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Optimal Portfolio Management with Transactions Costs and Capital Gains Taxes

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  • Leland, Hayne E.

Abstract

We examine the optimal trading strategy for an investment fund which in the absence of transactions costs would like to maintain assets in exogenously fixed proportions, e.g. 60/30/10 in stocks, bonds and cash. Transactions costs are assumed to be proportional, but may differ with buying and selling, and may include a (positive) capital gains tax component. We show that the optimal policy involves a no-trade region about the target stock proportions. As long as the actual proportions remain inside this region, no trading should occur. When proportions are outside the region, trading should be undertaken to move the ratio to the region's boundary. We compute the optimal multi-asset no-trade region and resulting annual turnover and tracking error of the optimal strategy. Almost surely, the strategy will require trading just one risky asset at any moment, although which asset is traded varies stochastically through time. Compared to the current practice of periodic rebalancing of all assets to their target proportions, the optimal strategy will reduce turnover by almost 50%. The optimal response to a capital gains tax is to allow proportions to substantially exceed their target levels before selling. When an asset's proportion exceeds a critical level, selling should occur to bring it back to that critical level. Capital gains taxes lead to lower optimal initial investment levels. Similarly, it is optimal to invest less initially in asset classes that have high transactions costs, such as emerging markets.

Suggested Citation

  • Leland, Hayne E., 1999. "Optimal Portfolio Management with Transactions Costs and Capital Gains Taxes," Research Program in Finance, Working Paper Series qt0fw6k0hm, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
  • Handle: RePEc:cdl:rpfina:qt0fw6k0hm
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    References listed on IDEAS

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    Cited by:

    1. Chavalle, Luc & Chavez-Bedoya, Luis, 2019. "The impact of transaction costs in portfolio optimization: A comparative analysis between the cost of trading in Peru and the United States," Journal of Economics, Finance and Administrative Science, Universidad ESAN, vol. 24(48), pages 288-311.
    2. Füss, Roland & Miebs, Felix & Trübenbach, Fabian, 2014. "A jackknife-type estimator for portfolio revision," Journal of Banking & Finance, Elsevier, vol. 43(C), pages 14-28.
    3. Fochmann, Martin & Rumpf, Dominik, 2008. "Modellierung von Aktienanlagen bei laufenden Umschichtungen und einer Besteuerung von Veräußerungsgewinnen," arqus Discussion Papers in Quantitative Tax Research 59, arqus - Arbeitskreis Quantitative Steuerlehre.
    4. Kourtis, Apostolos, 2014. "On the distribution and estimation of trading costs," Journal of Empirical Finance, Elsevier, vol. 28(C), pages 104-117.
    5. Hubert Dichtl & Wolfgang Drobetz & Martin Wambach, 2014. "Where is the value added of rebalancing? A systematic comparison of alternative rebalancing strategies," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 28(3), pages 209-231, August.
    6. Nicole Branger & Beate Breuer & Christian Schlag, 2010. "Discrete-time implementation of continuous-time portfolio strategies," The European Journal of Finance, Taylor & Francis Journals, vol. 16(2), pages 137-152.
    7. Rumpf, Dominik, 2013. "Zinsbereinigung bei der Dualen Einkommensteuer," Beiträge zur Finanzwissenschaft, Mohr Siebeck, Tübingen, edition 1, volume 32, number urn:isbn:9783161528699, December.
    8. Moorman, Theodore, 2014. "An empirical investigation of methods to reduce transaction costs," Journal of Empirical Finance, Elsevier, vol. 29(C), pages 230-246.
    9. Jiatu Cai & Xinfu Chen & Min Dai, 2018. "Portfolio Selection with Capital Gains Tax, Recursive Utility, and Regime Switching," Management Science, INFORMS, vol. 64(5), pages 2308-2324, May.

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