Model Comparison with Transaction Costs

Failing to account for transaction costs materially impacts inferences drawn when evaluating asset pricing models, biasing tests in favor of those employing high-cost factors. Ignoring transaction costs, Hou, Xue, and Zhang (2015, Review of Financial Studies, 28, 650–705) q-factor model and Barillas and Shanken (2018, The Journal of Finance, 73, 715–754) six-factor models have high maximum squared Sharpe ratios and small alphas across 205 anomalies. They do not, however, come close to spanning the achievable mean-variance efficient frontier. Accounting for transaction costs, the Fama and French (2015, Journal of Financial Economics, 116, 1–22; 2018, Journal of Financial Economics, 128, 234–252) five-factor model has a significantly higher squared Sharpe ratio than either of these alternative models, while variations employing cash profitability perform better still.