In Search of Negative Carry

One working definition of a professional investor is: somebody who needs to care about “carry.” The classic carry trade is the mid-90’s best against the Yen (I’m going to borrow from this Mark Dow writeup, because I am a macro tourist—literally, my main macro trade is that I avoid traveling to Europe when the Euro is strong). The Yen bet: the BOJ intended to keep rates low; rates in the US were high. So a smart person could borrow Yen, invest in USD, and pocket the difference. A smart person with risk tolerance could do this several times over, and make a very nice return indeed.

As it turns out, one risk of carry trades in FX is that they are a pretty good deal most of the time, so lots of hedge funds get involved, so when something else blows up, they unwind their carry trades, too. So at any given time: a) the carry trade is earning a positive return from the interest rate differential, b) the trade also has a tailwind from more people making the trade (ie every new “borrow Yen / short USD” transaction, but c) at any given time, there’s a possibility of a sudden and painful reversal.

Fortunately for anyone involved in such a trade, you earn your 2 and 20 on performance at a specific time, not on the expected contours of future performance. So for someone who wants pretty good odds of a pretty good return, a carry trade is a pretty good bet.

In fact, it’s such a good bet from an “expected current profits at any given time” perspective that it might be tempting to get involved in carry trades that have a poor expected value but a high chance of short-term returns. Beware anything that looks like an obvious way to make money; it’s probably worse than it looks.

But why do Yen trades from the Clinton administration matter to an equities guy like me?

Because every trade is a carry trade. In FX and credit, it’s explicit—there’s a difference between the interest you pay on what you borrow, and the interest you earn on what you buy. But in equities, there’s a difference in the return profile for different kinds of equally successful trades.

There’s a lot of market wisdom that sounds like total nonsense about selling short: you need thick skin, you can lose a lot of money, etc. That all sounds like it’s technically true but useless. It is in fact technically true, actually true, useful, and essential.

Because shorts aren’t longs.

Suppose you’re a good stockpicker. You have a sense of which companies are performing a little better than the price indicates, and which are performing a little worse. The natural way to think about this: you research two companies’ growth profiles and find that ABC is 10% too cheap, and competitor XYZ is 10% too expensive. When you buy ABC and sell XYZ short, they both kind of bounce around and gradually converge on the correct value.

Not so!

ABC’s management is happy to go on CNBC, investor relations is loquacious, management is forthright because they have much to be forthright about. ABC stock gradually creeps up. At XYZ, management is less chatty. But lack-of-good-news doesn’t read as bad news, and meanwhile they look cheap compared to ABC. So they move up a little, too. For most of the life of the trade, “long ABC, short XYZ” looks like a loser. It’s only when XYZ reports ok earnings but reduces their guidance that the stock violently moves lower.

This may be why a popular hedge fund model is to be net long, rather than flat and more levered. Although the net-long portfolio is more volatile, it’s mostly losing (less) money when the average investor is losing money—instead of underperforming nearly all the time, and making most of its outstanding returns from a few short positions.

It makes sense for professionals to care about carry, since their incentive structure is not “maximize expected return over an infinite future, while minimizing the risk of going to zero,”; it’s “maximize the value of a ‘snapshot’ of the portfolio when fees are calculated, and minimize the odds of looking so dumb you get fired.” Positive-carry trades trade off a small chance of a wipeout for a great chance to make money continuously.

If smart, sophisticated people with $2.4tr in assets under management all have an institutional incentive to be biased towards X, the natural lazy response is to be biased against X. This creates a weird market inefficiency, where the best stocks are “longs that look like shorts,” ie companies where management doesn’t talk much to investors, whose prices don’t follow a smooth trend, but who have a reasonable chance at surprising to the upside. Those aren’t going to end up in a smart hedge fund manager’s book, because when you check the results frequently enough, “right but early” translates to “wrong.”

| October 30th, 2014 | Posted in economics |

Leave a Reply