A Transaction-Cost Perspective on the Multitude of Firm Characteristics

We investigate how transaction costs change the number of characteristics that are jointly significant for an investor's optimal portfolio and, hence, how they change the dimension of the cross-section of stock returns. We find that transaction costs increase the number of significant characteristics from 6 to 15. The explanation is that, as we show theoretically and empirically, combining characteristics reduces transaction costs because the trades in the underlying stocks required to rebalance different characteristics often cancel out. Thus, transaction costs provide an economic rationale for considering a larger number of characteristics than that in prominent asset-pricing models.