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.
Bašić et al. (Tue,) studied this question.