Devil of a Dilemma: Add the Carry Trade to Trend Following?

We read a lot around these parts; it comes with the job, and we always like to come across well put together pieces from outside our offices, enter Eclipse‘s recent paper. It wouldn’t seem like the type of thing we would be into, titled: Combining Momentum and Carry Strategies Within a Foreign Exchange Portfolio.

For one, we’re not all that into ‘foreign exchange portfolios’ – seeing people get too carried away trying to get foreign exchange exposure without really understanding what that is or does. Anyway,  we liked how the paper starts off, with a nice little table highlighting the benefit of adding 20% managed futures exposure to a stock portfolio. (note it is through Mar. 2013, and still holds true, despite the poor environment managed futures has been in as of late).

BTOP SP500 compareSource: BarclayHedge
(Disclaimer: Past performance is not necessarily indicative of future results)

But the paper is more than just a managed futures advertorial, the paper is really about exploring the benefits of strategy level diversification, and on a more general level – combining a technical, systematic based model such as trend following/momentum, with a macro/fundamental strategy such as FX carry.

Ahhh, the old carry trade, often talked about but less frequently understood. Eclipse does a nice job of explaining just what the carry trade is, and why it is theoretically profitable.

“Carry is a simple, commonly used strategy in foreign exchange markets that involves buying currencies with higher yields and selling currencies with lower yields. One variation of this strategy can be easily accessed using Bloomberg’s Forward Rate Bias (or FX carry) function. The strategy, as we implemented it, ranks each currency based on that country’s 3-month deposit rate yield and takes long positions in the three highest yielding curren­cies and short positions in the three lowest yielding cur­rencies. Theoretically, as argued by Burnside, Eichenbaum, Kleshchelski and Rebelo (2011), the carry-trade bears fundamental economic risks and therefore should earn positive expected returns.”

They go into three different ways to weight a portfolio with momentum and carry, finding that equal weighting works the best. And, of course, combining the two together looks better than either do separately (we’ve yet to see any papers when the combined result is worse…) But the interesting thing to us wasn’t really how the combination performed. The interesting thing to us is seeing how the carry trade has performed over the past few years while the momentum trade has been struggling (we’ve added the down arrow to momentum since 2009 and upwards sloping arrow to the carry strategy).

Cumulative Daily FX Momuntum FX CarrySource: Eclipse Capital
(Disclaimer: Past performance is not necessarily indicative of future results)

This would explain the inclusion of the carry trade in quite a few ‘managed futures’ programs we’ve come across recently.  It’s hard to pass up that positive performance of late while the momentum strategy has been struggling, but beware the crisis period with too much carry trade exposure. Just check out 2008 for the carry trade up above – that’s quite the sell off. Indeed, Quest Partners piece from earlier this year showed that the largest managed futures programs (as represented by the BTop50) have become much more correlated to the FX Carry Trade, and warned that this may impact their performance to deliver crisis period performance in the future.

It’s a devil of a dilemma – add something to the portfolio that’s working now, but that may cause problems later… or forego what’s working now in order to maintain the purity of the crisis period performance profile later.  Or the third option – try and have it both ways, getting the good from the carry trade now, and timing its exit correctly when momentum comes back into vogue.

 

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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