Implementation Shortfall

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Implementation Shortfall
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Implementation Shortfall is defined as the difference between the money return on a notional or paper portfolio in which positions are established at the prevailing price when the decision to trade is made (known as the decision price, the arrival price, or the strike price) and the actual portfolio's return. The implementation shortfall method correctly captures all elements of transaction costs. The method takes into account not only explicit trading costs, but also the implicit costs, which are often significant for large orders[1].

Implementation shortfall is the execution price minus the decision price, divided by the decision price. Thus, with slippage (i.e., positive transaction costs), implementation shortfall is negative for both buys and sells. For example, if the decision price is $10 and purchase is executed at $10.15, then the implementation shortfall is -0.015, for cost of 1.5 percent[2]

Four components of implementation shortfall

Implementation shortfall can be analysed info four components[3]

  • explicit costs, including commissions, taxes, and fees
  • realized profit/loss, reflecting the price movement from the decision price to the execution price for the part of the trade executed on the day it is placed
  • delay costs, reflecting the change in price over the day an order is placed when the order is not executed that day; the calculation is based on the amount of the order actually filled subsequently
  • missed trade opportunity cost, reflecting the price difference between the trade cancellation price and the original benchmark price based on the amount of the order that was no filled

Implementation shortfall measurement

Implementation shortfall measures the price distance between the final, realized trade price, and pre-trade decision price. Implementation shortfall can be distinguished by three categories[4]:

  • paper portfolio represents the ideal situation. All securities are transacted at benchmark prices. Transaction costs, commissions, bid-ask spread, liquidity impact, opportunity costs, market trends, and slippage do not happen
  • actual portfolio reflects reality; all securities are transacted in real markets. Market impact, commissions, bid-ask spread, liquidity, opportunity costs, and slippage are factored in
  • rabbit portfolio represents expected trading costs; all securities are transacted in expected markets. The paper portfolio has no trading costs. The actual portfolio has high trading costs. The rabbit portfolio falls somewhere between the two. The rabbit portfolio is the benchmark by which traders measure performance

Improving the implementation shortfall

The implementation shortfall is a useful concept for several reasons. It is important to track whether your trading ideas are being successfully implemented in practice. A hedge fund is not interested in making money in principle but in practice, and a large shortfall drives a wedge between the two. Studying your performance and implementation shortfall can help you decide whether to focus your efforts on improving your trading implementation or the strategy's alpha signals. If your shortfall is low, you should focus on improving your strategy and developing new trading ideas. In contrast, if your paper portfolio is doing well but your actual portfolio is suffering from a large shortfall, then you should focus on implementation[5].


  1. CFA Program Curriculum 2018, p.251-251
  2. B. Litterman 2004, p.425
  3. CFA Program Curriculum 2018, p.252
  4. K. Kim 2010, p.54
  5. L.H Pedersen 2015, p.71


Author: Małgorzata Oleksińska