Applied Economics

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Mean-variance portfolio selection with estimation

risk and transaction costs

Xiaoling Mei, Huanjun Zhu & Chongzhu Chen

To cite this article: Xiaoling Mei, Huanjun Zhu & Chongzhu Chen (2023) Mean-variance
portfolio selection with estimation risk and transaction costs, Applied Economics, 55:13,
1436-1453, DOI: 10.1080/00036846.2022.2097191

To link to this article: https://doi.org/10.1080/00036846.2022.2097191

Published online: 21 Jul 2022.

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APPLIED ECONOMICS
2023, VOL. 55, NO. 13, 1436–1453
https://doi.org/10.1080/00036846.2022.2097191

Mean-variance portfolio selection with estimation risk and transaction costs

Xiaoling Meia, Huanjun Zhub and Chongzhu Chenc
a
Department of Finance, School of Economics, Wang Yanan Institute for Studies in Economics, Xiamen, China; bDepartment of
Statistics, School of Economics, Wang Yanan Institute for Studies in Economics, Xiamen, China; cITG FUTURES CO., LTD, Xiamen, China

ABSTRACT KEYWORDS
There are many approaches that have been proposed to improve the empirical performance of the Portfolio optimization;
Markowitz mean-variance model. Designed to mitigate the impact of parameter uncertainty and transaction costs; market
estimation error, these approaches have delivered substantially better out-of-sample performance. impact; mean-variance
analysis
In this paper, we consider the portfolio optimization problem for a single-period investor facing
different types of transaction costs. By reformulating the rebalancing problem into a linear regres­ JEL CLASSIFICATION
sion framework, we show analytically that considering different transaction costs is equivalent to G10; G11
imposing additional constraints on the portfolio weights, thus providing desired properties such as
sparsity and stability in the trading strategy.

I. Introduction Kan and Zhou (2007) also prove analytically

Portfolio optimization has been one of the most
important practical problems in finance ever since
Markowitz (1952) lays the cornerstone of the mean-
variance analysis, where the investor rebalances her
portfolio based on two key inputs: expected return
and covariance matrix. When the investor knows
the true values of the above parameters, the optimal
portfolio position can be calculated by solving
a quadratic optimization problem.
However, the traditional mean-variance analysis
has been widely criticized due to its poor out-of-
sample performance, and it is well documented
that the poor performance is mainly caused by
two elements: estimation error and neglect of
transaction costs. To implement the mean-
variance analysis, one needs to estimate the mean
and covariance matrix from historical data, and
one possibility is to use their sample estimators.
While the Markowitz portfolio is very sensitive to
the errors in the estimates of the parameters, espe­
cially when the portfolio size is large. For instance,
Michaud (1989) shows that the mean-variance ana­
lysis tends to maximize the effects of errors in the
parameters, thus yielding even inferior perfor­
mance than simple equal-weighting schemes (i.e.
the N1 strategy).
that, with sample estimates, the simple plug-in
procedure can lead to very poor out-of-sample
performance. Moreover, DeMiguel, Garlappi, and
Uppal (2009) study the impact of estimation error,
by comparing the performance of 14 models with
the 1/N strategy. They find that with sample esti­
mates, no strategy can consistently beat the 1/N
strategy in terms of out-of-sample performance,
indicating the devastating effects caused by the
estimation error in the model inputs.
Several techniques have been proposed to
address the aforementioned issues. To deal with
the estimation error in parameters, one popular
approach is to use shrinkage estimators, which are
obtained by shrinking the sample estimator
towards a target; see, for instance, Ledoit and
Wolf (2003, 2004). Other important approaches
including Bayesian method (e.g. Barry 1974;
Pástor 2000), robust optimization method (e.g.
Goldfarb and Iyengar 2003; Garlappi, Uppal, and
Wang 2007; Rustem, Becker, and Marty 2000),
machine learning approach (e.g. Ban, El Karoui,
and Lim (2018)), and the method focusing on
minimum variance portfolio selection (e.g. Best
and Grauer 1991; Jorion 1991, 1985, 1986) are
also suggested to tackle the portfolio optimization
problem in the presence of estimation error.

CONTACT Huanjun Zhu hzhu928@xmu.edu.cn Department of Statistics, School of Economics, Wang Yanan Institute for Studies in Economics, Xiamen,
China.
© 2022 Informa UK Limited, trading as Taylor & Francis Group

Another important way to cope with parameter
uncertainty is to impose constraints on the portfo­
lio weights. For example, Jagannathan and Ma
(2003) study the mean-variance portfolio model
with no short-selling constraint and find that
imposing such constraint can help to improve the
out-of-sample performance significantly. They
further explain and demonstrate that constraining
portfolio weights to be nonnegative is equivalent to
shrinking the sample covariance matrix. In addi­
tion, Lp -normal regulation is also widely adopted.
For instance, DeMiguel et al. (2009) propose to use
the L1 -norm constraint or the L2 -norm constraint
on the portfolio weights. They show that the port­
folio performance has been largely improved even
in the presence of estimation error, and a link
between their approach and the existing procedure
has also been provided. Aside from that, Gotoh and
Takeda (2011) suggest using L0 -norm to improve
the out-of-sample performance, aiming to obtain
a sparse portfolio, which can partially mitigate the
impact of estimation error.
Apart from the parameter estimation error, con­
siderable attention has been given to transaction
costs over the past several years. For instance,
Pogue (1970) presents an extended version of the
Markowitz’s portfolio selection model without pro­
viding an analytical solution to this model. Since
transaction costs can easily erode the gains from
a trading strategy, especially when there is high
turnover, Atsushi (1996) points out that portfolio
strategy without considering transaction cost is
usually suboptimal. An increasing number of stu­
dies have emerged to seek solutions to portfolio
optimization model in the presence of various
types of transaction costs under different model
settings. Prior studies include Subrahmanyam
(1982), who studied the portfolio selection problem
with fixed transaction costs in a mean-variance
context. They provide a simple algorithm to solve
the optimization problem by imposing additional
restrictions on the covariance matrix. Dai, Xu, and
Zhou (2010) study a continuous-time Markowitz’s
mean-variance portfolio selection problem in
a market with a single risky asset in the presence
of proportional transaction costs. Gârleanu and
Pedersen (2013) and DeMiguel, Martn-Utrera,
and Nogales (2015) study analytically the optimal
APPLIED ECONOMICS 1437
solution to the model with quadratic transaction
costs in a multiperiod setting, and Mei, DeMiguel,
and Nogales (2016) provide some analytical results
on the optimal portfolio policy for an investor
facing multiple risky assets in the presence of gen­
eral transaction costs. See also Constantinides
(1986), Davis and Norman (1990), Liu (2004) and
more, for example.
In this paper, we study the impact and role of
transaction costs from a different perspective from
the existing literature. For a single-period mean-
variance investor who faces estimation error and
various types of transaction costs, we show that the
investor’s rebalancing problem can be written into
a linear regression form so that considering differ­
ent transaction costs is equivalent to imposing reg­
ularization constraints on the regression
coefficient. In this case, we can provide
a statistical tool to establish the rebalancing strate­
gies with desired properties, such as sparsity or
stability.
Li (2015) also considers the Markowitz mean-
variance portfolio optimization and reformulates
it into a linear regression form. He suggests
imposing different constraints on the portfolio
weights so that to generate desired portfolio
weights. Similarly, we rewrite the optimization
with a linear regression form, but we choose the
trading amount as our decision variable instead
of portfolio weights. It becomes a different pro­
blem. Moreover, our model focuses on coping
with various transaction costs, which distin­
guishes this paper from Li (2015), who does
not take into account transaction costs directly
in the optimization.
The main contributions of this paper are as
follows. First, we connect the portfolio rebalancing
models with transaction costs to penalized least
square regression models and prove that taking
different types of transaction costs into considera­
tion helps to develop portfolio rebalancing strate­
gies with desired properties. More specifically, this
paper shows that a rebalancing model with linear
transaction cost is equivalent to a classical mean-
variance model with the L1 constraint; incorporat­
ing linear market impact costs can be rewritten into
a regression model with L2 penalty; the model
considers that general market impact costs is
1438 X. MEI ET AL.

equivalent to a model with Lp constraint. Secondly, before rebalancing wt . More specifically, rewriting
we study a more general case incorporating both the objective function Equation (2.1) into an
linear and general market impact transaction costs, expression that is related to initial position wt
and further transform the aforementioned model yields:
into an elastic net regression form, but in a more n γ T^ o
general form. Finally, the third contribution is to w� ¼ argmax wTt μ^ w �wt
wt 2 t
analyse empirically the superior performance of the
proposed model, and further confirm the impor­ n γ T^ ^ γ T^ ^ γ T^ o
; argmax wTt ^μ w �wt þ γwTt �w w �wt γwTt �w t þ wt �wt
tance of incorporating transaction costs in the wt 2 t t
2 t 2

rebalancing process through extensive robustness n γ γ T^ o

check. ; argmax wTt μ
^ ðwt wt ÞT �ðw
^ t wt Þ ^
γwTt �wt þ wt �wt
wt 2 2
The rest of the paper is organized as follows.
n γ γ o
Section II presents the portfolio rebalance model ; argmax wTt ð^
μ ^ Þ
γ�wt ðwt wt ÞT �ðw
^ t ^
wt Þ þ wt T �w t
wt 2 2
and associated properties for an investor with dif­
ferent types of transaction costs. Section III exam­ n γ o
; argmax ðwt wt ÞT ð^μ ^ Þ
γ�w ðwt wt ÞT �ðw
^ t wt Þ
ines empirically the performance of the proposed wt
t
2
model, which helps to mitigate partly the para­
n γ T^ o
meter uncertainty and improve the out-of-sample ; argmax ΔwTb
~
μ Δw �Δw ;
performance through the use of assets from Δw 2
CSI300. Section V checks the robustness of the
where b ~¼μ
μ ^ γ�w ^ , an ‘adjusted’ mean vector
t
method, and Section V concludes.
that is related to initial position wt ,
and Δw ¼ wt wt .
The objective of doing such rewriting is twofold.
II. General framework
First, the investor concerns more about how much
Suppose that one investor manages N risk she should trade at each period, rather than the
assets whose excess returns in terms of risk- portfolio position in general. Second, such rewrit­
free rate follow a multivariate normal distribu­ ing is helpful when one needs to incorporate dif­
tion with mean μ and variance-covariance ferent types of transaction costs, so as to derive the
matrix �, where μ is an N � 1 column vector, analytical property of the trading strategy. The
� is an N � N positive-definite matrix. At any following proposition summarizes the base model
time t, the standard portfolio choice problem that we will consider throughout the paper.
with mean-variance utility can be expressed as:
γ T Proposition 1 Let wt denote the vector of initial
Uðwt ; μ; �Þ ¼ wTt μ w �wt ; (2:1) portfolio weight. For an investor with a mean-
2 t
variance utility, the optimal trading amount Δwfor
where γ is the relative risk aversion parameter of the the investor is:
investor, wt is the vector of portfolio weight. The n γ T^ o
quadratic form in Equation (2.1) guarantees the Δw� ¼ argmax ΔwTb ~
μ Δw �Δw ; (2:3)
existence of the optimal portfolio weights that max­ Δw 2
imize the utility. Given that μ and � are unknown, where b
~¼μ
μ ^ γ�w^ ,μ ^
t ^, �are the estimators of the
the portfolio weight is usually obtained by plugging mean and covariance matrix, respectively.
the estimator μ^ and � ^ into the utility function: Proposition 1 shows that, in the absence of
n transaction costs, a traditional mean-variance
� T γ T^ o 1 ^ 1
wt ¼ argmax wt μ ^ w �wt ; � μ ^ (2:2) investor chooses to trade
wt 2 t γ � 1 ^ 1b
Δw ¼ wt wt ¼ γ � μ ~, so that she could
Now let us focus on the rebalancing strategy of remain at the Markowitz position at all times.
an investor and rewrite the previous mean-variance However, if the investor is concerned about the
utility by taking into account the portfolio weight transaction costs she may incur, she would

incorporate the costs into the objective function
Equation (2.2) to avoid overtrading. More specifi­
cally, we consider a transaction cost function in
a general form cðθ; ΔwÞ, in which θ is a set of
transaction cost parameters that control the type
and form of the cost function. In this case, the
optimal portfolio selection becomes:
n γ T^ o asset i that measures the amount of costs paid by the
Δw ¼ argmax ΔwTb
�
~
μ Δw �Δw cðθ; ΔwÞ :
Δw 2
(2:4)
The existence of transaction costs in the objec­
tive function Equation (2.4) makes the trading
amount in Equation (2.2) not optimal anymore.
Alternatively, the investor seeks different types of
trading strategy depending on the specific type of
transaction costs. To better understand the objec­
tive function, let us consider an alternative form.
pffiffi ^ 1=2
By following Li (2015), define X ¼ γ� and
1 ^ 1=2 b
~, the expression of optimal rebalancing
y ¼ γ� μ
strategy in (2.3) indicates that Δw� ¼ ðX T XÞ 1 XT y,
and it coincides with the OLS estimator of the
linear regression model y ¼ XΔw þ e:
� �
Δw�OLS ¼ argmax ky XΔwk22 : (2:5)
Δw
In other words, the Markowitz mean-variance
model can be rewritten into a linear regression
form, where the decision variable is the vector of
trading weights. Consequently, the mean-variance
model with transaction costs in Equation (2.4) can
also be rewritten into a linear regression form with
regularization, where the form of the regularization
depends on the specific type of transaction costs. In
general, transaction costs include direct costs and
indirect costs. In subsequent sections, we will
explain the portfolio rebalance model with such
transaction costs with more details.
Linear costs and LASSO
It is known that direct costs usually refer to bro­
kers’ commissions and spreads, which are the dif­
ferences between the bid and ask prices. In terms of
such costs, it is usually expressed by a linear form
APPLIED ECONOMICS 1439
that is proportional to the amount of trading. More
specifically, the linear transaction cost function of
asset i incurred at each period is:
� �
ci ¼ τ i �wi wi � (2:6)
where wi is the weight right before rebalancing, and
τi is the proportional transaction cost parameter of
investor for each unit trading amount. For example,
in China’s stock market, investors would be charged
a commission fee from 0.02% to 0.3%. Besides,
stamp duty is imposed on sell-side investors. All
such costs can be expressed in a proportional form,
where the level of proportion is measured by the
exogenous transaction cost parameter τi .
As has been previously studied in the literature
(see Magill and Constantinides 1976 and many
others), when the linear costs are imposed into
a portfolio optimization model, the optimal port­
folio weights are usually confined by a no-trade
region. Consequently, the investor will not trade
only if the portfolio weight inherited from the pre­
vious period falls out of the no-trade region. In
other words, in the presence of transaction costs,
a rational investor will weigh up the costs and
benefits, to decide the optimal portfolio weights.
More specifically, when an investor is managing
a large number of assets, trading part of the assets
while keeping the others remained unchanged is
a desired strategy. Equivalently, a sparse Δw is
favourable since it can reduce the transaction
costs and further lower the portfolio variance
caused by the estimation error, especially when
the sample length is relatively small compared to
the number of assets N.
To simplify the analysis, we assume an equal
proportional transaction cost parameter τ across
different assets. The following proposition shows
that a sparse portfolio trading strategy can be
obtained by incorporating proportional transaction
costs directly into the mean-variance portfolio
optimization problem.
Proposition 2 Let τbe the proportional transac­
tion cost parameter, and the total linear costs be
cðτ; ΔwÞ ¼ τ k Δw k11 . The portfolio rebalance
model with such costs
1440 X. MEI ET AL.

n γ T^ o
ΔwLinear ¼ argmax ΔwTb
~
μ Δw �Δw τkΔwk11 costs. Incorporating proportional transaction
Δw 2 costs in the portfolio rebalance model helps to
(2:7) produce such a strategy. On the one hand, zero
trading amount reduces transaction costs and port­
is equivalent to the optimization problem: folio management fees. On the other hand, L1
n γ T^ o norm regularization can partly mitigate the impact
ΔwLinear ¼ argmax ΔwTb ~
μ Δw �Δw (2:8) of estimation risk, especially when the number of
Δw 2
assets is large. Also note that as the level of pena­
lization λ depends on the linear cost parameter τ,
s:t: k Δw k11 � s1 (2:9)
a higher value in τ would result in fewer transac­
Thus, the existence of linear transaction costs auto­ tions in our model and thus decreases the overall
matically imposes a sparsity constraint on Δw, where transaction cost.
sis a proper threshold that controls the level of sparsity.
Quadratic costs and ridge regression
Remark.
� � � � Besides the linear form, transaction costs in
� �
�U Δw; b ^
~; �
μ ~; �Þ�
U ðΔw; μ a quadratic form are also widely considered in the
γ ^ portfolio selection literature. This type of transac­
� kb ~ μ
μ ~k1 kΔwk1 þ k� �k1 kΔwk21 tion cost is usually modelled when large trades are
2
(2:10) made and the market price is impacted by such
pffiffi ^ 1=2 trades. More specifically, the asset prices will be
Furthermore, let us define again X ¼ γ� impacted when there is a large trade, such that
^ 1=2b
and y ¼ 1γ � ~, optimizing Equation (2.7) yields:
μ the investor will place her transaction with a less
� � favourable price. The linear costs in Section 2.1,
ΔwLinear ¼ argmin ky XΔwk22 þ λkΔwk11 ; which are usually used to measure the costs of
Δw
small trades, are not capable of capturing such
(2:11)
price impact.
where λ ¼ 2τ � 0. The optimal trading amount is However, it is difficult to fully characterize the
the solution to the foregoing penalized least impact of large trades on stocks since many factors,
squares with an L1 norm regularization (LASSO), such as the stock market value, the price, and trad­
which is proposed by Tibshirani (1996) and has ing time (see Foster and Viswanathan 1993; Engle,
been widely used in statistics and economics, due Ferstenberg, and Russell 2006; Gârleanu and
to its favourable performance in variable selection Pedersen 2013) can cause the drift of stock prices.
and robustness against estimation error. Hence, In addition, institutional investors usually split lar­
incorporating the proportional transaction costs ger orders into smaller ones to reduce the costs
automatically imposes a sparsity constraint on the caused by market impact. For this reason, a large
decision variable Δw. number of existing studies in the broader literature
However, unlike the traditional Lasso, the para­ have focused on the trade-off between the market
meter λ in the penalty term is related to the pro­ impact and opportunity cost to minimize the total
portional transaction cost parameter τ. More cost (for example, volume-weighted-average-price
specifically, when there are no transaction costs strategy in Berkowitz, Logue, and Noser 1988).
(τ ¼ 0), λ ¼ 0, given that the investor has no Others have also focused on deriving the explicit
need to pay for trading amount Δwi ; i ¼ 1; . . . ; N; form of the transaction costs in the presence of the
when there are linear transaction costs (τ�0), Δw� market impact. For instance, Kyle (1985) proposes
are shrunk towards zero in the sense that the assets to use a linear function of the trading amount to
receiving a small trading amount may be excluded characterize the price impact induced by large
from the trading strategy. trades. Consequently, it implies that the total
In other words, a sparse trading strategy is costs incurred by the investor are in a quadratic
desired for an investor who incurs transaction form:

cit ¼ βi ðwi;t wi;t Þ2 (2:12)
where βi is the quadratic transaction cost para­
meter which is unknown and needed to be esti­
mated through regressions. Gârleanu and Pedersen
(2013) consider a model with such costs and
assume βi to be proportional to the variance of
the asset prices.
It has been well documented that due to estima­
tion error problems, extreme positions are usually
observed in the mean-variance portfolio. When an
investor is managing a large portfolio, the situation
would be aggravated since more extreme positions
indicate a larger impact on the market prices, lead­
ing to less favourable deal prices and higher trans­
action costs. Consequently, building a stable
portfolio is desirable for an investor managing
a large portfolio.
In order to mitigate the impact of estimation
error and build a more stable portfolio, we incor­
porate the quadratic transaction costs into the
portfolio rebalancing model. For the sake of con­
venience, we consider an investor who incurs
quadratic transaction costs with the form
c ¼ β k Δw k22 , where β is the quadratic transac­
tion cost parameter identical across all assets. Note
that with our model setting, a larger portfolio will
cause a more significant market impact for each
percentage change in the portfolio weight. The
following proposition summarizes our main
findings.
Proposition 3 Let βbe the quadratic transaction
cost parameter, and the total costs be c ¼ βPΔwP22 .
The portfolio rebalance model with such costs
n γ T^ o estimation error by confining the extreme transac­
Δwquadratic ¼ argmax ΔwT b
~
μ Δw �Δw βkΔwk22
Δw 2
(2:13)
is equivalent to the optimization problem:
n γ T^ o
Δwquadratic ¼ argmax ΔwTb
~
μ Δw �Q Δw ;
w 2
(2:14)
where �^Q ¼ � ^ þ 2β I. Moreover, it can be written
γ
into a penalized regression
APPLIED ECONOMICS 1441
� �
Δwquadratic ¼ argmin ky XΔwk22 þ λ2 kΔwk22 ;
Δw
(2:15)
pffiffi ^ 1=2 ^ 1=2b
where λ2 ¼ 2β, X ¼ γ� and y ¼ 1γ � ~.
μ
The detailed proof is shown in the Appendix.
Note that, solving Equation (2.14) indicates that
incorporating quadratic transaction costs into the
portfolio rebalancing model is equivalent to the
model that, instead of including the transaction
costs, shrinks the sample covariance matrix
towards the identity matrix I with shrinkage para­
meter 2β γ . Consequently, as mentioned in Ledoit
and Wolf (2004, 2003) and Li (2015), shrinking the
covariance matrix can help to mitigate the impact
of estimation error in sample covariance matrix,
thus providing more stable portfolio weights and
better out-of-sample performance.
More specifically, the explicit trading amount in
the presence of quadratic transaction costs is
^ þ 2β IÞ 1b
Δwquadratic ¼ 1γ ð� ~. Note that the para­
μ
γ
meter λ2 , which serves as the level of regularization
for the ridge regression, is related to quadratic
transaction cost parameter β: λ2 ¼ 2β. Moreover,
the amount of trading is a linear transformation of
the amount of trading in the absence of transaction
costs: Δwquadratic ¼ ðI AÞΔw with
γ ^ 1
A ¼ ðI þ 2β �Þ , and it is easy to show that the
amount of trading is shrunk towards zero
when λ2 ! 1.
It is noteworthy that the purpose of incorporat­
ing quadratic transaction costs into the portfolio
rebalancing model is different from that of the
proportional transaction costs, although both of
them aim at providing better out-of-sample perfor­
mance. The former seeks to mitigate the impact of
tion through a ridge-type regression, thus provid­
ing a more stable rebalancing strategy, while the
latter focuses on confining the number of assets
involved in the transaction.
General cost and elastic net
Compared to linear price impact as mentioned in
Section 2.2, Almgren et al. (2005) point out that the
square-root rule is more appropriate for modelling
the price impact: ΔP% / Qp , where usually p � 0:5
1442 X. MEI ET AL.
or 0.6 other than 1.0 as considered in Kyle (1985),
since large orders are often split to reduce the
market price impact. For instance, Moro et al.
(2009) study the case of Madrid stock exchange
and London stock exchange, and find that p � 0:5
and p � 0:7, respectively. Toth et al. (2011) also
find a value of smaller than 1 for the future market.
Consequently, if we use a function to measure such
impact, the resulting form would be approximately:
cit ¼ κi jwi;t wi;t jp (2:16)
where κi is a general transaction cost parameter
and p 2 ð1; 2Þ is used to measure the level of mar­
ket price impact.
For simplification, let us consider the case where κi
p
is identical for each asset: c ¼ κ k Δw kp . So the
portfolio rebalancing model in the presence of such
costs is:
n γ T^
Tb
Δwgeneral ¼ argmax Δw μ ~ Δw �Δw κkΔwkp :
w 2
(2:17)
Analogously, model Equation (2.17) can be writ­
ten into the following penalized linear model:
� �
Δwgeneral ¼ argmin ky XΔwk22 þ λp kΔwkpp ;
w market impact parameter p that controls the
(2:18)
pffiffi ^ 1=2
where λp ¼ 2κ, X ¼ γ� ^ 1=2b
and y ¼ 1γ �
Consequently, imposing general transaction costs
is equivalent to considering a bridge regression
with 1 < p < 2. It results in a stable trading strategy,
similar to the case with quadratic transaction costs.
However, when an investor is managing a large
portfolio with many assets, a sparse trading strategy
is also desired.
To build such a strategy, a natural way is to
incorporate a variable selection regularization into
the model. Also note that, besides the market
impact costs, an investor also incurs linear costs.
Consequently, incorporating both the linear costs
and market impact costs into the portfolio rebalan­
cing model yields:
n γ T^
�
Δw ¼ argmax Δw μ Tb
~ 1
Δw �Δw τkΔwk1 κkΔwkp : p a sparse trading strategy, which is desired for an
2
Δw
(2:19)
Model Equation (2.19) then provides an investor
with a trading strategy that is both sparse and
stable. More importantly, it characterizes more
precisely the impact of large trades on the market
prices. The following proposition further shows
that our proposed model is related to a regression
with an elastic net regularization (see Zou and
Hastie 2005), but with a more general form:
Proposition 4 Consider a portfolio rebalancing
p
model with total costs c ¼ τ k Δw k11 þκ k Δw kp
in Equation (2.19), which is equivalent to the opti­
mization problem:
� p�
wgeneral ¼ argmin Py XΔwP22 þ λ1 PΔwP11 þ λp PΔwPp ;
w
(2:20)
where λ1 ¼ 2τand λp ¼ 2κ. If we further define
λp
αp ¼ λ1 þλ p
and λ ¼ λ1 þ λp , then:
o Δw� ¼ argmin�Py XΔwP22 þ λ� 1 αp �PΔwP11 þ αp PΔwPpp ��:
p
Δw
(2:21)
Our proposed model enjoys several advan­
tages compared to the linear model with elastic
net regularization. On the one hand, our model
framework is more general in the sense that, the
stability can provide a strategy that performs at
least as well as the one from the elastic net, if we
~.
μ allow the parameter p to be obtained through
cross validation. On the other hand, our model
allows us to incorporate simultaneously the pro­
portional transaction costs and the general mar­
ket impact costs, although the parameter p is
now given exogenously.
Also note that when we consider only the
general costs, the consequent model can be writ­
ten as a penalized least-squares regression with
Lp regularization, resulting in a stable but not
sparse trading strategy; when both general costs
and linear costs are incorporated, the model is
equivalent to a least square regression with both
Lp and Lp regularization. And due to the exis­
tence of a Lp norm penalty, our model also gives
o
investor who manages a large number of assets,
thus providing better out-of-sample perfor­
mance compared to the model that ignores
transaction costs.
 APPLIED ECONOMICS 1443

III. Empirical analysis is repeated by adding the risky asset returns of the
next period to the dataset and dropping the earliest
In this section, we study empirically the out-of-
sample performance of our proposed model in return, until the end of the dataset is reached.
the presence of various transaction costs and com­ Using this rolling window procedure, we are able
pare it with that of the models without considering to obtain T t out-of-sample returns. We then
the transaction costs before the transaction based compare the out-of-sample performance of the
on a real dataset. More specifically, we use the strategies through the Sharpe ratio computed in
constituent stocks of CSI 300 as our asset pool, the following way:
which represents the largest stocks of China’s �p
μ
A-share market. We consider weekly returns of SR ¼ ; (3:1)
σp
these assets ranging from January 2009 to
April 2019. After removing the stocks whose IPO
1 X
T 1
dates are after 2009 and those that have been sus­ �p ¼
μ ðrp;tþ1 rf Þ; (3:2)
pended for more than half a year, there are 161 T s t¼s
assets remaining in our asset pool. For simplicity,
we consider the case with N ¼ 100, including the 1 X
T 1

remaining top 100 companies by market value. We σp ¼ ½ðrp;tþ1 rf Þ � p �2 ;

μ (3:3)
T s 1 t¼s
consider a relative risk aversion of γ ¼ 3:87,1 and
the 7-day interbank rate as the risk-free rate. where we denote the next period assets return as
The models proposed in this paper (including rtþ1 ¼ ½r1;tþ1 ; r2;tþ1 ; . . . ; rN;tþ1 �T with
cost function, ICF for short) are compared against T
rp;tþ1 ¼ wt rtþ1 , and rf is the risk-free rate. We
several classic portfolio rules in the literature: (1) also report the out-of-sample Sharpe ratio net of
the Markowitz mean-variance portfolio based on various types of transaction costs:
the sample mean and sample covariance (MV), (2)
�p;tc
μ
the global minimum variance portfolio based on SRtc ¼ ; (3:4)
the sample covariance matrix (GMV), (3) the naive σ p;tc
strategy that allocates equally across all the assets
(1/N). Note that for the first two strategies, we use 1 X
T 1
net
�p;tc ¼
μ ðrp;tþ1 rf Þ; (3:5)
the sample estimators as model input, in order to T s t¼s
show the impact of estimation error on the portfo­
lio performance and the advantage of incorporat­ X
T 1
1
ing transaction costs in the portfolio rebalancing σ p;tc ¼ net
½ðrp;tþ1 rf Þ �p;tc �2 ; (3:6)
μ
model. T s 1 t¼s
To evaluate the performance of the considered net
with rp;tþ1 ¼ rp;tþ1 cðθ; ΔwÞ, and Δw ¼ wt wt
models, we conduct a rolling window approach as where wt ¼ wTt 1 ð� þ rt Þ=ð1 þ rp;t Þ is the portfolio
follows. Given a dataset of asset returns (which
weights before rebalancing with � ¼ ð1; . . . ; 1ÞT .
consists of N risky assets and T weekly observa­
Besides Sharpe ratios, we also report the total
tions), we choose an estimation window of length
transaction costs incurred under each rebalancing
t ¼ 364 weeks (7 years). In each week s, starting strategy (denoted as TC), the average number of
from s ¼ t þ 1, we estimate the parameters needed nonzero elements in Δw over the out-of-sample
to implement the previous models. These para­ period (denoted as Rebalance), and the ratio of
meters are then used to determine the portfolio portfolio variance from an alternative model to
weights. We then use these weights to compute that from our proposed model (denoted as
the portfolio return in week s þ 1. The procedure Variance).
1
Wang and Cai (2011) use CSI 300 index to represent risk assets, and found that γ is between 3 and 6 according to questionnaires. In this paper, we use the
median of γ ¼ 3:87 as a representative.
1444 X. MEI ET AL.
For the setting of transaction cost parameters,
note that it is usually the case that commission fee
for both sellers and buyers ranges from 0.02% to
0.3% in China’s stock market, depending on the
bargaining power of brokers. And transfer fee (only
in Shanghai stock exchange) also exists and is
charged bi-directionally at a level of around
0.002%. Moreover, stamp duty is charged in both
the Shanghai and Shenzhen stock exchange at
a rate of 0.1% (only on the seller’s side).
Consequently, we consider a level of 300 basis
points (τ ¼ 0:3%) for the model with proportional
transaction costs in the base case for the purpose of
simplification. To obtain a proper value of the
quadratic transaction cost parameter, we look into
the price impact index, which denotes the percen­
tage of price change when the turnover is
0.1 million CNY. According to The Performance
of Shanghai Stock Exchange (2018) and The
Performance of Shenzhen Stock Exchange (2017),
the price impact index is about 0.1%. Note that β
is related to the portfolio size M, we thus have
β ¼ 1=2 � ðM � 0:10%Þ=ð10 � 104 Þ ¼ 5 � 10 9 M
. Equivalently, β ¼ 0:5 with 0.1 billion CNY, and
1:0 with 0.2 billion CNY. Finally, for the case with
general transaction costs, the cost function is con­
p
sidered to be c ¼ κ k Δw kp , where p 2 ð1; 2Þ is the
market impact costs parameter, and κ is related to
the liquidity level of the asset as well as the size of
the portfolio.
Results
Proportional transaction costs
Table 1 reports the out-of-sample performance of
our proposed model with proportional transaction
costs against other portfolio rules. In terms of the
Sharpe ratio, the model incorporating transaction
costs outperforms the other strategies, both before
and after deducting linear costs. The main reason is
that, for the MV portfolio rebalancing model and
the GMV model, the error in the sample estimators
Table 1. Out-Of-Sample performance with linear costs.
Portfolio rule SR Rτ Variance Rebalance
ICF 0.0540 0.0529 1.0000 1.5740
MV −0.0506 −0.2306 3.5205 100.0000
GMV 0.0262 −0.0316 0.3190 100.0000
1/N 0.0369 0.0340 0.4493 99.2367
leads to an extremely unstable trading strategy,
thus resulting in overtrading in the out-of-sample
period. Not surprisingly, the GMV strategy pro­
vides the lowest out-of-sample portfolio variance,
although it leads to negative average return after
deducting the transaction cost. Moreover, the ICF
model we propose results in the lowest average
number of assets in the transactions, due to the
existence of the cost term which is equivalent to
an L1 norm penalty. Furthermore, our model
incurs the least total costs, followed by the N1 strat­
egy, which is also considered to be a simple but
stable trading strategy (see DeMiguel, Garlappi,
and Uppal 2009).
Figure 1 shows the cumulative return net of
linear cost for different portfolio rules. In the pre­
sence of proportional transaction costs, our pro­
posed model dominates the other strategies, with
a return of 38.86% ranging from January 2016 to
April 2019, while that of the CSI 300 index
is 4.88%.
As mentioned in Section 2.1, the benefits of
incorporating transaction costs in the portfolio
rebalancing model are twofold: (i) after impos­
ing transaction costs, the portfolio rebalancing
model can be rewritten into a least square pro­
blem with an L1 penalty, thus mitigating the
impact of risk in the sample estimators to
some extent; (ii) with the form of proportional
transaction costs, the sparsity in the trading
amount Δw reduces greatly the turnover at
each period, thus providing higher average
return and Sharpe ratios.
Quadratic transaction costs
When we consider large transactions and linear
market impacts, quadratic transaction costs should
be imposed in the rebalancing model. Note that the
quadratic costs parameter β is related to the port­
folio size. Consequently, to show the advantage of
our proposed model, we list the out-of-sample
performance of different portfolio rules based on
different values of β. For example, when β ¼ 0:5, it
indicates that when the weight is adjusted by 1%,
TC the return rate net of transaction cost will decrease
0.0090 by 0.005%. Table 2 shows the out-of-sample per­
6.0959
0.1752
formance of different strategies when β ¼ 0:5
0.0127 and β ¼ 1:0.
 APPLIED ECONOMICS 1445

Figure 1. Cumulative return under linear cost.

Table 2. Out-Of-Sample performance with quadratic cost.

Portfolio SR Rτ Variance Rebalance TC
β ¼ 0:5 ICF 0.0312 0.0299 1.0000 99.9527 0.0109
MV −0.0506 −0.2385 257.7637 100.0000 537.6007
GMV 0.0262 −0.0829 0.5841 100.0000 0.5032
1/N 0.0369 0.0366 0.4902 99.2367 0.0011
β ¼ 1:0 ICF 0.0566 0.0555 1.0000 99.9704 0.0076
MV −0.0506 −0.2381 657.6871 100.0000 0.1075E4
GMV 0.0262 −0.1099 1.2273 100.0000 1.0065
1/N 0.0369 0.0364 0.6252 99.9367 0.0022

For the case of β ¼ 0:5, the N1 strategy over­ quadratic transaction costs with β ¼ 1.
whelms the others in terms of Sharpe ratio and Figure 2(a) shows that the ICF model generates
portfolio variance, as well as total transaction the highest cumulative return of over 40%, fol­
costs incurred in the out-of-sample period. Note lowed by a 21% return from the N1 strategy. With
that the portfolio rebalancing model incorporating
an equal-weight initial portfolio, each rebalancing
quadratic transaction costs is equivalent to a ridge
regression form about Δw, thus it provides a linear strategy incurs large transaction costs in the first
shrinkage on Δ based on the mean-variance model. period, while incorporating transaction costs in the
The shrinkage intensity depends on the quadratic model can partly alleviate such high costs. More
transaction cost parameter β: with a small β, the specifically, our proposed model shows that, the
shrinkage intensity is small as well, thus leading to optimal allocation for the first week is:
a trading strategy that is close to Markowitz’s � �
γ T^ 1 2
mean-variance strategy; with a higher β, our ICF Δw� ¼ argmax ΔwT b
~μ Δw �Δw βPw P (3:7)
Δw;�T w¼1 2 N 2
model with quadratic transaction costs outper­
forms the others in terms of the Sharpe ratio, due when β ! 1,
to a more stable trading strategy derived from � �
a stronger shrinkage intensity. � 1
w ¼ argmax βPw P
We also show graphically the cumulative return Δw;�T w¼1 N
� �
of our proposed model against the other strategies, 1 1
¼ argmax Pw P ¼ lN�1 (3:8)
including the CSI300 index, after charging Δw;�T w¼1 N N
1446 X. MEI ET AL.

Figure 2. Cumulative returns with quadratic costs.

Note that the value of β depends on the size of the portfolio under management. To demonstrate its impact, Figure 3 shows the
Sharpe ratios net of costs for different values of β. When β is below 1.5, the out-of-sample performance is improved as β increases,
since the instability of the model can be alleviated with a higher level of penalization. However, when β is above 1.5, the decline in
return from rising costs dominates, thus resulting in a declining Sharpe ratio net of transaction costs for an increasing β.

Figure 3. Sharpe ratio for different βs.

That is, as the value of β increases, the opti­
mal portfolio with quadratic cost will eventually
converge to the N1 portfolio, while the GMV
portfolio rebalancing policy costs much more
than the other strategies in the first period, due
to the absence of considering transaction costs.
To mitigate the impact of the initial position, we
also show the cumulative return that excludes
the first period. As it has been shown in
Figure 2b, the model that considers quadratic
cost still outperforms the others, while that of
the global minimum variance remains the
lowest.
General transaction costs
To characterize the market price impact more
properly, the general transaction costs are also con­
sidered in our model. For the cost form, c ¼ κ k
p
Δw kp with p 2 ð1; 2Þ, κ is usually related to spe­
cific asset liquidity and portfolio size, and p is used
 APPLIED ECONOMICS 1447

Table 3. Out-Of-Sample performance with general costs. both before and after deducting transaction costs.
Portfolio SR Rτ Variance Rebalance TC
Besides, the portfolio variance of our model
p = 1.4 ICF 0.0450 0.0446 1.0000 83.3669 0.0020
MV −0.0506 −0.4531 64.9490 100.0000 132.64 declines rapidly compared to the mean-variance
GMV 0.0262 −0.1952 0.9236 100.0000 0.9016 portfolio and is close to that of the global mini­
1/N 0.0369 0.0325 0.9422 99.2367 0.0191
p = 1.5 ICF 0.0594 0.0584 1.0000 94.4260 0.0051 mum variance strategy and the N1 strategy. More
MV −0.0506 −0.3992 58.2715 100.0000 123.7416
GMV 0.0262 −0.1323 0.7191 100.0000 0.5916
importantly, the total cost of the proposed model
1/N 0.0369 0.0348 0.7975 99.2367 0.0090 is the lowest and the trading amount Δw is sparse,
p = 1.6 ICF 0.0622 0.0610 1.0000 98.4320 0.0081
MV −0.0506 −0.3550 49.7963 100.0000 117.1169 due to the presence of both general transaction
GMV 0.0262 −0.0873 0.5414 100.0000 0.3965 cost that controls stability, and the linear transac­
1/N 0.0369 0.0360 0.6397 99.2367 0.0042
tion costs that regulate the sparsity. Note that
these two properties are important to build an
to model the extent to which transactions move the efficient portfolio, especially when the number of
price of the assets. Table 3 shows the out-of-sample risky assets is large: when the amount of adjust­
performance of our proposed model against the ment in each period is sparse, the investment
others for several values of p. manager may pay more attention to the stocks
It shows that the out-of-sample performance of with larger adjustments and ignore the assets
the model that considers general costs is much with little adjustment. This not only reduces the
better than that of other portfolios in terms of the transaction costs and management fees but also
Sharpe ratio net of costs. The variance and total increases the stability of the portfolio. Moreover,
transaction cost are far smaller than those of the the penalty term combining L1 with Lp can deal
MV model for different p, which confirms that the with problems that have multicollinearity issue,
imposing p-norm penalization can help to improve and meanwhile avoid excessive sparsity like
the stability of the model. Note that the number of LASSO2
active assets in our model is close to N, implying Analogously, Figure 4 shows the cumulative
return net of costs of our proposed model and
a non-sparse but stable trading strategy, as shown
other strategies, including CSI300 index. It
in Section 2.3.
shows that the model incorporating transaction
After taking into account both the linear
costs dominates the CSI300 and the other port­
costs and market impact costs, the investor
folio models, by reaching 23.90% after deducting
now incurs total transaction costs:
p 1
transaction costs, while that of the CSI300 is
cðθ; ΔwÞ ¼ k k Δw kp þτ k Δw k1 . In this sec­
only 4.88%.
tion, we propose to consider a portfolio reba­
We also study the performance of our pro­
lancing model incorporating both parts.
posed model depending on different pairs of
Table 4 shows the out-of-sample performance
cost parameters. More specifically, we would
of each rebalancing policy, where the linear
like to investigate how these parameters affect
cost parameter τ ¼ 0:003, and general cost
the sparsity and out-of-sample Sharpe ratios.
parameters κ ¼ 0:1 and p ¼ 1:5.
Intuitively, for a fixed market impact costs para­
In this case, our model still outperforms the
meter κ, a higher τ means a stronger penalization
other strategies in terms of different performance
on the L1 norm, thus leading to a more sparse
evaluation criteria: it has the highest Sharpe ratio,
trading strategy Δw. Figure 5a further confirms
our discussion. In addition, for a fixed value of τ,
Table 4. Out-Of-Sample performance with general costs and an increasing κ indicates αp ! 1, thus
linear costs. a dominating weight on Lp norm penalization.
Portfolio SR Rτ Variance Rebalance TC Consequently, a first increase and then a stable
ICF 0.0418 0.0414 1.0000 20.2899 0.0016
MV −0.0506 −0.4093 70.6400 100.0000 129.8355
average number of active assets are observed.
GMV 0.0262 −0.1718 0.8807 100.0000 0.0767 To demonstrate the superior performance of
1/N 0.0369 0.0319 0.9453 99.2367 0.0216
the proposed model, Figure 5b graphs the
2
The average active asset is only 1.57 for the case with linear costs, while that of the case with both rises to 20.29..
1448 X. MEI ET AL.
Figure 4. Cumulative returns with general and linear costs.
Figure 5. Performance for different k and τ with quadratic costs.
Sharpe ratios of our model against N1 strategy
based on various pairs of transaction cost para­
meters.Not surprisingly, our model always out­
performs the N1 strategy, after accounting for
both types of transaction costs.
IV. Robustness check
To demonstrate the robustness of the proposed
model and the importance of incorporating trans­
action costs during the decision process, we also
consider other empirical settings, including differ­
ent datasets, window lengths, and adding con­
straints to the model.
Randomly selected dataset
Previously, the 161 assets from CSI300 are
selected by excluding the unlisted ones in
January 2009, and the ones that are suspended
for more than six months. Among them, we
choose the top 100 assets with the largest market
 APPLIED ECONOMICS 1449

Figure 6. The distribution of Sharpe ratio differences between two models.

value. In this section, we randomly select a subset Window length

of N ¼ 100 assets out of the 161 assets. And we
As has been pointed out in Barry (1974), the dis­
calculate the Sharpe ratios after deducting costs
tribution of security prices can be unstable because
from the four models we have considered. We
repeat the random selection 100 times, based on of the structural changes in companies, markets,
the setting of linear costs parameter τ ¼ 0:003 and and the economy, leading to a changing distribu­
general costs parameters κ ¼ 0:1 and p ¼ 1:5. tion of asset returns over time. Consequently, the
Moreover, we take the proposed model corporat­ latest data is relatively more important than the old
ing both proportional and market impact costs as ones when estimating the mean and covariance
the benchmark model and subtract the Sharpe matrix. As a result, the impact caused by parameter
ratios of other models. If SRICF
1=N
SRτ > 0, the uncertainty will be intensified for a given historical
τ
proposed model is considered to be better than dataset. For instance, DeMiguel, Garlappi, and
the N1 model. Uppal (2009) show, based on U.S. stock market
Figure 6 shows the frequency histogram of data, that to outperform the N1 strategy, the
our model compared against the N1 strategy, required estimation window length for a sample-
the GMV and the traditional MV portfolio. It based mean variance (MV) model is approximately
shows that our model dominates both the global 3,000 months for a 25-asset portfolio, and 6000
minimum variance model and the mean- months for a 50-asset portfolio.
variance model over all the randomly selected To mitigate the impact of improper estimation
datasets, indicating the importance of incorpor­ of window length and demonstrate the robustness
ating transaction costs during the decision pro­ of our model, we consider different window lengths
cess, while the Sharpe ratios of the N1 model ranging from 2 years to 6 years. Table 5 reports the
barely beats that of our model. Introducing the
transaction costs can partly reduce the para­ Table 5. Out-Of-Sample performance for different window length.
meter uncertainty, which further results in Portfolio SR Rτ Variance Rebalance TC
Window length=2 years (Observation=103)
a sparse and stable trading strategy. It is not ICF 0.0494 0.0424 1.0000 42.6071 0.0593
surprising that the out-of-sample performance MV 0.0614 −0.2795 3.8825E6 100.0000 3.1339E7
GMV −0.0168 −0.7745 25.9744 100.0000 580.1117
is in general better than the N1 strategy, whose 1/N 0.0537 0.0439 0.7380 99.6118 0.0608
position is also stable but lacks the improvement Window length=4 years (Observation=206)
ICF 0.0590 0.0582 1.0000 22.7205 0.0093
in potential utility brought by the mean. Also MV −0.1067 −0.1846 0.8587E4 100.0000 1.8381E4
note that there are very few (8 out of 100 ran­ GMV 0.1074 −0.2763 0.8793 99.9876 3.7601
1/N 0.0785 0.0736 0.8273 99.5217 0.0482
dom subsets) cases where the N1 strategy is bet­ Window length=6 years (Observation=309)
ter than our model, which can be partly ICF 0.0435 0.0431 1.0000 17.2922 0.0024
MV −0.1361 −0.1031 0.2584E4 99.9954 0.2029E4
explained by the impact of extreme parameter GMV 0.0887 −0.1318 0.7401 99.9908 1.1935
uncertainty raised in some datasets. 1/N 0.0442 0.0396 0.9381 99.3699 0.0331
1450 X. MEI ET AL.
Table 6. Out-Of-Sample performance with shortsell constraint.
Portfolio SR Rτ Variance Nonzero Rebalance
Window Length=2 years, with shortsell constrain
ICF 0.0621 0.0610 1.0000 42.0282 19.3200
MV 0.0573 −0.0974 1.1675 5.6612 6.4447
GMV 0.0855 −0.0050 0.5574 38.1224 40.9953
1/N 0.0537 0.0439 0.7380 100.0000 99.6118
out-of-sample performance based on various cri­
teria of different models. As the window length
decreases, the instability in the rebalancing strategy
caused by a larger error in the estimation of μ and
� aggravates, resulting in worse out-of-sample per­
formance in all models, excepting the N1 strategy
that does not require estimation. Consequently, the
1 with Jagannathan and Ma (2003).
N strategy outperforms the others when the win­
dow length is 2 years. While when the estimation
window length increases to 6 years, our proposed
model with transaction costs beats the others, indi­
cating that a longer window helps to embody
sufficient information required for parameter esti­
mation, and to further improve the performance of
the models that rely on estimation.
Adding constraint
In previous empirical examples, we do not consider
any portfolio constraints that confine the investor’s
trading strategy. In this section, we would like to
show how the trading strategies are affected by add­
ing a short-selling constraint. Table 6 lists the out-of
-sample performance, with a window length of 2
years. The idea of considering such a short window
length is to amplify the impact of adding such con­
straints during rebalancing. It shows that the perfor­
mance of the mean-variance model and the global
minimum variance model is significantly improved,
as the short-selling constraint helps to prevent
extreme weights. As it has been pointed out in
DeMiguel et al. (2009), adding the short-selling con­
straint results in a similar shrinking effect when
considering the L1 constraint, since negative weights
would be shrunk to zero, which generates sparse
portfolios. For instance, the mean-variance model
only invests 5.66 stocks on average, while that of the
global minimum variance model is 38.12, far less
than the one before a short-selling constraint.
In addition, the N1 strategy no longer beats
TC the others, as the instability in the first three
0.0178 models can be reduced by adding short-selling
3.0777 constraint. And note that our proposed model
0.0855
0.0608 now dominates in terms of out-of-sample
Sharpe ratios. This can be explained in the
sense that, since the sparse portfolio is being
produced by adding a short-selling constraint,
the transaction costs can thus be reduced
through lower turnover. Furthermore, as has
been shown from the variance, adding a short-
selling constraint prevents extreme negative
positions; therefore, it increases the stability of
the rebalancing strategy, which is consistent
V. Conclusion
The classical Markowitz mean-variance is not
applicable in practice, usually due to the lack of
consideration of important factors, such as para­
meter uncertainty and transaction costs. While
parameter uncertainty is mainly caused by the esti­
mation error in model inputs μ and �, and transac­
tion costs have different forms depending on the
size of the portfolio. In this article, we investigate
the roles of various transaction costs in portfolio
rebalancing problems, and show the advantage of
imposing transaction costs in dealing with the
impact of parameter uncertainty and producing
a rebalancing strategy with desired properties.
By rewriting the classical mean-variance model
into a least square regression problem, we find
that considering proportional transaction costs is
equivalent to adding an L1 norm penalization,
which helps to produce a sparse rebalancing strat­
egy. When market impact costs are considered,
the portfolio rebalancing model can be trans­
formed into a least square regression with differ­
ent norm penalties, depending on how we
characterize the impact of the transactions on
the asset prices. We further show that these penal­
ties are crucial for an investor who wants to ease
the effect of estimation error. Finally, empirical
analysis and robustness check show the superior
out-of-sample performance of our proposed
model, and the model that ignores transaction

costs may suffer a large loss due to uncertainty in
model parameters.
Acknowledgements
We are grateful to the editor and the anonymous referee for
their constructive comments.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Funding
The work was supported by the National Natural Science
Foundation of China [71901186,71903166,71988101];
Natural Science Foundation of Fujian Province
[2019J05013]; the Ministry of Education in China (MOE)
Project [19YJC790206]
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 APPLIED ECONOMICS 1453

� � 1
Appendix 1 ^ 2β ^�^ 1b
¼ �þ I � ~
μ
γ γ

Proof of Proposition 3: Rewrite the objective func­ � � 1

tion with quadratic transaction cost cðβ; ΔwÞ ¼ β k 2β ^ 1 1 ^ 1b
¼ Iþ � � μ~
γ γ
Δw k22 yields:
n γ T^ o
Δw ¼ argmax ΔwTb
�
~
μ Δw �Δw βkΔwk22 �
2β ^ 1
� 1
Δw 2 ¼ Iþ � Δw� :
γ
� � � �
γ T ^ 2β Multiply both sides of this equation by I þ 2β ^ 1 ,
�
; argmax ΔwT b
~
μ Δw ð� þ IÞΔw γ
Δw 2 γ
2β ^ 1
Δwquadratic ¼ Δw � Δwquadratic
n o γ
γ T^
; argmax ΔwT b
~μ Δw �Q Δw
Δw 2
� � 1
2β ^ 1 2β ^ 1
^Q ¼ �^ þ 2β I. When we do not consider the ¼ Δw � Iþ � Δw
where � γ
γ γ
transaction cost, the optimal adjustment is
^ 1μ " � #
Δw� ¼ 1γ � ^0 . After we consider the quadratic �
γ ^ 1
¼ I Iþ � Δw
transaction cost, the optimal adjustment changes 2β
intoΔw� ¼ 1� ^ Q 1b
~. Hence,
μ
quadratic γ
¼ ðI AÞΔw;
1 ^ 1b
Δwquadratic ¼ � ~
Q μ � � 1
γ where A ¼ I þ 2β γ ^
� , a positive definite matrix. It
shows the amount of trading in the presence of quadratic
� � 1 transaction costs Δwquadratic is a linear transformation of
1 ^ 2β b the amount of trading in the absence of transaction costs
¼ �þ I ~
μ
γ γ Δw.