Backtesting

Abstract

When evaluating a trading strategy, it is routine to discount the Sharpe ratio from a historical backtest. The reason is simple: there is inevitable data mining by both the researcher and by other researchers in the past. Our paper provides a statistical framework that systematically accounts for these multiple tests. We propose a method to determine the appropriate haircut for any given reported Sharpe ratio. We also provide a profit hurdle that any strategy needs to achieve in order to be deemed "significant".

Note: Related papers: Multiple Testing in Economics and …and the Cross-Section of Expected Returns

Keywords: Sharpe ratio, Multiple tests, Backtest, Haircut, Trading Strategies, Out-of-Sample tests, In-Sample tests

JEL Classification: G12, G14, G30, G00, C12, C20, B41