Memo 002: Vol targeting and transaction costs

Two themes that show up in almost every strategy in the database: vol targeting and transaction costs.

Vol targeting: Scaling exposure so that portfolio volatility stays near a target (e.g. 10%) avoids over-leveraging in calm markets and reduces exposure when vol spikes. See the Vol Targeting (Multi-Asset) strategy and the vol-targeting concept. We use it as an overlay in trend and carry strategies.

Transaction costs: In backtests we often assume 0 or 5 bps per side. In reality, high-turnover strategies (e.g. Stat Arb Pairs, Mean Reversion Russell) can lose most of their edge to slippage and spread. The transaction-costs concept page spells out how to model and stress-test costs.

What would change our mind? If execution technology improves so that retail-sized flow can trade at institutional cost, some high-turnover ideas become more viable. Until then, we prefer strategies with moderate turnover and liquid instruments.