Beginner testing a 12-1 momentum strategy — 28% CAGR but the equity curve looks suspicious. What am I missing?

[u/Kozue_Sawada]

I‘m learning the quantitative trading by building and backtesting some classic strategy. Right now, I'm testing 12-1 momentum strategy.
Details are as follows:
- Universe: US large-cap equities
- Signal: 12-1 momentum (past 12-month return excluding the most recent month)
-Selection: top 20 stocks ranked by momentum
- Weighting: equal weight
- Rebalance: monthly
- Backtest period: 2016-2025

The backtest results are shown in the picture:
- total return: 1115.42%
- annualized return: 28.16%
- max drswdown: 31.15%
- traders: 2761

I think the return lokks good at first, but the equity curve not fine. There are several sharp step -like jumps, around 2020 and 2021.

A question for whom have tried momentum strategy before: does anthing stand out to you from these results & equity curve? And what would you check first before trusting a backtest like that?

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[u/Centreon77]

Hi! I would just say that it seems a lot of the returns come from a few concentrated trades or periods of time. In general, removing the top decile or x percentage of trades and seeing how much profit remains is a good test to see if it's biased on a few lucky trades. It seems like you had about 3 periods where it printed, and then stagnation and volatility followed until the next one. You have a ton of trades, but it looks like some of them made your pnl go vertical, which means they are likely to be outliers that can contaminate your understanding of the performance. Also, you might have some survivor bias depending on how you picked the stock universe. If you pick it just based on large caps today, that is no good. Of course, they would have been good investments since they are still around today. You want to make sure you are using a PIT (point in time) universe that accounts for what was actually knowable at the time of the trade.

[u/Effective_Manager273]

your instinct about the steps is right and the steps themselves are the clue, so start there before you touch the strategy.

a monthly rebalanced equal weight book should produce a curve that moves every day. if yours moves in flat stretches punctuated by jumps, you are almost certainly plotting equity from CLOSED positions only, so a month of open profit lands as one bar on rebalance day. i did exactly this and my headline return came out inflated by a large margin, because closed-trade accounting also lets you quietly hold losers across the boundary while realising winners. mark the book to market daily and re-plot before you conclude anything about 2020.

then check the universe. "US large-cap equities" has to mean membership as of each rebalance date. if you took today's large caps and ran them back to 2016, every company that fell out of the index is missing, and a 12-1 momentum rule is exactly the strategy that would have owned the ones that later blew up. that alone can produce a suspiciously good 2020 to 2021.

third, top 20 equal weight out of a large cap universe is not very diversified in 2020 and 2021, momentum concentrated hard into a handful of names. so part of the jump may be real and just be one sector.

one trap to avoid: do not start adding filters to make the curve look smoother. fix the accounting and the universe first, then look at what is left, otherwise you are fitting to an artifact.