The carry trade, the strategy based on borrowing the lowest yielding currencies and taking long positions on the highest yielding, performs well when interest rate spreads are high and the economy is stable and strong. It is therefore normally associated with economic growth, and tends to do well over the long term, but can be prone to sharp reversals in difficult markets. Some years, like in 2008, it can inflict huge losses on those who follow it.
“Over the past 30 years, carry trade has been a good money-making strategy,“ says Elizabeth Para, currency investment strategist at Overlay Asset Management. “But while it produces a small steady incremental profit year after year, in one year it can make a loss that wipes out all the previous years’ gains.” Consequently, she notes, managers that were overly reliant on carry trade were hurt quite badly, and investors need to be aware of the risks.
“Most FX managers continue with it because it is so useful, but they are not 100 per cent reliant on it,” she adds. “Part of the key to this is diversification using the broadest range of strategies, with different frequency trading models and different time horizons to help reduce risk. The other important part is to build models that can detect the reversal of the carry trade.”
Systematic risk can be reduced by using a mix of strategies. Most managers use a combination of the carry trade, crossover momentum and volatility trading, and a few also use options programmes. Each strategy produces different results at different stages of the cycle.
While carry trade does well when economies are strong, volatility strategies, which are based on buying implied currency volatility, do well when equity risk premiums are rising.
Volatility trading produces widely fluctuating returns – usually explosive ones in uncertain climates, and big losses when conditions are benign. Its high risk means few investors want heavy exposure to it.
A crossover strategy involves trading the carry trade time series in a long or short fashion, using technical trading indicators, basing the crossover chart on varying timespans. A crossover momentum rule applied to the carry strategy produces slightly lower long-term returns than a pure carry trade strategy, but excels when carry trades unwind, outperforming when conditions are uncertain. This makes it a useful partner to carry strategies.
UBS has done some work on how the strategies correlate with each other, backtested over 20 years. It concludes that an optimal strategy will have features of all three strategies, but will predominately consist of the carry trade, while the volatility strategy element should be very small. UBS notes that the cross correlations between these three prime strategies are generally low, and that the carry trade and volatility strategies are in fact ’directionally opposed’.
There is a relatively insignificant correlation between crossover and carry strategies, suggesting they also make compatible portfolio partners.
“It’s one thing to have a set of managers with different strategies,” says Collin Crownover, managing director and head of currency management for State Street Global Advisors. “But the important part is to monitor them all. Many managers who had used several strategies developed a creep towards the carry trade in the lead up to 2008, so you could do worse than adding a manager with no exposure to it at all. It is not a fluke that it underperformed during the crisis.“
“There has been a structural shift towards a lower allocation to carry strategy,“ says Jaco Rouw, senior global fixed income investment manager at ING Investment Management. “If you look at beta returns compared with carry returns, the conclusion is that currency managers have lower exposure to carry trade because of the huge shake-out in these strategies in August to October 2008. This is shown by the relationship of beta currency trading returns to carry trade returns, which was 0.5 to 1 per cent, but dropped to 0 to 0.3 per cent after Lehman.“
Last year was a profitable environment for carry, he adds, and the beta of currency strategies to carry trade picked up in the fourth quarter of 2009, showing renewed interest in the strategy.
