Tuesday, January 09, 2007
Macro Man has finally found the time to write up the results of his research into the FX carry component of the “beta plus” research program. Of all the macro strategies available, FX carry is among the most attractive to include in a portfolio as a source of “alpha.” Transaction costs are negligible and the long term return to risk profile is remarkably attractive. Indeed, since 1988, a simple G10 carry basket has delivered a return to risk ratio of nearly 0.9. Small wonder, then, that it is such a popular strategy.
The construction of the basic G10 basket could not be simpler. You start with the universe of the G10 currencies: USD, JPY, EUR, GBP, CHF, SEK, NOK, CAD, AUD, and NZD. Pick the three currencies with the highest yield: those are the ones you will be long. Pick the three currencies with the lowest yield: those are your funding currencies. Hold the basket until a currency falls out of either the carry or the funding baskets, then substitute the relevant replacement. It literally couldn’t be easier....and the returns, as demonstrated below, have truly been impressive.
So how can we improve the performance of the simple passive carry strategy? An obvious source of improvement is to use some sort of ‘risk appetite’ filter. The theory is that these filters can identify periods in which investors are likely to unwind risky positions, in which case the model can either exit or reverse the carry trade. When the indicators move back into risk-seeking territory, the carry trade is then re-established. A number of banks calculate their own version of these indices, including JP Morgan, Credit Suisse, Deutsche Bank, Morgan Stanley, and UBS.
The chart below illustrates the return of both the naked and filtered (using one of the banks’ risk indices) FX carry strategy combined with the SPX “beta plus” value filter. It also illustrates the returns of the SPX from a buy and hold perspective, as well as the Tremont Global Macro Hedge Fund return index. The returns of each of these are scaled to a 10 % risk level.
Nevertheless, to come even close to the after fees returns of global macro managers using a simple two factor model that does not include fixed income, non-US equities, emerging markets, commodities, or vol-selling strategies is impressive. Macro Man plans to run with the beta-plus portfolio as a foundation on top of which to overlay alpha-generating trades. As ever, timing is of the essence, and Macro Man is not yet convinced that risky assets are out of the water. Although Macro Man does not believe that next week’s BOJ meeting should matter, he concedes that there may be market participants who think it does. As such, carry strategies could easily see some volatility until the BOJ meeting (and its putative rate hike) are safely under the bridge. Macro Man will therefore wait (as indeed he has been all year) for a correction rather than buying thins like NZD/USD or AUD/JPY at nosebleed levels. Stay tuned...