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 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:
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:
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.
Investment Grade (VFSTX)
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.