The risk of falling short : Implementation Shortfall variance in portfolio construction

Basic, Filip and Martin Utrera, Alberto and Nolte, Ingmar and Nolte, Sandra (2026) The risk of falling short : Implementation Shortfall variance in portfolio construction. European Journal of Finance, 32 (4-6). pp. 546-563. ISSN 1351-847X

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Abstract

Transaction cost variance introduces a risk often neglected in portfolio optimization. Adopting a mean-variance portfolio optimization problem, we show that including a transaction cost variance term can significantly impact the associated portfolios' performances. Transaction cost variance is estimated based on a transaction cost model constructed using proprietary data from a large institutional investment company. In addition to variance, we estimate transaction cost covariances and construct a transaction cost covariance matrix. Using a standard time-series model setup for returns, we show that considering transaction cost covariance leads to improved net risk-adjusted performance.