Carry and trend - the match for CTA's

 

Trend-following is a good stand-alone strategy, yet there are many investors that find the swings in performance hard to take. Of course, when trend is added in a portfolio the overall portfolio will do better; however, investors often focus on the risk of individual assets and not the risk of the portfolio to their detriment. This bias of focusing on the parts and not the whole is hard to break. The answer that investors should just get over it does not seem to be helpful. The alternative is to mix strategies in a portfolio in a thoughtful way that will produce the desired return profile. It may be viewed as suboptimal, yet it may allow investors to get closer to the preferred mix at the portfolio level.

So, what mixes well with trend-following? Trend-following is concentrated in futures and across all asset classes, so it would be helpful to integrate another strategy trough futures in a manner that can take advantage of the inherent leverage in futures. Additionally, an investor would like an additional strategy that will complement trend-following and do well when trend returns are subpar and see drawdowns when trend-following exceed expectations. This strategy would be carry.

Carry strategies can be applied to all major asset classes. In the case of commodities, backwardation and contango can be exploited. In currencies, the interest differential can be played. In bonds, the roll-down the yield curve as well as term premium can be gained. In equities, dividend yields can be exploited. The table from Nick Baltas provides the basics of carry across asset classes.

The advantage of carry combined with trend in futures markets is that the two can be integrated. If you are long futures form trend, and the market is in backwardation, the trend can be adjusted through moving to a different point on the futures curve. Clearly, the trend returns, especially when held for the longer-term, will be impacted by the shape of the futures curve. The same can be said for currencies and bonds. The carry effects will either enhance or detract from trend. Although it is a second order effect, carry will supplement trends, so it should be integrated with trend strategies even if there is no explicit embedded carry strategy. In fact, one could argue that carry cannot be separated from trend within the futures markets.