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The Perils Of The Carry Trade

What’s known as the carry trade is one of the more popular strategies of hedge funds, and it’s also becoming popular for investors seeking alternative fixed-income strategies that can provide higher yields in today’s environment of low rates.

The strategy involves borrowing (going short) a currency with a relatively low interest rate and using the proceeds to purchase (going long) a currency yielding a higher interest rate, capturing the interest differential. The strategy can be “enhanced” through the use of leverage.

The papers “The Time-Varying Systematic Risk of Carry Trade Strategies” and “Carry Trades, Momentum Trading and the Forward Premium Anomaly” reached the same conclusions.

  • The carry trade strategy has been quite successful.
  • The carry trade experiences what can be called crashes—they come with the risk of large losses (so-called fat tails) that tend to occur at the same time that equity markets are crashing.

The authors of the 2013 paper, “Carry” took another look at the subject of the carry trade. They noted: “The concept of ‘carry’ has been applied almost exclusively to currencies, where it simply represents the interest differential between two countries. However, carry is a more general phenomenon that can be applied to any asset. Put simply, we define carry as the expected return on an asset assuming its price does not change.”

(In other words, assuming stock prices don’t change; currency yields don’t change; bond yields don’t change; and spot commodity prices remain unchanged).

To put a finer point on it, this means:

  • For equities, the carry trade is defined by the dividend yield—the strategy is going long countries with high dividend yield and short currencies with low dividend yield
  • For bonds, by the term structure of rates
  • For commodities, by the roll return—the difference between spot rates and future rates.

The time periods used varied based on availability but were at least 20 years. Their findings confirm the result found in prior research on the subject. The following is a summary of their conclusions:

  • A carry trade that goes long high-carry assets and shorts low-carry assets earns significant returns in each asset class with an annualized Sharpe ratio of 0.7 on average. Further, a diversified portfolio of carry strategies across all asset classes earns a Sharpe ratio of 1.1
  • The evidence suggests a strong cross-sectional link between carry and expected returns
  • Carry predicts future returns in every asset class with a positive coefficient, but the magnitude of the predictive coefficient differs across asset classes
  • In global equities, global bonds and credit markets, the estimated predictive coefficient is greater than 1, implying that carry predicts positive future price changes that add to returns, over and above the carry itself
  • In commodity and option markets, the estimated predictive coefficient is less than 1, implying that the market takes back part of the carry
  • Though the currency carry trade does exhibit negative skewness (the returns to the left of the mean are fewer but further from the mean), this is not true of other carry trades, which on average have skewness of close to zero
  • The correlations among carry strategies are low. This reduces the volatility of a diversified portfolio substantially, and mitigates the risks of fat tails that are associated with all carry trades. The result is that while all individual carry strategies have excess kurtosis, an across-all-asset-classes diversified carry strategy has a skewness close to zero and thinner tails than a diversified passive exposure to the global market portfolio
  • Despite the high Sharpe ratios, carry strategies are far from riskless—all individual carry strategies have excess kurtosis (fat tails)—exhibiting sizable declines for extended periods of time. These periods coincide with bad states of the global economy (August 1972 to September 1975, March 1980 to June 1982, and August 2008 to February 2009) —recessions and liquidity crises. In other words, carry strategies in almost all asset classes are positively exposed to global liquidity shocks and negatively exposed to volatility risk. Thus, carry strategies tend to incur losses during times of worsened liquidity and heightened volatility (when stocks do poorly). These exposures help explain carry’s return premium—assets that do poorly in bad times should carry premiums. However, an exception is the carry trade across U.S. Treasurys of different maturities, which has the opposite loadings on liquidity and volatility risks, thus making it a hedge against the other carry strategies.

Before summarizing, let’s take a look at the performance of the PowerShares DB G10 Currency Harvest Fund (DBV | B-59)—a strategy based on the carry trade. The portfolio is composed of a long position in the three currencies associated with the highest interest rates and a short position in the three currencies with the lowest interest rates, and is rebalanced quarterly.

We’ll compare its returns to those of two safe short-term bond funds from Vanguard. Note the crash risk appearing in 2008.

2007 2008 2009 2010 2011 2012 2013
DBV 8.9 -28.4 21.3 -0.9 -0.1 10.1 -2.8
Vanguard Short-term
Investment Grade (VFSTX)
5.9 -4.7 14.0 5.2 1.9 4.5 1.0
Vanguard Short-term
Federal (VSGBX)
7.4 2.8 3.2 2.8 0.8 1.4 -0.4

Another interesting and related alternative is a new fund from AQR, a Style Premia Alternative Fund (QSPIX) that was launched at the end of October 2013.

The fund seeks to provide long-term positive expected returns with low correlation to traditional asset classes by investing long and short in a broad spectrum of asset classes and markets.

It uses market-neutral long/short strategies across six asset groups and four distinct investment styles. The six different asset groups are: stocks of major developed markets, country indexes, bond futures, interest-rate futures, currencies and commodities. The four investment styles are value, momentum, carry and defensive.

For those investors seeking alternatives to traditional equity and bond strategies, the carry trade is worth considering, as long as you understand the carry premium is not a free lunch. It involves the risks of crashes that occur at the same time your equity holdings are likely to be experiencing large losses.

Thus, your overall portfolio allocation should take this risk into account.


Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.

 

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