Liquidity, Volatility, and Equity Trading Costs Across Countries and Over Time
Ian Domowitz, Pennsylvania State University
Ananth Madhavan, Marshall School of Business at USC

Actual investment performance reflects the underlying strategy of the portfolio manager and the execution costs incurred in realizing those objectives. Execution costs, especially in illiquid markets, can dramatically reduce the notional return to an investment strategy. This research project ex­amined the interactions between cost, liquidity, and volatility, and their determinants using panel-data for 42 countries from September 1996 to December 1998. The results show that trading costs vary widely across countries; emerging markets in particular have significantly higher trading costs even after correcting for factors affecting costs such as market capitalization and volatility. The authors analyze the inter-relationships between turnover, equity trading costs, and volatility, and investigate the impact of these variables on equity returns. Their results show that increased volatility, acting through costs, reduces a portfolio’ s expected return. However, higher volatility reduces turnover also, mitigating the actual impact of higher costs on returns. Further, turnover is inversely related to trading costs, providing a possible explanation for the in­crease in turnover in recent years. The results demonstrate that the composition of global effi­cient portfolios can change dramatically when cost and turnover are taken into account. (Accepted Fall 2000.)