Optimization constrains portfolio turnover and controls risk by limiting the size of active factor and industry bets. These bets are measured relative to the index exposure to each factor. Tracking error relative to an index is held to target levels. The market impact effects are typically much larger. This cost is real and potentially large enough to swamp the value added by any investment strategy.
Efficient implementation requires attention before, during, and after the actual trade execution.
Pre-trade implementation cost control centers on deciding which names are eligible for inclusion in a portfolio, and how large a position will be allowed in each security. For all portfolios, we restrict the investable universe to the more liquid equities and limit position sizes as a function of daily volume. Efficient trading also exploits the diversity of the equity markets. Alternate execution channels and techniques such as crossing networks and guaranteed principal bid trading provide a means to reduce market impact. Shorting stocks may present unique challenges as well.