{"id":22803,"date":"2021-11-09T08:53:59","date_gmt":"2021-11-09T08:53:59","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=22803"},"modified":"2026-01-12T14:51:45","modified_gmt":"2026-01-12T14:51:45","slug":"the-backtesting-process","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/","title":{"rendered":"The Backtesting Process"},"content":{"rendered":"\r\n<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Impact of frequent portfolio rebalancing on transaction costs\",\r\n    \"text\": \"Which of the following is likely to occur when an investment manager rebalances their portfolio every week?\\n\\nA. The transaction costs will increase.\\n\\nB. The transaction costs will reduce.\\n\\nC. Transaction costs will remain the same.\",\r\n    \"answerCount\": 3,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"A. The transaction costs will increase.\",\r\n      \"commentary\": \"More frequent portfolio rebalancing leads to a higher number of trades. Each trade incurs costs such as commissions, bid\u2013ask spreads, and market impact, resulting in increased total transaction costs.\"\r\n    }\r\n  }\r\n}\r\n<\/script>\r\n\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/FqQEumbr5is\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<p>There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting.<\/p>\r\n<h2>Step 1: Strategy Design<\/h2>\r\n<p>The first step is to formulate the investment hypothesis and goals. An active strategy would aim to achieve excess returns above the relevant benchmark. Note that an investment hypothesis is a security selection criterion, trading rule, and a portfolio whose objective is to achieve the investment goal. A procedure is then conducted by translating the hypothesis into specific key parameters, rules, and processes that need to be tested. The key parameters are:<\/p>\r\n<ul>\r\n\t<li><strong>Investment universe<\/strong>: An investment universe refers to all potential securities that we can invest in. Most investors use broad market indexes as their universe. For this reading, we will use, S&amp;P\/TSX Composite Index for Canada, MSCI China A for mainland China, Russell 3000 Index for the USA, and S&amp;P Global Broad Market Index (BMI) for all other markets.<\/li>\r\n\t<li><strong>Return definition<\/strong>: The currency in which the return will be computed needs to be determined. A manager can either use one currency or denominate reruns in the local currency. If a portfolio manager does not hedge their currency exposure, they will backtest using single-currency-denominated returns. A benchmark must be specified if the aim of the investment strategy is an excess return. It is imperative to note that the benchmark must relate to the investment universe.<\/li>\r\n\t<li><strong>Rebalancing frequency and transaction cost<\/strong>: Managers often rebalance their portfolios on a monthly frequency. Higher or daily frequency rebalancing will often result in higher transaction costs. Consequently, bid-ask spreads will cause price data to become biased. Many market anomalies are included once transaction costs are included. It is, therefore, imperative to consider them.<\/li>\r\n\t<li><strong>Start and end date<\/strong>: Other factors held constant, investment managers will always prefer backtesting investment strategies with a long history. This is because a larger sample implies a much higher level of statistical confidence in the results. However, long period performance should be supplemented with the examination of discrete regimes within the long history.<\/li>\r\n<\/ul>\r\n<h2>Step 2: Historical Investment Simulation<\/h2>\r\n<p>During this step, the portfolio will be constructed. The portfolio must be rebalanced based on a pre-determined frequency. It is noteworthy that the construction process will depend on the investment hypothesis considered in step 1. Equally noteworthy is the fact that the investment manager\u2019s styles and capabilities, and the client\u2019s investment mandate are relevant to the potential strategy.<\/p>\r\n<p>Analysts typically use rolling windows to simulate rebalancing. In rolling windows, a strategy or portfolio is constructed initially using historical in-sample period data. The strategy or portfolio is then tested with the out-of-sample period. As time goes by, the process becomes iterative and replicates the live investing process since managers adjust their positions based on newly available information.<\/p>\r\n<h2>Step 3: Analysis of Backtesting Output<\/h2>\r\n<p>During this step, backtesting results are presented and interpreted. Here, we are concerned about the risk profile as well as the average return of the portfolio. Therefore, it is common for analysts to use the Sortino ratio, Sharpe ratio, volatility, and maximum drawdown. Apart from measures, graphical representations are also key performance outputs. Graphical representations are a good way of summarizing multiple data points that reveal more than one number summary measure.<\/p>\r\n<p>It is useful to assess the backtested cumulative performance of an investment strategy over an extended history. Performance should be plotted using a logarithmic scale where percentage changes are presented as the same vertical distance on the y-axis. One can readily identify downside risk, structural breaks, and performance decay using the cumulative performance graphs. Regime breaks or structural changes result from external factors, making the past an unreliable prediction of the future.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Which of the following is likely to occur when an investment manager rebalances their portfolio every week?<\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>The transaction costs will increase.<\/li>\r\n\t<li>The transaction cost will reduce.\u00a0<\/li>\r\n\t<li>Transaction costs will remain the same.<\/li>\r\n<\/ol>\r\n<h3>Solution<\/h3>\r\n<p><strong>The correct answer is A.<\/strong><\/p>\r\n<p>The consequence of increased frequency in rebalancing is higher transaction costs.<\/p>\r\n<\/blockquote>\r\n<p>Reading 42: Backtesting and Simulation<\/p>\r\n<p><em>LOS 42 (b) Describe and contrast steps and procedures in backtesting an investment strategy.<\/em><\/p>","protected":false},"excerpt":{"rendered":"<p>There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting. Step 1: Strategy Design The first step is to formulate the investment hypothesis and goals. An active strategy would aim to achieve excess returns above&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,473],"tags":[216,564,568],"class_list":["post-22803","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-portfolio-management","tag-cfa-level-2","tag-portfolio-management","tag-reading-41-backtesting-and-simulation","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>The Backtesting Process - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"The Backtesting Process - CFA, FRM, and Actuarial Exams Study Notes\" \/>\n<meta property=\"og:description\" content=\"There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting.\" \/>\n<meta property=\"og:url\" content=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/\" \/>\n<meta property=\"og:site_name\" content=\"CFA, FRM, and Actuarial Exams Study Notes\" \/>\n<meta property=\"article:published_time\" content=\"2021-11-09T08:53:59+00:00\" \/>\n<meta property=\"article:modified_time\" content=\"2026-01-12T14:51:45+00:00\" \/>\n<meta name=\"author\" content=\"Irene R\" \/>\n<meta name=\"twitter:card\" content=\"summary_large_image\" \/>\n<meta name=\"twitter:label1\" content=\"Written by\" \/>\n\t<meta name=\"twitter:data1\" content=\"Irene R\" \/>\n\t<meta name=\"twitter:label2\" content=\"Est. reading time\" \/>\n\t<meta name=\"twitter:data2\" content=\"3 minutes\" \/>\n<script type=\"application\/ld+json\" class=\"yoast-schema-graph\">{\"@context\":\"https:\\\/\\\/schema.org\",\"@graph\":[{\"@type\":\"Article\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/#article\",\"isPartOf\":{\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/\"},\"author\":{\"name\":\"Irene R\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/#\\\/schema\\\/person\\\/7002f30d8f174958802c1c30b167eaf5\"},\"headline\":\"The Backtesting Process\",\"datePublished\":\"2021-11-09T08:53:59+00:00\",\"dateModified\":\"2026-01-12T14:51:45+00:00\",\"mainEntityOfPage\":{\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/\"},\"wordCount\":675,\"keywords\":[\"CFA-level-2\",\"Portfolio management\",\"Reading 41: Backtesting and Simulation\"],\"articleSection\":[\"CFA Level II Study Notes\",\"Portfolio Management\"],\"inLanguage\":\"en-US\"},{\"@type\":\"WebPage\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/\",\"url\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/\",\"name\":\"The Backtesting Process - CFA, FRM, and Actuarial Exams Study Notes\",\"isPartOf\":{\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/#website\"},\"datePublished\":\"2021-11-09T08:53:59+00:00\",\"dateModified\":\"2026-01-12T14:51:45+00:00\",\"author\":{\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/#\\\/schema\\\/person\\\/7002f30d8f174958802c1c30b167eaf5\"},\"description\":\"There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting.\",\"breadcrumb\":{\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/#breadcrumb\"},\"inLanguage\":\"en-US\",\"potentialAction\":[{\"@type\":\"ReadAction\",\"target\":[\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/\"]}]},{\"@type\":\"BreadcrumbList\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/cfa-level-2\\\/the-backtesting-process\\\/#breadcrumb\",\"itemListElement\":[{\"@type\":\"ListItem\",\"position\":1,\"name\":\"Home\",\"item\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/\"},{\"@type\":\"ListItem\",\"position\":2,\"name\":\"The Backtesting Process\"}]},{\"@type\":\"WebSite\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/#website\",\"url\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/\",\"name\":\"CFA, FRM, and Actuarial Exams Study Notes\",\"description\":\"Question Bank and Study Notes for the CFA, FRM, and Actuarial exams\",\"potentialAction\":[{\"@type\":\"SearchAction\",\"target\":{\"@type\":\"EntryPoint\",\"urlTemplate\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/?s={search_term_string}\"},\"query-input\":{\"@type\":\"PropertyValueSpecification\",\"valueRequired\":true,\"valueName\":\"search_term_string\"}}],\"inLanguage\":\"en-US\"},{\"@type\":\"Person\",\"@id\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/#\\\/schema\\\/person\\\/7002f30d8f174958802c1c30b167eaf5\",\"name\":\"Irene R\",\"image\":{\"@type\":\"ImageObject\",\"inLanguage\":\"en-US\",\"@id\":\"https:\\\/\\\/secure.gravatar.com\\\/avatar\\\/33caf1e1bcb63ee970b36351f165c7bc714b19614993ab9c2c8bf36273b7df48?s=96&d=mm&r=g\",\"url\":\"https:\\\/\\\/secure.gravatar.com\\\/avatar\\\/33caf1e1bcb63ee970b36351f165c7bc714b19614993ab9c2c8bf36273b7df48?s=96&d=mm&r=g\",\"contentUrl\":\"https:\\\/\\\/secure.gravatar.com\\\/avatar\\\/33caf1e1bcb63ee970b36351f165c7bc714b19614993ab9c2c8bf36273b7df48?s=96&d=mm&r=g\",\"caption\":\"Irene R\"},\"url\":\"https:\\\/\\\/analystprep.com\\\/study-notes\\\/author\\\/irene\\\/\"}]}<\/script>\n<meta property=\"og:video\" content=\"https:\/\/www.youtube.com\/embed\/FqQEumbr5is\" \/>\n<meta property=\"og:video:type\" content=\"text\/html\" \/>\n<meta property=\"og:video:duration\" content=\"2400\" \/>\n<meta property=\"og:video:width\" content=\"480\" \/>\n<meta property=\"og:video:height\" content=\"270\" \/>\n<meta property=\"ya:ovs:adult\" content=\"false\" \/>\n<meta property=\"ya:ovs:upload_date\" content=\"2021-11-09T08:53:59+00:00\" \/>\n<meta property=\"ya:ovs:allow_embed\" content=\"true\" \/>\n<!-- \/ Yoast SEO plugin. -->","yoast_head_json":{"title":"The Backtesting Process - CFA, FRM, and Actuarial Exams Study Notes","description":"There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting.","robots":{"index":"index","follow":"follow","max-snippet":"max-snippet:-1","max-image-preview":"max-image-preview:large","max-video-preview":"max-video-preview:-1"},"canonical":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/","og_locale":"en_US","og_type":"article","og_title":"The Backtesting Process - CFA, FRM, and Actuarial Exams Study Notes","og_description":"There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting.","og_url":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/","og_site_name":"CFA, FRM, and Actuarial Exams Study Notes","article_published_time":"2021-11-09T08:53:59+00:00","article_modified_time":"2026-01-12T14:51:45+00:00","author":"Irene R","twitter_card":"summary_large_image","twitter_misc":{"Written by":"Irene R","Est. reading time":"3 minutes"},"schema":{"@context":"https:\/\/schema.org","@graph":[{"@type":"Article","@id":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/#article","isPartOf":{"@id":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/"},"author":{"name":"Irene R","@id":"https:\/\/analystprep.com\/study-notes\/#\/schema\/person\/7002f30d8f174958802c1c30b167eaf5"},"headline":"The Backtesting Process","datePublished":"2021-11-09T08:53:59+00:00","dateModified":"2026-01-12T14:51:45+00:00","mainEntityOfPage":{"@id":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/"},"wordCount":675,"keywords":["CFA-level-2","Portfolio management","Reading 41: Backtesting and Simulation"],"articleSection":["CFA Level II Study Notes","Portfolio Management"],"inLanguage":"en-US"},{"@type":"WebPage","@id":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/","url":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/","name":"The Backtesting Process - CFA, FRM, and Actuarial Exams Study Notes","isPartOf":{"@id":"https:\/\/analystprep.com\/study-notes\/#website"},"datePublished":"2021-11-09T08:53:59+00:00","dateModified":"2026-01-12T14:51:45+00:00","author":{"@id":"https:\/\/analystprep.com\/study-notes\/#\/schema\/person\/7002f30d8f174958802c1c30b167eaf5"},"description":"There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting.","breadcrumb":{"@id":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/#breadcrumb"},"inLanguage":"en-US","potentialAction":[{"@type":"ReadAction","target":["https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/"]}]},{"@type":"BreadcrumbList","@id":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/the-backtesting-process\/#breadcrumb","itemListElement":[{"@type":"ListItem","position":1,"name":"Home","item":"https:\/\/analystprep.com\/study-notes\/"},{"@type":"ListItem","position":2,"name":"The Backtesting Process"}]},{"@type":"WebSite","@id":"https:\/\/analystprep.com\/study-notes\/#website","url":"https:\/\/analystprep.com\/study-notes\/","name":"CFA, FRM, and Actuarial Exams Study Notes","description":"Question Bank and Study Notes for the CFA, FRM, and Actuarial exams","potentialAction":[{"@type":"SearchAction","target":{"@type":"EntryPoint","urlTemplate":"https:\/\/analystprep.com\/study-notes\/?s={search_term_string}"},"query-input":{"@type":"PropertyValueSpecification","valueRequired":true,"valueName":"search_term_string"}}],"inLanguage":"en-US"},{"@type":"Person","@id":"https:\/\/analystprep.com\/study-notes\/#\/schema\/person\/7002f30d8f174958802c1c30b167eaf5","name":"Irene R","image":{"@type":"ImageObject","inLanguage":"en-US","@id":"https:\/\/secure.gravatar.com\/avatar\/33caf1e1bcb63ee970b36351f165c7bc714b19614993ab9c2c8bf36273b7df48?s=96&d=mm&r=g","url":"https:\/\/secure.gravatar.com\/avatar\/33caf1e1bcb63ee970b36351f165c7bc714b19614993ab9c2c8bf36273b7df48?s=96&d=mm&r=g","contentUrl":"https:\/\/secure.gravatar.com\/avatar\/33caf1e1bcb63ee970b36351f165c7bc714b19614993ab9c2c8bf36273b7df48?s=96&d=mm&r=g","caption":"Irene R"},"url":"https:\/\/analystprep.com\/study-notes\/author\/irene\/"}]},"og_video":"https:\/\/www.youtube.com\/embed\/FqQEumbr5is","og_video_type":"text\/html","og_video_duration":"2400","og_video_width":"480","og_video_height":"270","ya_ovs_adult":"false","ya_ovs_upload_date":"2021-11-09T08:53:59+00:00","ya_ovs_allow_embed":"true"},"_links":{"self":[{"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/posts\/22803","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/users\/5"}],"replies":[{"embeddable":true,"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/comments?post=22803"}],"version-history":[{"count":12,"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/posts\/22803\/revisions"}],"predecessor-version":[{"id":41847,"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/posts\/22803\/revisions\/41847"}],"wp:attachment":[{"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/media?parent=22803"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/categories?post=22803"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/analystprep.com\/study-notes\/wp-json\/wp\/v2\/tags?post=22803"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}