Tuesday, January 09, 2007

Carry Me Home

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 what’s the problem? Well, Macro Man is a touch concerned that the basic G10 carry trade has gone a bit tabloid. The FT carried a story yesterday on a BGI automated FX fund that replicates the FX carry trade, and Deutsche Bank has already listed an ETF designed to capture the FX carry trade. It’s not exactly the economist crowing over dollar weakness, but it’s not far off, either. These sorts of products are going to introduce a new entrant into the FX carry arena. Without wishing to be rude, the products will likely cater to “dumb” money, and could potentially increase the volatility of what had heretofore been an attractive strategy. The mixed returns of the carry trade in 2006 also suggest that the na├»ve carry strategy could be headed for a period of underperformance, as was observed in the early 1990’s.

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.

As you can see, just two elements of a “beta plus” benchmark deliver superior returns to the Tremont Global Macro Index over the last twelve years! A couple of caveats are obviously warranted. The Tremont Index is net of fees, whereas the beta plus strategy is not. The Tremont index is actual returns, whereas the beta plus index is backtested. Moreover, the history of ‘risk appetite’ indices suggests that something not captured in the index has an impact on prices more often than one would like. So to a degree, there is an element of data mining in the beta plus returns.

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...


Anonymous said...

great post

thanks for illuminating something that most people hear about but don't know enough about

Anonymous said...

Pardon the embarrassingly retail questions, but:

- what are you using to determine a currency's yield? fed funds rate? tbills? libor?

- any idea where folks who don't have access to a bloomberg might get access to such data for non-US currencies?

Many thanks!


Macro Man said...

I use interbank lending rates, which you can get from the FT. The basket is relatively static, so you can get away with only checking once a week or so. Alternatively, there is an ETF, DBV, which provides passive exposure to the G10 FX carry basket.

Anonymous said...

thanks so much!