What if there were a simple, straightforward methodology to measure an investment’s expected return—in multiple types of investments?
It turns out there is. The notion of “carry,” an asset’s expected return assuming its price remains the same, elegantly provides that methodology, according to research by Professor Tobias J. Moskowitz, with Ralph S.J. Koijen of the London Business School (and formerly of Chicago Booth), NYU’s Lasse Heje Pedersen, and VU University Amsterdam’s Evert B. Vrugt.
In finance, carry typically refers to currency trades in which money is borrowed in a currency with low interest rates and invested somewhere else that has higher rates of return. The authors argue, however, that the concept of carry can be applied to virtually any asset class, and provides a framework to link return predictors—such as dividend yields and bond coupons—in different asset classes. Carry can be used to predict returns in these assets classes, and applying it across asset classes can improve returns.
“The simple concept [of carry] characterizes a lot of different predictors that people previously thought were disconnected,” says Moskowitz.
Macro hedge funds have long utilized the currency carry trade—borrowing money in Japan, for example, and reinvesting in other countries where assets provide higher yields. But by studying carry in eight varying financial markets, the authors demonstrate that carry itself is an effective predictor of an asset’s return.
They show that bond carry is closely related to the slope of the yield curve, for example, and equity carry is a “forward-looking measure related to dividend yields.” In the commodity realm, the convenience yield—the benefit of holding the underlying physical good—is a predictor of future spot prices in a host of commodities (e.g., oil). “And that’s the case in every market—the carry does predict future price appreciation,” Moskowitz says.
Do other return factors such as value and momentum explain the returns to carry investment strategies? The researchers find that there can be a relationship between these other factors and carry. However, none of these factors disrupts the returns predicted by carry, leading the researchers to conclude that “carry represents a unique return predictor in each asset class above and beyond these factors.”
The straightforward carry, by providing a uniform strategy across multiple asset classes, could be a valuable tool for investors. The researchers’ analysis shows that a “zero-cost carry trade portfolio”—one that buys high-carry securities and sells low-carry ones—captures a significantly better risk-adjusted return within each asset class than other asset pricing models do. And forming a portfolio of carry strategies across all asset classes improves returns significantly more, suggesting benefits from diversification.