Swedroe: The Carry Trade Defies Theory

The carry trade strategy actually works, but financial theory says it shouldn’t.

The success of the carry trade strategy has led to its widespread proliferation, despite the fact that it contradicts economic theory. In short, this 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. It can be “enhanced” by employing leverage.

Uncovered interest parity (UIP) theory states that there should be an equality of expected returns on otherwise-comparable financial assets denominated in two different currencies. Thus, according to UIP, we should expect an appreciation of the low-yielding currency by the same amount as the return differential. However, there’s overwhelming empirical evidence against the UIP theory. Thus, we have what is known as the UIP puzzle.

Unraveling The UIP Puzzle
A lot of research has attempted to shed greater light on this puzzle, resulting in a number of solid, risk-based explanations for the success of the carry trade. Some recent findings include:

• Financial and macroeconomic variables are important drivers of the foreign exchange risk premium.
• The carry trade has a significantly high and persistent average return, but it’s one that also displays significant negative skewness.
• Time-varying excess returns are compensation for both currency risk and interest-rate risk. High-interest-rate currencies depreciate, on average, when domestic consumption growth is low (such as in 2008), while low-interest-rate currencies appreciate under the same conditions.
• Excess returns are related to changes in global equity market volatility. High-(low)-interest-rate currencies tend to depreciate (appreciate) when global equity volatility is high. Thus, expected excess returns are related to global risk aversion. In times of global-market uncertainty and higher funding-liquidity constraints, investors demand higher risk premiums on high-yield currencies while they accept lower (or more negative) risk premiums on low-yield currencies. This supports flight-to-quality and flight-to-liquidity arguments for the risk premium in the carry trade.
• More than 90 percent of cross-sectional excess returns from the carry trade are explained by FX volatility. Lower-interest-rate currencies offer insurance, because their exchange rate tends to appreciate in response to an adverse global shock. Thus, these “safe havens” (such as the Swiss franc) earn a lower risk premium than others that are perceived as riskier. Safe-haven currencies tend to appreciate when market risk and illiquidity increase.

The Carry Trade And Trend-Following
A July 2015 paper, “Carry and Trend Following Returns in the Foreign Exchange Market,” by Andrew Clare, James Seaton, Peter Smith and Steve Thomas, studied the carry trade in combination with trend-following.

Their research, which covered 39 currencies measured against the U.S. dollar and the period January 1981 through December 2012, focused on the issue of market liquidity, which has been identified as a source of risk in all financial markets. The following is a summary of the authors’ findings:

• Equity market betas conditional on market liquidity price a cross section of currency returns and provide an explanation for the excess return on the carry trade. The high, negative-skewed returns of the carry trade are compensation for the increased exposure to market risk due to reduced market liquidity.
• While a strategy of buying any currency that shows positive carry against the U.S. dollar provides a positive average return, the strategy focusing on those currencies with the highest (and lowest) carry generate the highest average return and Sharpe ratio.
• When measuring the return to the carry trade by taking the average returns from the highest forward premium quintile and subtracting the average returns of the lowest quintile, the average carry trade return is 0.623 percent per month.
• Trend-following (adopting long positions when the trend is positive and short positions, or cash, when the trend is negative) can provide a successful hedge against the risks of the carry trade while generating a significant unexplained average return in a similar order of magnitude to that offered by carry. The results based on moving averages between four and 12 months were similar.
• When combined with a trend-following overlay, the combined strategy generates an average return well above that of its individual components. The increased average return also has desirable characteristics. It offers a higher Sharpe ratio and positive skewness as well as a smaller maximum drawdown than the components of alternative strategies.

Worth The Risk?

For investors seeking alternatives to traditional equity and bond strategies, the carry trade is worth considering, as long as you understand that the carry premium isn’t a free lunch. It involves the risk of crashes that occur at the same time equity holdings are likely to be experiencing large losses. Thus, an investor’s overall portfolio allocation should take this risk into account.

There are also some additional thoughts to consider. First, the research shows the carry premium persists across asset classes. And when carry is applied across many asset classes, it exhibits less skewness. In fact, when carry is diversified across all asset classes, there’s no skewness. Thus, diversification of carry across asset classes can reduce the portfolio impact of rare events.

Second, both carry and trend-following can be linked to liquidity, but at different times that tend to hedge each other. This is another reason why combining investment styles can be an excellent way to diversify. In this case, the skewness associated with carry strategies is ameliorated by trend. On the other hand, trend's illiquid traps are mitigated by carry.

For those interested in alternatives such as carry, there is a relatively new fund from AQR: the Style Premia Alternative I fund (QSPIX). It 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 the stocks of major developed markets, country indexes, bond futures, interest-rate futures, currencies and commodities. The four investment styles are value, momentum (which should not be confused with trend-following because momentum is a relative measure while trend is an absolute measure), carry and defensive.

Specifically, the carry style is implemented across the bond, currency and commodity asset classes. In 2014, the fund returned 11.3 percent. Year-to-date through July 28, it has gained 0.3 percent. (Full disclosure: My firm, Buckingham, recommends AQR funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.