Swedroe: Carry & Trend Effects Up Close

Two of the most well-known phenomena in investing are the carry effect and the trend effect. Trend is related to momentum. While carry is typically used in the context of currency markets (currencies with higher yields tend to produce higher returns than currencies with lower yields), it can also be employed in a broader context.

Specifically, assets such as stocks and bonds with higher yields produce higher returns, and commodities with lower futures prices (in backwardation) produce higher returns than commodities with higher futures prices (in contango). Thus, carry can be best thought of as the expected return on an asset, assuming that market conditions, including price, stay the same.

Vineer Bhansali, Josh Davis, Matthew Dorsten and Graham Rennison—authors of the March 2015 paper “Carry and Trend in Lots of Places”—studied four asset classes (stocks, bonds, commodities and currencies) across five different major country markets for a total of 20 sets of data. The study covered an extended sample period from 1960 to 2014.

Categorizing Assets

For each market, they categorize assets into one of four groups:

1. positive carry and positive trend
2. positive carry and negative trend
3. negative carry and positive trend
4. negative carry and negative trend

Their results “confirm overwhelmingly that having momentum and carry in your favor leads to significantly better returns, on both an absolute and a risk-adjusted basis.”

The following example, which is based on results for the U.S. 10-year Treasury note, clearly demonstrates how having both factors in your favor can improve investor outcomes. The authors found that “over the full sample, the average excess return for carry was 2.9 percent per year, but in periods when both trend and carry were in favor (i.e., positive), the average annualized excess return was almost double the average, at 5.2 percent per year.

Conversely, when both trend and carry were against the position, the average return was -4.2 percent. The mixed categories, with one of trend and carry against, and one in favor, the returns were in between, at 1.6 percent and 3.2 percent, respectively.”

Results ‘Robust’

The authors also found this result “appears remarkably robust across samples, including the period of rising interest rates from 1960 to 1982.” In particular, they found that “while carry predicts returns almost unconditionally, trend-following works far better when carry is in agreement.”

The authors add: “The results are striking and intuitive. In all but one case (Bund futures), the positive-carry, positive-trend buckets significantly outperform the negative-trend, negative-carry positions.”

A November 2013 study—“Carry,” by Ralph Koijen, Tobias Moskowitz, Lasse Pedersen and Evert Vrugt—found supporting results. For example, these authors found:

• 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.
• Carry predicts future returns in every asset class with a positive coefficient, but the magnitude of the predictive coefficient differs across asset classes.

Asness Findings Confirmed

These conclusions confirm the findings from the study “Value and Momentum Everywhere,” by Clifford Asness, Tobias Moskowitz and Lasse Pedersen. In their paper, which appeared in the June 2013 issue of The Journal of Finance, the authors examined the value factor and momentum factor across eight different markets and asset classes (individual stocks in the U.S., U.K., continental Europe and Japan, as well as country equity index futures, government bonds, currencies and commodity futures).

The following is a summary of their findings:

• There are significant return premia to value and momentum in every asset class. The value premium was persistent in every stock market, with the strongest performance in Japan. The momentum premium was also positive in every market, especially in Europe, though statistically insignificant in Japan.
• Value strategies are positively correlated with other value strategies across otherwise unrelated markets. In addition, momentum strategies are positively correlated with other momentum strategies globally. This persistence helps assuage data mining concerns.
• Value and momentum are negatively correlated with each other within and across asset classes. The negative correlation between value and momentum within each asset class is consistent and averages -0.49. For stocks, the correlation averaged -0.60. Their negative correlation and high positive expected return implies that a simple combination of the two is much closer to the efficient frontier than either strategy alone. Combining strategies results in improved Sharpe ratios.
• There’s significant evidence that liquidity risk is both negatively related to value and positively related to momentum globally across asset classes. The implication is that part of the negative correlation between value and momentum is driven by opposite-signed exposure to liquidity risk. However, liquidity risk can only explain a small fraction of the value and momentum return premia and co-movement.

Momentum Vs. Value

The authors of the study offered the following explanation for why momentum loads positively on liquidity risk and value loads negatively: “A simple and natural story might be that momentum represents the most popular trades, as investors chase returns and flock to the assets whose prices appreciated most recently.

Value, on the other hand, represents a contrarian view. When a liquidity shock occurs, investors engaged in liquidating sell-offs (due to cash needs and risk management) will put more price pressure on the most popular and crowded trades, such as high momentum securities, as everyone runs for the exit at the same time, while the less crowded contrarian/value trades will be less affected.”

While the previous study, like most academic papers, focused on gross returns, a 2012 study, “Trading Costs of Asset Pricing Anomalies,” found value and momentum strategies can be scaled considerably and still generate strong net returns.

Evidence Mounting

The evidence that investors can improve the efficiency of their portfolios by using investment vehicles incorporating value and momentum strategies is piling up. And with the publication of Robert Novy-Marx’s 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” we have strong evidence that combining this third factor with value and momentum improves portfolio efficiency even further.  

One set of funds designed to implement these concepts together is the recently launched AQR Multi-Style Equity Funds (QCELX, QSMLX, QICLX and QEELX). The four multistyle (or factor) equity funds were launched in March 2013 (except QEELX, which was launched May 2014) and offer direct exposure to a combination of value, momentum and profitability.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.