Back in 1985, the deposit rate on Mrs. Watanabe’s savings account was probably around 5%. Since she was astute and wanted the best for her family, she opened a bank account in Australia where she could earn something closer to 15%. Of course, this decision wasn’t risk-free since the exchange rate between the Australian dollar (AUD) and the Japanese yen (JPY) are always shifting.
Still, though, the 10% interest rate differential created a cushion for changes in the currency rates. If rates stayed unchanged, then she would earn the full 10% difference. If the JPY appreciated versus the AUD by 5%, she would still have earned 5% more than she otherwise would have if she had left her money in her local bank. And, of course, if the JPY weakened 5% versus the AUD, then she would earn 20% on her hard earned savings – four times what her local bank paid at the time.
Academics noticed what Mrs. Watanabe was doing and concluded that she was earning the equivalent of a free lunch, which doesn’t really exist in economic theory. When real life doesn’t match economic models, academics refer to it as a ‘puzzle’ since they can’t explain a phenomenon that shouldn’t exist.
Hedge funds and banks realized that this is exactly the kind of puzzle worth exploiting and began to employ the carry trade, which means that they borrow money in countries with low exchange rates (funding currencies) and invest in countries with high exchange rates (investment currencies).
This trade didn’t just work in Japan, it worked all over the world. Anytime there are large interest rate differentials, it has been profitable to borrow in countries with low yields and invest in countries with high yields, even after decades of literature on the subject should have ‘arbitraged’ away the free lunch.
Now that the hedge fund style investing is being democratized by the mutual fund and Exchange Traded Products community in the form of ‘liquid alternatives,’ the carry trade is available to individual investors through two products. The first is the iPath Optimized Currency Carry ETN (ICI) and the second is the Powershares DB G10 Currency Harvest (DBV).
There are several articles that compare and contrast the two products, but none that takes a longer view of the indexes that they follow. For the analysis, I used monthly data from Bloomberg for the ten years ending February 2011.
The iPath product, ICI, tracks the Barclays Intelligent Carry interest, which earned an annualized return of 7.28%, and had an annualized standard deviation of 6.30% for a Sharpe Ratio of 0.81. The Powershares product, DBV, tracks Deutsche Bank G10 Currency Harvest index, which earned an annualized 5.11% return, and had an annualized standard deviation of 9.73% for a Sharpe Ratio of 0.30.
Over the same time period, stocks had poor returns of 1.77%, high volatility of 16.88% and a resulting low Sharpe Ratio of -0.02. Bonds, as measured by the Barclays Aggregate, gained 5.68%, had low volatility of 3.83% and a Sharpe Ratio of 0.92.
Both carry indexes beat the S&P 500 (SPY), but it was an unusually bad time for stocks. The Barclays Intelligent Carry index beat bonds in straight performance, but also had higher volatility. Bonds beat the DB Currency Harvest in both nominal and risk-adjusted terms.
In addition to the risk/return characteristics, it is useful to look at the correlation of the two indexes to stocks and bonds, in order to understand whether they could help diversify a portfolio. The Barclays Intelligent Carry Index had a correlation of 0.19 to stocks and -0.01 to bonds, suggesting no meaningful relationship. The DB Currency Harvest didn’t fare quite as well; it had a correlation of 0.61 to stocks and 0.03 to bonds.
Much of the correlation, for both carry indexes, was the result of meaningful losses during the financial crisis. In 2008, when stocks fell 37%, the Barclays Intelligent Carry index dropped 15.49% and the DB Currency Harvest fell 28.50%. During the crisis, many of the funding currencies like the US Dollar and Japanese yen gained sharply since they are viewed as ‘safe havens.’ Another funding currency, the euro, dropped in value as it appeared that their banking system was in more trouble than ours.
Additionally, as hedge funds and banks needed to raise capital, the carry trade was one of the easiest to unwind since the foreign exchange market is perhaps the world’s most liquid market.
In the short run, it’s difficult to say how the carry trade will perform despite the attractive long-term characteristics. On the plus side, interest rate differentials are more meaningful and the ‘risk-on, risk-off’ trade seems to be abating.
On the other hand, the carry trade is most effective during periods of strong global stability. Today, with more possible sovereign defaults in Europe, generational change in the Middle East, and the Federal Reserve engaged in uncharted policy actions, it hard to argue that we are in a period of stability.
Still, over the long run, the carry trade, better implemented by Barclays thus far, makes sense in a portfolio because it has attractive rates of return, particularly on a risk-adjusted basis, and a low correlation to stocks and bonds.
Mrs. Watanabe is probably looking to get back into the carry trade, but is probably wise to hold off for now.