Quantifying Backtest Overfitting in Alternative Beta Strategies

The authors investigate the biases in the backtested performance of “alternative beta” strategies using a unique sample of 215 trading strategies developed and promoted by global investment banks. Their results lend support to the cautions in the recent literature regarding backtest overfitting and lack of robustness in trading strategy performance during the “live” period (out of sample). The authors report a median 73% deterioration in Sharpe ratios between backtested and live performance periods for the strategies, and they establish a link between performance deterioration and strategy complexity, with the realized reduction in live versus backtested Sharpe ratios of the most complex strategies exceeding those of the simplest ones by over 30 percentage points. The robustness of strategy exposure to risk factors varies between asset classes and strategies; it appears reasonable in equity volatility and FX carry strategies but quite weak in the equity value strategy in particular.