Why and How Systematic Strategies Decay
45 Pages Posted: 18 May 2021
Date Written: May 14, 2021
In this paper, we propose ex-ante characteristics that predict the drop in risk-adjusted performance out-of-sample for a large set of stock anomalies published in finance and accounting academic journals. Our set of predictors is generated by hypotheses of OOS decay put forward by McLean and Pontiff (2016): arbitrage capital flowing into newly published strategies and in-sample overfitting linked to multiple hypothesis testing. The year of publication alone—compatible with both hypotheses—explains 30% of the variance of Sharpe decay across factors: Every year, the Sharpe decay of newly-published factors increases by 5ppt. The other important variables are directly related to overfitting: the number of operations required to calculate the signal and two measures of sensitivity of in-sample Sharpe to outliers together add another 15% of explanatory power. Some arbitrage-related variables are statistically significant, but their predictive power is marginal.
Keywords: factor returns, arbitrage, overfitting
JEL Classification: G14, G15, G40
Suggested Citation: Suggested Citation