Although the carry trade is most widely
associated with the foreign exchange market, a new report by Campbell &
Company offers research into the “powerful portfolio effect” and “superior long
term, risk-adjusted returns” that can be gained from a multi-asset class
approach to carry.
The paper, written by Campbell &
Company product specialist Susan Roberts, creates a generic, hypothetical
global carry strategy – it does not rely on the firm’s proprietary methodologies,
however – across fixed income, equity, FX and commodities markets.
Using data back to
1992, the research shows that the correlations of carry returns across these asset
classes were low, and actually negative in several instances. Using foreign
exchange as an example, the correlation to fixed income carry was -4%, while
the correlation to commodity carry was even lower, at -15%. The highest
correlation was observed with equity carry, at +9%.
“The foreign exchange
example is an important one, as FX carry trading is known to have historically
experienced significant drawdowns during periods of unusually high market
stress,” the paper states. “However, because of the portfolio effect of
combining carry signals across asset classes, the Hypothetical Global Carry
Strategy did not historically exhibit the same tendency.”
In negative years for
its FX carry component, though it posted an average loss of 4.7% in years it
was down, carry in each of the other asset classes had positive average returns
in those years, the research shows. “As a result, the Hypothetical Global Carry
Strategy was actually profitable in down years for FX carry, with +3.7% average
gains,” it states.
Of the nine negative
years for FX carry, the hypothetical stratgegy was profitable in six of them.
The paper also looks
at the synergies with directional strategies and finds that during the 24-year
period from 1992, the Barclay CTA Index returned 4.7% per annum with volatility
Blending the CTA Index
with a 20% allocation to carry would have increased the annualised return by
24% (i.e., from 4.7% to 5.8% per annum) and reduced volatility by 10% (i.e.,
from 7.3% to 6.6% per annum),” the paper finds. “The combination of higher
returns and lower volatility led to a large increase in the return/risk ratio,
which rose from 0.65 to 0.89,” it adds. “Furthermore, the number of negative
years would have dropped from eight to three.”
The paper finds that similar
synergies can be demonstrated with traditional portfolios, such as those with a
60% allocation to global equities and a 40% allocation to global bonds. Using
the MSCI World and JP Morgan Global Bond Indices to approximate performance for
equities and bonds, respectively, the research finds that the annualised performance
of the blended portfolio would have been “significantly enhanced, with returns
increasing and volatility declining”.
The return/risk ratio
would have increased by approximately 35%, from 0.69 to 0.94 over the 24-year
period. The number of down years would have also declined: the 60/40 portfolio
experienced seven negative years since 1992, while the blended portfolio had
four negative years.
The paper also notes that a risk inherent to all carry strategies is that
the asset price will change in an adverse way, eroding profits. If the spot
price moves enough in the wrong direction, it can completely eliminate the
benefit of holding the asset, leading to losses.
However it finds the
hypothetical strategy “an effective way to address the risk of adverse spot price
movements,” through diversification across a wide range of markets and asset
classes. “This approach has tended to be effective at mitigating tail risk
because of the very low historical correlation between carry returns across
asset classes,” the paper states.
Assumptions in the
creation of the strategy include equal risk weighting by asset class, constant
capital, a 10% annualised volatility target and a 1% flat fee structure.
Colin_lambert@profit-loss.com Twitter @lamboPnL