Amid subpar prospects for forward-looking returns in virtually every asset class, more investors are looking at using alternative strategies, such as carry, to capture returns with relatively low correlation and volatility
It's no secret that forward-looking returns are being squeezed in virtually every asset class. Long-term returns on the S&P 500, the broad benchmark of the U.S. stock market, are tracking less than half their historic norm, while bond investors are bracing for returns that are less than a third of their historic averages. Add it up and investors in a traditional 60/40 portfolio of stocks and bonds may be lucky to eke out 3% to 4% returns in the coming decade.
There’s another way: Dispersion within asset classes. While government bond yields are close to record lows, the yield differentials between countries are well above average. In stocks, the difference for return on equity and valuations between the U.S. and Europe are their highest since the mid-1990s. This is also true for the currency and commodity markets, where the gaps between leaders and laggards are substantial.
For investors, this presents an opportunity to glean equity-like returns by systematically capturing these discrepancies through a strategy known as carry.
“Carry does particularly well in a low-growth environment that many fear is the new normal,” says Andrew Sheets, Morgan Stanley’s Chief Cross-Asset Strategist and co-author of a new report on how, done right, a strategy based on carry could complement or even take the place of some other alternative investments.
Investors can further diversify—and improve their odds of success—by implementing carry across multiple asset classes.
The concept of carry isn't new. Commodities traders “carry” the cost of holding, say, copper ore in terms of storage and other overhead expenses, in hopes of selling at a much higher price later, thereby turning the cost into a higher return, but it can apply to virtually every asset class, including stocks, bonds, currencies and others.
How does it work? “The way we think about it is: What is the expected return of an asset class over a period of time, such as a month or a quarter, all things being equal?” says Sheets, adding that most investors use futures to measure carry, i.e., the price quoted now vs. the price other investors believe it will have at a certain date in the future—the difference could be your carry return or cost. “We then create carry portfolios, going long the best and short the worst carry assets within asset classes.” In effect, this allows investors to benefit from a wide differential between high and low carry assets.
Take the currency, or FX, market. An investor interested in using carry can rank currencies from high to low, based on expected returns over the next month, then take long positions in, say, the top quartile and short positions in the bottom quartile. The investor would hold, or “carry,” that basket of securities for a month (or other set interval), then sell the positions, re-rank and repeat. “This is something we like because it is a systematic, rules-based strategy,” says Sheets.
While options are still limited for individual investors interested in carry investing, institutions and large asset managers have begun incorporating carry into their portfolios, namely through factor-based strategies. “There are more tools available to implement sophisticated strategies, and there is a growing interest,” notes Sheets.
Investors can further diversify—and improve their odds of success—by implementing carry across multiple asset classes. Over the past two decades, an aggregate carry portfolio from FX, equity, commodities and rates, has produced 11% returns and with less volatility than global equities, and a low correlation.
Source: Bloomberg, Morgan Stanley Research
Contrary to conventional wisdom, rising rates don’t pose additional risk to carry trades. In fact, a diversified carry portfolio does better when rates are rising than when they are falling, Sheets notes. Similarly, it's better to enter carry trades when volatility in the equity markets is high.
Carry can work in most market environments, but there are nuances across asset classes. “The biggest risk is in implementation,” says Sheets, who notes that transaction costs also needed to be factored into anticipated returns. Finally, carry strategies require patience: “You are counting on doing this again and again over time to capture these small risk premiums,” he adds.