To Trade or Not to Trade? Informed Trading with Short-Term Signals for Long-Term Investors

Roni Israelov and Michael Katz

Financial Analysts Journal, 2011, vol. 67, issue 5, 23-36

Abstract: When long-term investors trade slowly changing portfolios, they are not particularly sensitive to when they should place or modify their bets. Short-term information can be used to guide investors on how to time their trades. Strategic trade modification provides exposure to short-term signals without imposing additional transaction costs or capacity limits. Long-term investors should not ignore short-term information simply because it is too expensive to trade on.When a long-term investor trades a slowly changing portfolio, she is not particularly sensitive to when she should place or change her bet. The value of the embedded optionality provided by this flexibility may be extracted by using short-term information to choose when to trade (i.e., exercise the option).In this article, we show that strategic trade modification provides exposure to short-term signals without having to pay additional transaction costs and without capacity limits. We implement a parsimonious informed-trading algorithm on real and simulated portfolios to illustrate its effect on portfolio performance. The algorithm delays long-term trades when they are in conflict with the short-term information about the direction of asset returns.We show that realistic portfolios can achieve a 5 percent exposure to a short-term signal. In addition to providing a desirable exposure to the short-term signal, informed trading has two additional benefits: reduced transaction costs and increased exposure to the long-term view. Because all views tend to revert with some probability, trading less often reduces transaction costs. Informed trading allows investors to strategically select the time and the assets to trade aggressively, which reduces transaction costs that arise from unprofitable round-trips. Second, this baseline reduction in transaction costs makes trading more aggressively profitable for the investor, on average. In turn, more aggressive trading results in a portfolio that has higher exposure not only to the short-term signals but also to the long-term view. Long-term investors should no longer ignore short-term information just because it is too expensive to trade on.

Date: 2011
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DOI: 10.2469/faj.v67.n5.3

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