How hard is it to pick the right model? MCS and backtest overfitting

Abstract

Recent advances in machine learning, artificial intelligence, and the availability of billions of high frequency data signals have made model selection a challenging and pressing need. However, most of the model selection methods available in modern finance are subject to backtest overfitting. This is the probability that one will select a financial strategy that outperforms during backtest, but underperforms in practice. We evaluate the performance of the novel model confidence set (MCS) introduced in Hansen et al. (2011a) in a simple machine learning trading strategy problem. We find that MCS is not robust to multiple testing and that it requires a very high signal-to-noise ratio to be utilizable. More generally, we raise awareness on the limitations of model selection in finance.