Carry trading in many asset classes will be subject to crashes when there is a change in the risk regime. Momentum trading also will be subject to crashes when there is increased crowdedness and a change in expectations. Other risk factors can be subject to sharp reversals when they are isolated as target long/short risk premia. This is an overlooked fact concerning alternative risk premia that is sometimes masked when describing its long-term performance. Long-term performance may seem high, but as risk premia are further isolated there is the potential for performance behavior with sharp declines. These crash reversals may be often bundled under the common theme of crowdedness, when the weight of opinion is skewed in a similar direction.
A more well-defined and selective risk premium will more likely be subject to crashes. For example, G10 carry is well-defined and highly selective. A change in carry opinion will lead to a strong reversal of returns. A strategy risk premia that is more diversified across asset classes and harder to define will have less likelihood of crashes. For example, a carry strategy that is applied across asset classes will have smoother returns with lower return and risk. The market portfolio as a combination or bundle of long-only risk premia provides diversification from the crashes of a single premia.
A more well-defined and selective risk premium will more likely be subject to crashes. For example, G10 carry is well-defined and highly selective. A change in carry opinion will lead to a strong reversal of returns. A strategy risk premia that is more diversified across asset classes and harder to define will have less likelihood of crashes. For example, a carry strategy that is applied across asset classes will have smoother returns with lower return and risk. The market portfolio as a combination or bundle of long-only risk premia provides diversification from the crashes of a single premia.
Crowdedness and crash likelihood can explain the higher risk premium for many strategies. Hence, it is critical to focus on crowdedness through flow and narrative consensus. Opportunistic trading will focus on determining how to identify and avoid maximum crowdedness. If that cannot be done, then the best alternative is to ensure any risk premium investment strategy has stop-losses to offset the potential for crash surprises. A stop-loss does not change the underlying risk strategy distribution but reduces the tail risk that is embedded in these strategies which may be the core reason for higher compensation. While not always easy, actions that cut the tail (negaitve skew) will maintain the strategy return.
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