Magnitude of Transaction Cost for Institutional Investors

Question

For my thesis, I'm writing about robust portfolio allocation. I have the idea to include a measure of transaction cost, since ignoring them seems too simplifying for a real-world problem. Comparing a traditional and a robust portfolio, it has been found that the robust portfolio consists of fewer assets and needs less restructuring, so if we assume transaction cost, it is even better than a traditional portfolio.

My question is now, what is the magnitude that I can assume for both private and institutional investor's transaction cost? I'm not trading myself; I heard that a private person's stock trading takes around 1% transaction fee. I assume it is much lower for a large private or commercial investor, but still above 0. The asset classes should involve stocks, funds, indices.

My idea on the measure of the transaction cost $c_i$ for the readjustment of the portfolio $x$ between periods $i$ and $i+1$ would look as follows: \begin{alignat*}{5} c_i \thicksim \sum_{j=1}^n |(x_{i+1})_j-(x_i)_j| \end{alignat*}

Answer 1

For a thesis, it makes sense just to assume a range of fixed costs (e.g. 0.5%, 1%, 2%) and look how this affects your optimal portfolio and overall profitability.

Fees for large institutional investors usually don't represent much of the trading costs. Most of the costs come from liquidity (bid-ask spread you have to pay) and market impact (how much your own trading affects the prices). Transaction costs modelling is a large topics. However, if it's not a central topic of your thesis, you might want to make a quick estimate using bid-ask spread as a main cost driver. If you want to account for a market impact, you can try to take the results of Almgren's paper Direct Estimation of Equity Market Impact. It's already calibrated for equity markets so you just need to plug your own values.

For a retail trader, you can just take fee structure of any popular brokerage firm as a benchmark, like Interactive Brokers.