In-Sample and Out-of-Sample Sharpe Ratios for Linear Predictive Models
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| Format: | Preprint |
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2025
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| _version_ | 1866914175253479424 |
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| author | Jacquier, Antoine Muhle-Karbe, Johannes Mulligan, Joseph |
| author_facet | Jacquier, Antoine Muhle-Karbe, Johannes Mulligan, Joseph |
| contents | We study how much the in-sample performance of trading strategies based on linear predictive models is reduced out-of-sample due to overfitting. More specifically, we compute the in- and out-of-sample means and variances of the corresponding PnLs and use these to derive a closed-form approximation for the corresponding Sharpe ratios. We find that the out-of-sample "replication ratio" diminishes for complex strategies with many assets based on many weak rather than a few strong trading signals, and increases when more training data is used. The substantial quantitative importance of these effects is illustrated with a simulation case study for commodity futures following the methodology of Gârleanu and Pedersen, and an empirical case study using the dataset compiled by Goyal, Welch and Zafirov. |
| format | Preprint |
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arxiv_https___arxiv_org_abs_2501_03938 |
| institution | arXiv |
| publishDate | 2025 |
| record_format | arxiv |
| spellingShingle | In-Sample and Out-of-Sample Sharpe Ratios for Linear Predictive Models Jacquier, Antoine Muhle-Karbe, Johannes Mulligan, Joseph Mathematical Finance Portfolio Management We study how much the in-sample performance of trading strategies based on linear predictive models is reduced out-of-sample due to overfitting. More specifically, we compute the in- and out-of-sample means and variances of the corresponding PnLs and use these to derive a closed-form approximation for the corresponding Sharpe ratios. We find that the out-of-sample "replication ratio" diminishes for complex strategies with many assets based on many weak rather than a few strong trading signals, and increases when more training data is used. The substantial quantitative importance of these effects is illustrated with a simulation case study for commodity futures following the methodology of Gârleanu and Pedersen, and an empirical case study using the dataset compiled by Goyal, Welch and Zafirov. |
| title | In-Sample and Out-of-Sample Sharpe Ratios for Linear Predictive Models |
| topic | Mathematical Finance Portfolio Management |
| url | https://arxiv.org/abs/2501.03938 |