Swedroe: Carry Factor Spans Assets

August 30, 2017

One of the problems facing investors is that there are hundreds of investment factors populating a veritable factor “zoo.” In our book, “Your Complete Guide to Factor-Based Investing,” my co-author Andrew Berkin and I reduce the number of “exhibits” worth visiting to just seven by establishing five criteria that a factor must meet before you consider investing in it. One of those seven is the carry factor.

The carry factor is the tendency for higher-yielding assets to provide higher returns than lower-yielding assets. It is a cousin to the value factor—the tendency for relatively cheap assets to outperform relatively expensive ones. A simplified description of carry is the return that an investor receives (net of financing) if an asset’s price remains the same.

Carry Across Asset Classes
The classic application of carry involves currencies; specifically, in going long currencies of countries with the highest interest rates and shorting those with the lowest. Currency carry has been both a well-known and profitable strategy over several decades. However, the carry trade is a general phenomenon, and not limited to currencies.

For example, in commodities, assets with a term structure exhibiting futures in backwardation (futures prices are lower than spot prices) should generate a positive roll yield and, therefore, a positive excess return when market conditions remain unchanged. These assets should thus be overweighted in a carry portfolio.

Conversely, commodities exhibiting futures in contango (futures prices are higher than spot prices) should be underweighted. In other words, in commodities, carry is the slope of the futures curve. In bonds, carry is the slope of the yield curve. And in stocks, carry is the expected dividend yield.

It has been well-documented in recent literature that carry has been profitable across asset classes. For example, Ralph Koijen, Tobias Moskowitz, Lasse Pedersen and Evert Vrugt, authors of the 2016 study “Carry,” found that a carry trade taking long positions in high-carry assets and short positions in low-carry assets earned significant returns in each of the asset classes they examined, with an annualized Sharpe ratio of 0.8 on average.

Further, a diversified portfolio of carry strategies across all asset classes earned a Sharpe ratio of 1.2. They also found that carry predicts future returns in every asset class, although the strength of that predictability varies across them.


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