Leakage of rank-dependent functionally generated trading strategies

TL;DR

This paper analyzes the leakage effect in rank-dependent functionally generated trading strategies, providing a new explicit finite-variation expression and a practical discrete-time estimation method, supported by empirical examples.

Contribution

It introduces a novel explicit finite-variation formula for leakage and a practical discrete-time estimation approach for rank-dependent trading strategies.

Findings

Leakage effect can be explicitly quantified by a finite-variation term.

The new estimation method is practical for real-world data.

Empirical examples demonstrate leakage under different portfolio sizes.

Abstract

This paper investigates the so-called leakage effect of trading strategies generated functionally from rank-dependent portfolio generating functions. This effect measures the loss in wealth of trading strategies due to renewing the portfolio constituent stocks. Theoretically, the leakage effect of a trading strategy is expressed explicitly by a finite-variation term. The computation of the leakage is different from what previous research has suggested. The method to estimate leakage in discrete time is then introduced with some practical considerations. An empirical example illustrates the leakage of the corresponding trading strategies under different constituent list sizes.