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Carry Trade’s Long Winning Streak Fades – For Now

By Brian Brugman and Sharat Kotikalpudi (click to enlarge) Currency carry trades haven’t worked so well lately. But instead of discarding them altogether, we think investors should just put them aside for now and focus on more promising return sources from other asset classes. For years, carry trades had delivered solid returns before running into their recent weak patch, and there are good reasons why they’ve faltered. But no strategy works all the time, and in years to come, carry trades may well start to pay off again. So, they still belong in investors’ multi-asset tool kits. How Currency Carry Trades Work Carry trades involve selling (or going short) developed-market (DM) currencies with low interest rates and buying (or going long) ones with high rates. A typical carry trade would work like this: an investor might borrow ¥1 million from a Japanese bank, where borrowing costs are set at 0.1%, and use the money to buy a bond priced in Australian dollars that yields 5.5%. By exploiting the gap in interest rates, the investor stands to make a profit of about 5.4%, if the currency exchange rate doesn’t change. But exchange rates do change, and that’s where the risk in carry trades comes from – the unexpected moves in exchange rates. In this scenario, a fall in the Australian dollar relative to the yen could eat into – or even offset – the gains from the difference in interest rates. Diminishing Returns Over the past several decades, the positive interest earned from carry trades has usually been large enough to outweigh modest exchange rate moves. But since 2009, currency carry strategies have resulted in flat or negative returns. (Display). What’s Gone Wrong? To start with, exchange rates have fluctuated more in recent years, because countries with relatively high interest rates have been cutting them. Central banks in Norway and Australia – both large commodity producers – cut rates this year to record lows to help cushion their economies from a sharp decline in the price of oil and other natural resources. When countries with high interest rates start to cut them, investor demand for their currencies declines, their currencies fall in value, and the gap between high and low interest rates narrows, making carry trades less profitable. Zero Interest Rates Upend Carry Strategies The global financial crisis created another handicap – zero interest rates. Because rates are already near zero in the US, Japan and the eurozone, going lower would require a move into negative territory, something most central banks are reluctant to allow. That effectively means those rates won’t fall any more. On the other hand, central banks in places like Australia still have plenty of room to cut rates, and currencies like the Australian dollar have plenty of room to decline in value. As a result, the interest rate gap between high-yielding currencies and low-yielding ones is closing more quickly than it would have if high- and low-rate central banks had been easing policy at the same time. That means carry trades will continue to struggle. Carry Will Recover – But Not Yet These dynamics will change when some of the central banks with zero or near-zero interest rates – the Federal Reserve and the Bank of England come to mind – start raising them. If they keep at it for several quarters, the US dollar and sterling could become attractive carry trade targets relative to currencies from weaker economies with lower interest rates, such as the euro. But this won’t happen overnight. The rise in US rates, once they start to go up, will probably be much more gradual than in past cycles. That means it will take time before DM currency carry trades start to match the sort of returns seen in years past. The Importance of Being Flexible In the meantime, we think investors should focus more of their active risk in fixed-income and equity strategies. Within currencies, we see better opportunities in emerging market carry. It’s easy to get hooked on strategies that deliver consistently strong returns, but focusing on just one can be dangerous. All strategies go through periods of low or negative returns, just as stocks, bonds and other asset classes do. That’s why it’s important to invest in a wide range of strategies – and to know which ones work best in which conditions. We think a nimble, integrated and dynamic multi-asset approach that taps many sources of risk and return is a better way to go. This way, investors can move quickly when a once profitable strategy like the currency carry trade starts to recover. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Brian T. Brugman – Portfolio Manager – Multi-Asset Sharat Kotikalpudi – Quantitative Analyst – Dynamic Asset Allocation

Jeremy Siegel’s Case For Equities

Jeremy Siegel has done more work on historical stock returns than pretty much anyone. He literally wrote the book on it, pulling stock data going back to 1802 for Stocks for the Long Run . In a recent Master in Business podcast interview he summed up his case for equities simply: What I showed was when you stretch out your holding period, up to 15, 20, 30 years, stocks actually were safer than bonds – had a lower variance and lower volatility than bonds. The long term, of course, gets overlooked with stocks. Everything – returns, variance, volatility – smooths out once you start to stack years together. I’ve broken down the S&P 500 returns over longer periods before. Since 1926, one-year returns range from a 54% gain to a 43% loss. If you put five years together, the annual returns range from a 29% gain to a 12% loss. Ten-year annual returns range from a 20% gain to a 1% loss. Fifteen-year annual returns range from a 19% gain to a 1% gain. Notice a trend? The range of possible returns shrinks as you extend the holding period. This is why stocks are Siegel’s asset of choice: If we know that return over that longer period of time is going to beat bonds by 3-4-5% per year, wow, that becomes the asset of choice for the long run. So why not only own stocks? Because people still fixate on one-year returns. It’s not much of a reach to suggest that fixation does more harm than good. It drives action. People look at one year’s return and expect it to continue. So money flows into stocks after a great year, and out after a terrible year. This need to act is why diversification is so important. Bonds become a psychological buffer for the short term craziness in the markets. And then there’s valuation. There are times when stocks become so expensive in the short term that it negates much of that long-term potential. The difficulty is in trying to time these periods because a high valuation doesn’t guarantee immediate poor returns – high priced stocks can always go higher in the short term – and valuation tools, like the CAPE ratio , don’t help the cause. Prior to the dot-com bubble, Siegel was a devout index fund fan: I was wedded to cap-weighted at the same time I said tech was crazy. And I didn’t know how to reconcile those two. Your typical index fund is market-cap weighted , which makes it extremely efficient. There’s just one big flaw. If a few stocks become wildly inefficiently priced (like internet stocks during the dot-com bubble) there’s no way to sell those stocks in a cap-weighted index. Rather, the cap-weighted index fund continues to buy more as the market cap rises. So Siegel’s solution was to change the weighting – essentially creating fundamentally-weighted index funds based on objective earnings data and opening the door for the rise of smart beta. Now, the fundamental weighting method isn’t perfect either. It won’t magically prevent a losing year. But if you’re only focused on one-year returns, it won’t matter anyway, you’ll be too busy acting before you ever see the benefits.

Dual ETF Momentum November Update

Scott’s Investments provides a free “Dual ETF Momentum” spreadsheet which was originally created in February 2013. The strategy was inspired by a paper written by Gary Antonacci and available on Optimal Momentum . Antonacci’s book ” Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk ” also details Dual Momentum as a total portfolio strategy. My Dual ETF Momentum spreadsheet is available here , and the objective is to track four pairs of ETFs and provide an “Invested” signal for the ETF in each pair with the highest relative momentum. Invested signals also require positive absolute momentum, hence the term “Dual Momentum”. Relative momentum is gauged by the 12-month total returns of each ETF. The 12-month total returns of each ETF is also compared to a short-term Treasury ETF (a “cash” filter) in the form of the iShares Barclays 1-3 Treasury Bond ETF (NYSEARCA: SHY ). In order to have an “Invested” signal, the ETF with the highest relative strength must also have 12-month total returns greater than the 12-month total returns of SHY. This is the absolute momentum filter which is detailed in-depth by Antonacci, and has historically helped increase risk-adjusted returns. An “average” return signal for each ETF is also available on the spreadsheet. The concept is the same as the 12-month relative momentum. However, the “average” return signal uses the average of the past 3-, 6-, and 12- (“3/6/12”) month total returns for each ETF. The “invested” signal is based on the ETF with the highest relative momentum for the past 3, 6 and 12 months. The ETF with the highest average relative strength must also have average 3/6/12 total returns greater than the 3/6/12 total returns of the cash ETF. Portfolio123 was used to test a similar strategy using the same portfolios and combined momentum score (“3/6/12”). The test results were posted in the 2013 Year in Review and the January 2015 Update . Below are the four portfolios along with the current signals: (click to enlarge) As an added bonus, the spreadsheet also has four additional sheets using a dual momentum strategy with broker-specific, commission-free ETFs for TD Ameritrade, Charles Schwab, Fidelity, and Vanguard. It is important to note that each broker may have additional trade restrictions, and the terms of their commission-free ETFs could change in the future. Disclosure: None.