0919 0.1049
6.09% 4.46% 3.59% 4.24% 14.15%
0.0100 0.0857 0.0872 0.0873 0.0868 0.0913 0.1020
6.13% 4.49% 4.42% 4.51% 11.75%
7 0.0020 0.1001 0.1016 0.1037 0.1036 0.1058 0.1213
5.89% 3.97% 1.98% 2.08% 14.65%
0.0050 0.1002 0.1017 0.1034 0.1034 0.1061 0.1192
5.55% 4.15% 2.56% 2.66% 12.34%
0.0100 0.1229 0.1241 0.1241 0.1241 0.1311 0.1559
5.96% 4.13% 4.01% 3.94% 12.57%

mean-variance framework, it is then intuitive that the optimal
amount of rebalancing decreases given that a more risk averse
investor chooses to trade less and put more weights in riskless
assets.
Finally, we find that the simple policy performs the worst
among the proposed heuristic policies, especially when there is
more volatility in the predictive variables. On the other hand, the
NTR-P beats the other policies in most of the cases, with the high-
est certainty equivalent loss being no more than 8.4%, followed by
the ROH-P. The superior performance of NTR-P and ROH-P relies
on the fact that there is a no-trade region confining the invest-
ment at each period, which is consistent with the spirit showed
in Lynch and Tan (2010) and Muthuraman and Kumar (2006), who
demonstrate that the optimal investment is constrained by a no-
trade region for an investor who maximizes CRRA utility of inter-
mediate consumption. However, in contrast to the structure of the
no-trade region in NTR-P and ROH-P, Lynch and Tan (2010) and
(Muthuraman and Kumar, 2006) show that the no-trade region
may not be centered around an aim portfolio, which further ex-
plain this part of the losses in both strategies. In addition, note that
for all the cases, the certainty equivalent losses are evaluated by
comparing them with the upper bound, which is typically greater
than that of the optimal strategy.
Overall, our results show that the certainty equivalent losses as-
sociated with the proposed feasible policies are quite acceptable,
with the no-trade region policy outperforming the other approxi-
mate strategies for most of the cases. In addition to the reasonable
time needed to determine the proposed strategies, the approxi-
mate strategies based on the mean-variance framework allow us
to deal with many risky assets simultaneously.
4.3.3. The investment horizon and the number of assets
To analyze the robustness and applicability of the proposed ap-
proximate trading strategies against different parameter settings,
we consider a more general case when the investor has a longer
investment horizon and more risky assets to invest. We first en-
large the investment horizon to 12, 24 and 48 months. Then we
examine the certainty equivalents of the policies when there are
three risky assets, including the G&P type predictability model. To
illustrate the main insights, in all cases, we focus on the base-case
scenario where an investor has a risk averse parameter γ = 5 and
a proportional transaction cost rate of 50 basis points.
146 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151
Table A6
Computing times required to evaluate approximate strategies and upper bounds. This table shows the
computing times(in seconds) required to evaluate the performance of proposed approximate trading
strategies and the associated upper bounds depending on different investment horizons. Specifically,
the first column specifies the horizons, columns 2–3 report the run time needed for frictionless mod-
els, columns 4–7 show the computing times of heuristic strategies and the last two column report
time required to obtain the upper bounds.
Frictionless models Policies
Horizon Terminal Inter. S-P L-P
wealth Consum.
6 1.5 1.3 0.9 678.6
12 2.8 2.5 3.2 1289.3
24 5.1 5.5 7.5 2497.5
48 10.5 11.33 16.3 5102.1
a. The investment horizon
Table A.6 provides the computational times of evaluating the
approximate strategies and the proposed upper bounds in a simu-
lation with 10 0 0 trials for four different time horizons (T).To com-
pute the policies, we have used a Dell desktop with a 3.50 GHz
Intel Xeon CPU processor and 16GB of RAM, running Windows 7.
The calculations are performed using Matlab with a single proces-
sor. The first two columns report the time required to solve the
dynamic program for the model without transaction costs (fric-
tionless model) for both the utility with terminal wealth and inter-
mediate consumption. As showed in Table A.6, the computational
times for these two models are similar and grow linearly with
the horizons. Moreover, the evaluation of the heuristic strategies
takes most of time, especially for the linear policy, the no-trade re-
gion policy and the rolling optimize-and-hold policy. Among them,
the linear policy needs most of the time to calibrate the value of
λ, while the no-trade region policy and rolling optimize-and-hold
policy require solving a constrained optimization problem at each
period for each trial. Similarly, the computational time approxi-
mately grows linearly with the number of periods and the number
of trials. Compared to the heuristics, the upper bounds take less
time to be computed. Finally, note if we are interested in any of
the proposed heuristics, we only need to solve one optimization
problem for the current state and period.
Table A.7 reports the certainty equivalent losses of the heuris-
tics as a function of the number of periods. In terms of annualized
wealth, the certainty equivalent losses of each approximate strate-
gies increase slightly with T, being the no-trade region policy the
best for most of the cases. The simple policy is more sensitive to
the change in T, because the losses from predictability accumulate
from period to period, reaching the maximum at the end of invest-
ment horizon. Moreover, despite of the increasing loss in the cer-
tainty equivalent wealth, the maximum absolute loss of the best
approximate strategy (the no-trade region policy) does not exceed
0.05$, which suggests a good performance of the proposed strat-
egy.
ft+1 = − ft + t+1 , (38)
Finally, we analyze the certainty equivalent consumption losses
of the proposed approximate strategies. Similar to the case with
utility of terminal wealth, the simple policy attains the highest loss
in all the cases whereas the no-trade region policy outperforms the
others, followed by the rolling optimize-and-hold policy. Moreover,
the loss of each strategy slightly increases with the investment
horizon except for the case when T = 48. Finally, Fig. A.4 shows the
comparison between the certainty equivalent of the no-trade re-
gion policy and that of the lower and upper bounds. Note that de-
spite of the high loss in percentage for the no-trade region policy,
the upper bound of the consumption is only 1.09% when T = 48,
and the absolute loss of the no-trade region is less than 0.1%. That
Upper bounds
NTR-P ROH-P Zero Non-zero
Penalty Penalty
522.5 568.2 153.4 291.7
1184.3 1220.1 279.3 530.5
2401.7 2589.8 724.6 1406.3
4950.5 5211.9 1847.6 3267.2
b. The Number of assets
We compare now the certainty equivalent losses of the ap-
proximate strategies when an investor faces three risky assets. We
first assume risky assets returns are predictable by the L&T model
specified in (10) and (11). In particular, we consider the three-
asset model which has been used in Lynch (2001); Lynch and
Tan (2010) and Brown and Smith (2011). Following the discrete
approximation approach in Section 4.3, we run a simulation
considering 10 0 0 trials.
Table A.8 reports the computational times and certainty equiva-
lents of the simulation. The computational times required for eval-
uating the policies and the upper bounds bounds increase but less
than two times due to the extra decision variable involved at each
period in each trial. In terms of certainty equivalent loss in ter-
minal wealth, the associated loss in percentage of each policy has
slightly increased, with the lowest loss around 3.03%. However, if
we compare the absolute loss in dollars with the model with two
risky assets, we find that there is only 0.0149$ increment in loss of
annualized terminal wealth. That means the extra loss caused by
increasing the number of assets is acceptable. Similarly, when an-
alyzing the certainly equivalent loss in intermediate consumption,
the extra absolute loss in consumption created by adding a third
asset is only 0.24%, despite of the small increase in percentage
loss. Overall, the no-trade region policy consistently outperforms
the other strategies for most of the cases, with a reasonable loss
in both terminal wealth and intermediate consumption, followed
by the rolling optimize-and-hold policy and the linear policy.
We now analyze the performance of the proposed strategies
when the predictive model is based on Gârleanu and Peder-
sen (2013). In this model, each risky asset can be predicted by
more than one predictors:
rt+1 = Ar + Br ft + ut+1 , (37)
where ft+1 denotes the vector of predictors with length K,  is
a K × K mean-reversion matrix of lag coefficients. To make a fair
comparison with the model in Lynch and Tan (2010), we let rt+1 be
again the vector of log risky-asset returns instead of price changes
in excess of the risk-free return as in the G&P model. In addition,
Br is a N × K matrix of factor loadings, and Ar a N × 1 vector of
mean returns. To illustrate the main insights, we consider a simple
model with two predictors and three risky assets.12
12
The parameters of the VAR(1) model for the factors are identical to those spec-
ified in Gârleanu and Pedersen (2013), footnote 9. That is, the mean-reversion
coefficient matrix is diagonal with φ1 = 0.1 and φ2 = 0.4. The shock of factors
implies the no-trade region policy provides very reasonable perfor- has variance  = I2×2 . In addition, we consider a the same mean vector Ar as in
mance in practice for all cases. Lynch and Tan (2010), and a factor loading of Br = [0.470.31; 0.390.45; 0.300.44],
indicating a volatility of each assets 7.37%, 6.46% and 5.54% respectively.
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151 147

Table A7
Certainty equivalents with different investment horizons: policies and bounds. This ta-
ble reports the certainty-equivalent annualized wealth and consumption of the proposed
heuristic policies and upper bounds depending on different investment horizon, T. The
first column specifies the investment horizons. Columns 3–6 give the values of cer-
tainty equivalents of the simple policy(S-P), the linear policy(L-P), the no-trade region
policy(NTR-P) and the rolling optimize-and-hold policy(ROH-P), respectively. The last col-
umn reports that of the upper bound. In each row, the value of the CEQ and the corre-
sponding gap with respect to the upper bound with penalty function (in %) is reported.

Horizon CEQ S-P L-P NTR-P ROH-P Penalty-based

upper bounds

T=6 Wealth 1.0884 1.1055 1.1136 1.1107 1.1398

4.51% 3.01% 2.30% 2.55%
Consumption 0.0863 0.0878 0.0886 0.0880 0.0919
6.09% 4.46% 3.59% 4.24%
T = 12 Wealth 1.1549 1.1839 1.1824 1.1797 1.2201
5.34% 2.97% 3.09% 3.31%
Consumption 0.0430 0.0437 0.0437 0.0436 0.0458
6.11% 4.58% 4.59% 4.80%
T = 24 Wealth 1.1875 1.2654 1.2685 1.2592 1.3104
9.38% 3.43% 3.20% 3.91%
Consumption 0.0211 0.0217 0.0218 0.0216 0.0228
7.46% 4.82% 4.38% 5.26%
T = 48 Wealth 1.2205 1.3114 1.3243 1.3231 1.3725
11.71% 4.45% 3.51% 3.60%
Consumption 0.0096 0.0097 0.0099 0.0098 0.0109
11.93% 11.01% 9.17% 10.09%

Fig. A4. Certainty equivalents with the investment horizon. This figure shows the comparison between certainty equivalents of the no-trade region policy and that of the
upper and lower bounds (obtained based on frictionless model) depending on the investment horizon T. The left panel shows the certainty-equivalent annualized wealth of
the no-trade region policy against that of the lower and upper bounds. The right panel compares the certainty-equivalent consumption of the no-trade region policy with
the upper bounds obtained with zero penalty function (dark line) and gradient-based penalty function (red line).. (For interpretation of the references to color in this figure
legend, the reader is referred to the web version of this article.)

Table A.8 specifies the computational times required to evaluate
the performance of the proposed strategies and the corresponding
certainty equivalents. We find that there is a reasonable increase in
computational time except for the linear policy and upper bounds.
For the linear policy, it requires more time to calibrate the parame-
ter λ when there are more predictors. For upper bounds, note that
the additional predictor produces more discretization nodes in the
approximation, implying more optimization problems to solve at
each node. We also find a small increase in certainty equivalent
losses both in terms of annualized terminal wealth and interme-
diate consumption, especially for the linear policy and the no-trade
region one. Taking into account that both the linear policy and the
no-trade region one choose to trade partially to the aim portfolio
at each period, the increase in losses can partly be explained by
the presence of multiple predictors, which causes the aim portfo-
lio deviates more from its true counterpart at each period. Finally,
the absolute loss of the rolling optimize-and-hold policy in termi-
nal wealth is less than 0.05$, and that in intermediate consump-
148 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151

Table A8
Certainty equivalents for three-assets case: policies and bounds. This table reports the certainty-
equivalent annualized wealth and consumption of the proposed heuristic policies and upper
bounds when the number of risky assets N = 3. The first column specifies the predictabil-
ity model. Columns 3–6 give the values of performance measures of the simple policy(S-P),
the linear policy(L-P), the no-trade region policy(NTR-P) and the rolling optimize-and-hold
policy(ROH-P), respectively. The last column reports that of the upper bound.

Models Performance S-P L-P NTR-P ROH-P Penalty-based

upper bounds

L&T Computing times (s) 1.2 871.8 776.9 805.0 426.6

CEQ Wealth($) 1.2557 1.2891 1.3141 1.2955 1.3552
7.34% 4.87% 3.03% 4.41%
CEQ Consum.($) 0.0901 0.0915 0.0925 0.0919 0.0982
8.24% 6.82% 5.80% 6.41%
G&P Computing times (s) 4.5 1077.2 859.9 924.8 1243.1
CEQ Wealth($) 1.1039 1.1061 1.1349 1.1431 1.1948
7.61% 7.42% 5.01% 4.33%
CEQ Consum.($) 0.0802 0.0807 0.0812 0.0814 0.0876
8.56% 7.88% 7.31% 7.08%

tion is 0.006, suggesting a very small loss from considering such not only consumption at each period, but also the liquidation costs
policy. to support consumption.

4.3.4. Liquidation costs for consumption
Note that in previous analysis we evaluate the performance of
the proposed trading and the consumption strategies in the ab-
sence of liquidation costs. The reason is twofold. First, the pres-
ence of liquidation costs has little impact on the mean-variance
framework which we rely on for the heuristic trading strategies.
Second, the consumption strategy cannot be solved efficiently for
the model with liquidation costs when there are more than two
risky assets and no transaction costs. However, transaction cost in
liquidating the risky assets to buy the consumption good may also
have impact on the investor’s consumption strategy.
To analyse such impact, we proceed in two steps. First, consider
a given consumption strategy, i.e., the strategy derived from the
frictionless model, and a heuristic trading strategy. For the 10 0 0
trials, we assess the average certainty equivalent consumption of
the model with only transaction costs and that of the model with
both transaction costs and liquidation costs based on the given
consumption and trading strategy. Second, for a fixed trading strat-
egy, we perform a “pseudo-dynamic programming” approach to
calculate the fraction of consumption at each period for the model
with and without liquidation costs, respectively. Note that the first
step is to gauge the impact of liquidation costs on certainty equiv-
alent returns, and the second step is assess the impact of liquida-
tion costs on consumption. To demonstrate the main insights, we
consider the parameter setting as in the base-case scenario.
Panel A of Table A.9 shows how the liquidation costs of con-
sumption affect the certainty-equivalent consumption. For each
trading strategy, there is a slight difference between the certainty-
equivalent consumption of the models before and after taking
into account liquidation costs. The small difference may be ex-
plained by the fact that deriving trading and consumption strate-
gies from the model without liquidation costs may result in
over-consumption. To further confirm this conjecture, Panel B of
Table A.9 reports the average level of consumption at each period
over 10 0 0 trials when different heuristic trading strategies are con-
sidered. Compared to the model that ignores liquidation costs for
consumption, we find that the level of consumption at each pe-
riod is reduced slightly after directly taking into account the liq-
uidation costs in the model, regardless of the trading strategy. In
other words, the decrease in the level of consumption may be in-
terpreted by the fact that liquidation costs decrease consumption,
since the gains from liquidating part of the portfolio need to fund
5. Conclusion
We consider a multiperiod CRRA investor who faces transaction
costs and has access to multiple risky assets in the presence of pre-
dictability. We propose some feasible trading strategies for the as-
sociated multiperiod portfolio selection problem with proportional
transaction costs, and develop lower and upper bounds for the
certainty-equivalent consumptions of these policies. In particular,
we base our feasible strategies on the framework in Gârleanu and
Pedersen (2013) that allows us to obtain portfolio weights through
a quadratic optimization problem. Our empirical analysis shows
that there is a very small mean-variance certainty equivalent loss,
suggesting some of the proposed strategies are nearly optimal in
the Gârleanu and Pedersen (2013) framework. With a power util-
ity, we find that the certainty equivalent losses are also low and
practical, and in addition, we can consider many risky assets given
that the predictability model admits a discretization approxima-
tion. For both cases, we have performed some comparative statics
and robustness checks to better understand the losses associated
when considering the proposed approximate strategies. Finally, we
have shown how the upper bounds of the certainty equivalent
consumption can be significantly improved using duality methods
based on a information relaxation.
Acknowledgement
The authors gratefully acknowledge financial support from
the Spanish government through projects MTM2013- 44902-P
and MTM2017-88979-P, and from the Chinese Fundamental Re-
search Funds for the Central Universities #20720171057 and
#20720181004.
Appendix A. Figures and Tables
.
Appendix B. Derivation of heuristic policies
Aim portfolio in linear policy
Starting from the last period, we know the aim portfolio for an
investor is just Markowitz strategy
MarkowitzT −1 = (γ )−1 μT −1 .
 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151 149

Table A9
Certainty Equivalents and Level of Consumption: with and without liquidation costs. This table
reports the certainty-equivalent consumption and level of consumption for different trading
strategies with and without liquidation costs for consumption respectively. Panel A reports
the Certainty Equivalents when we consider the frictionless-model consumption strategy to-
gether with the four heuristic trading strategy in the presence of transaction costs. Panel B
specifies the average level of consumption at each period when different trading strategies
are predetermined. All results are based on the same parameter setting as in base-case sce-
nario.

Panel A: Certainty-equivalent Consumption

Setting\Policies S-P L-P NTR-P ROH-P

Without Liquidation Costs 0.0863 0.0878 0.0886 0.0880

With Liquidation Costs 0.0861 0.0876 0.0885 0.0878
Panel B: Level of Consumption
Periods\Setting Liquidation Costs S-P L-P NTR-P ROH-P
for Consumption
t=1 No 0.6784 0.6775 0.6781 0.6782
Yes 0.6703 0.6667 0.6677 0.6677
t=2 No 0.7916 0.7929 0.7920 0.7921
Yes 0.7786 0.7842 0.7835 0.7837
t=3 No 0.6537 0.6518 0.6532 0.6531
Yes 0.6349 0.6334 0.6388 0.6385
t=4 No 0.8205 0.8226 0.8211 0.8212
Yes 0.8005 0.8117 0.8112 0.8116
t=5 No 0.5358 0.5382 0.5365 0.5364
Yes 0.5269 0.5278 0.5272 0.5273
t=6 No 0.5007 0.5012 0.5009 0.5008
Yes 0.4891 0.4897 0.4893 0.4893

Given the model dynamics specified in (10) and (11), the condi- ≡ max ρ T −1 (xT −2 [μT −2 + ρμT −1→T −2 ]
tional mean for each period is μt = Ar + Br dt . The aim portfolio for
xT −1

γ (1 + ρ )  
the second last period is
− xT −2 xT −2
2
aimT −2 = zMarkowitzT −2 + (1 − z )ET −2 (aimT −1 )
−ρ T −2 K (xT −1 − xT −2 )1 . (B.6)
= zMarkowitzT −2 + (1 − z )ET −2 (MarkowitzT −1 )
In Mei et al. (2016), they show problem (B.6) is equivalent to the
1 z
= −1 (Ar + Br bd dT −2 ) + −1 Br dT −2 (1 − bd ). (B.1) following constrained optimization problem
γ γ
min (xT −2 − xT −3 ) (xT −2 − xT −3 )
Analogously, the aim portfolio for period t can be derived as fol- xT −2
lows 1
s.t. K −1 (xT −2 − xCT −2 )∞ ≤ ,
aimt = zMarkowitzt + (1 − z )Et (aimt+1 ) ργT −2
  
= (γ ) −1
Ar + Br ad gt (bd ) + bTd −1−t dt where xCT −2 = γ 1 −1 μT −2 , γT −2 = (1 + ρ )γ and μT −2 = μT −2 +
T −2
(1 − ρ )μT −1|T −2 . Analogously, assume trading only occurs in pe-
+z(γ )−1 Br [dt ft (bd ) − ad ht (bd )], (B.2)
riod t, then each period the investor selects her portfolio by solving
where ft (bd ) is a polynomial of bd changing along period with ex- optimization problem (18)-(19). 
pression
Appendix C. Derivation of penalty function
ft (bd ) = (1 − z )bd ft+1 (bd ) + 1 − bTd −1−t (B.3)
A brief review about duality based on information relaxation
−t−2
T
has been made in Haugh and Wang (2014). This approach has been
ht (bd ) = bid + bd (1 − z )ht+1 (bd ) (B.4) explained in detail in Brown et al. (2010) as well as in Brown and
i=0
Smith (2014). The following we are going to derive the expression
gt (bd ) = bTd −t−2 + gt+1 (bd ) (B.5) for penalty function based on approximate reward functions (33).
Given y˜t∗ to be the optimal solution to the problem without trans-
and fT −1 = 0, hT −1 = 0, gT −1 = 0.  action costs, for each period the derivative for reward function is
Derivation of rolling optimize-and-optimize policy
∂ I˜t ∂ I˜t ∂ I˜t ∂ I˜t
Starting with the period before the last t = T − 2, and assuming ∇ I˜t (y˜t∗ ) = ( , ,··· , , )| ∗ , (C.1)
the investor does not trade at t = T − 1 (which means xT −1 = xT −2 ), ∂ c1 ∂ x1 ∂ ct ∂ xt y=y˜t
the value function for the last period is where
γ ∂ I˜t 1 −γ 1−γ R p, j+1
VT∗−1 (xT −2 , μT −1 ) = ρ T (x
T −2 μT −1 − T −2 xT −2 ).
x = −ρ t ct Wt , for j = 1, · · · , t − 1
2 ∂cj W j+1
The optimal strategy at t = T − 2 is the solution to the following ∂ I˜t 1 −γ 1 −γ
(1 − c j )Rej+1
problem = ρ t ct Wt , for j = 1, · · · , t − 1
∂xj W j+1
γ
VT −2 (xT −3 , μT −2 ) = max ρ T −1 (xT −2 μT −2 − T −2 xT −2 )
x ∂ I˜t −γ −γ
xT −2 2 = ρ t ct Wt−1 Wt
∂ ct
−ρ T −2 K (xT −2 − xT −3 )1
∂ I˜t
+ET −2 [VT∗−1 (μT −1 , xT −2 )] =0 (C.2)
∂ xt
150 X. Mei, F.J. Nogales / Journal of Banking and Finance 94 (2018) 131–151

Table D.10
Sample Statistics, VAR coefficients and Quadrature Approximation: High and Low Book-to-Market Portfolios.This table repro-
duces the quadrature method based on the estimated VAR model given in (10) and (11). The information indicated under the
table ‘DATA’ is the estimation from the sample, while the values under the table ‘QUADRATURE’ are the results obtained from
quadrature approximations. It reports the moments and parameters for the high and low book-to-market portfolios adapted
from Lynch and Tan (2010) and calculated for the quadrature approximation based on the VAR model that uses log dividend
yield as the only state variable. High and low book-to-market portfolios are denoted as High BM and Low BM respectively.
Panel A reports unconditional means, VAR slopes and the corresponding coefficients of determination for the data and the
quadrature approximation. Panel B reported the unconditional covariance matrix for the data and for the quadrature ap-
proximation. All results are for continuously compounded returns. Returns are expressed per month and in percentages. The
coefficients of determination are expressed in percentages.

Panel A: Unconditional Sample Moments and VAR coefficients

DATA QUADRATURE
2
Asset/Variable Uncond. Mean Slope R Asset/Variable Uncond. Mean Slope R2

High BM 0.80 0.49 0.45 High BM 0.83 0.47 0.40

Low BM 0.53 0.39 0.38 Low BM 0.51 0.39 0.37
Dividend yield 0.00 0.98 96.03 Dividend yield 0.00 0.98 95.98
Panel B: Unconditional Standard Deviations, Covariance(above diagonal) and Correlations(below)
DATA QUADRATURE
Asset/Variable High BM Low BM Div.Yield Asset/Variable High BM Low BM Div.Yield
High BM 7.33 41.70 -0.82 High BM 7.37 42.12 -0.83
Low BM 0.89 6.41 -0.70 Low BM 0.88 6.44 -0.70
Dividend yield -0.11 -0.11 1.00 Dividend yield -0.11 -0.11 1.00
Panel C: Unconditional Standard Deviations, Covariance and Correlations for Residuals
DATA QUADRATURE
Asset/Variable High BM Low BM Div.Yield Asset/Variable High BM Low BM Div.Yield
High BM 7.32 41.52 -1.27 High BM 7.35 41.94 -1.29
Low BM 0.89 6.40 -1.08 Low BM 0.89 6.43 -1.09
Dividend yield -0.88 -0.85 0.20 Dividend yield -0.88 -0.84 0.20

with Rte the risky asset returns excess of risk-free asset. When we
solve problem (35) for each sample path, y˜t∗ is computed through
dynamic programming by discretizing the state variable space. Tak-
ing into account the fact that y˜t∗ does not involve transaction costs,
it can be solved in short time.
Appendix D. Approximate Consumption for the Model with
Transaction Costs
When we adapt the heuristic policies to power utility frame-
work, we let the consumption for each period to be the one for
the model without transaction costs. We discretize first the state
variable space in order to implement dynamic programming pro-
cedure.
The VAR model is discretized using a variation of Tauchen and
Hussey (1991) Gaussian quadrature method, which has been de-
scribed in Balduzzi and Lynch (1999). The variation is designed to
ensure that d is the only state variable to predict the risky assets
returns. Specifically, for an VAR specified in (8)-(9), it assumes that
any return predictability is fully captured by dt . Without specify-
 1 −γ 
ing that the residual terms in (8) and (9) are uncorrelated, this
VAR model also implies that the following expression for stock re-
turns:
rt+1 = Ar + Br dt + ηt+1 + ut+1
where η is N × 1 vector of coefficients from a regression of et+1 on
t+1 , and ut+1 is a i.i.d. disturbance vector with zero mean and co-
variance matrix u , and is uncorrelated with t+1 . With this speci-
fication, we can first discretize dt using a variation of the Gaussian
quadrature method described by Tauchen and Hussey (1991) for a
first-order autoregressive process. Then, we can calculate a discrete
distribution for rt+1 for each {dt+1 , dt } pair from the transforma-
tion of dt , since (D.1) implies
rt+1 = Ar + Br dt + η (dt+1 − ad − bd dt ) + ut+1 ,
given the model followed by dt in (9). Follow-
ing Lynch (2001) and Lynch and Tan (2010), the discretization
is implemented so as to match both the conditional mean vector
and the covariance matrix for log returns at all grid points of
the predictive variable as well as the unconditional volatilities
of the predictive variables. We choose 19 grid points for the
dividend yield and 3 grid points for each of the stock-return
innovations since Balduzzi and Lynch (1999) find that the resulting
approximation is able to capture important dimensions of the
return predictability in the data. In Table D.10, we reproduce the
quadrature method based on the estimated VAR model given
in Lynch (2001). In this table, all the results are for continuously
compounded returns. Returns are expressed per month and in
percentages. The coefficients of determination are expressed in
percentages.
Besides, the Bellman equation corresponding to prob-
lem (4) with utility function (5), without transaction costs
is
Vt (dt )
1−γ
 c 1 −γ
(1 − ct )1−γ 
= max t
+ρ E xt Rt+1 + (1 − xt e )R f Vt+1 (dt+1 ) .
ct ,xt 1−γ 1−γ
(D.2)
Note that the above equation does not depend on previous stage
(D.1)
position. Starting from the last period, it costs no effort to solve
for the optimal consumption of each period at each node point by
backward iteration. In numerical experiments, the corresponding
consumption which is not on the grid can be computed by linear
interpolation.
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