The Derivative - Carry On: Demystifying the Carry Trade with Rodrigo Gordillo & Adam Butler of ReSolve

Episode Date: June 26, 2024

We’re back! Today’s podcast features The Derivative show stoppers Rodrigo Gordillo and Adam Butler of Resolve Asset Management discussing the carry trade and its applications in investment strategies. They begin by explaining what the carry trade is and discussing common misconceptions around it. They then dive into different types of carry that can be found in various asset classes like bonds, commodities, currencies, and equities. The guests discuss how carry strategies can be implemented, either on their own or as part of a larger multi-strategy portfolio. They also compare carry to trend following strategies and debate the pros and cons of each approach. The podcast explores how a diversified carry factor can provide returns with reduced risk when combined with other strategies. Rodrigo and Adam explain how carry fits into their risk parity framework and can be used to tilt allocations. They also discuss integrating carry and trend signals to lower trading costs. Gear up to receive that spoonful of sugar that indeed will make the medicine go down with tons of insight and access to some great content as an investment factor and perspectives on its role in multi-asset portfolios. Chapters: 00:00-01:31= Intro 01:32-10:31= What’s a carry trade? 10:32-20:34= Types of carry in different asset classes & Implementing strategies 20:35-33:11= Carry vs Trend & portfolio applications of carry 33:12-49:05= Combining carry & trend: How does it fit together? 49:06-01:04:54= Why Carry? The future of carry strategies From the episode: The Rise of Carry(Book) The Carry Trade post Get Stacked Podcast ReSolve Riffs Podcast Setting the Risk Parity Record Straight - The Derivative episode Researching the Risks of return stacking with Corey Hoffstein & Rodrigo Gordillo - The Derivative episode Asset Allocation, AI, and the Alpha process with Resolve - The Derivative episode Follow along with ReSolve Asset Management on Twitter/X @InvestReSolve Adam Butler @GestaltU & Rodrigo Gordillo @RodGordilloP, LinkedIn and check out their research page for more information Don't forget to subscribe to ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠The Derivative⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠, follow us on Twitter at ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠@rcmAlts⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ and our host Jeff at ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠@AttainCap2⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠, or ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠LinkedIn⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠ , and ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠Facebook⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠, and ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠sign-up for our blog digest⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit ⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠⁠www.rcmalternatives.com/disclaimer⁠

Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. Hello there. Welcome back. That was an unexpected few weeks off. Sorry about that. I had some COVID-like something pop

up. Then a guest couldn't make it. Then some summer schedules got in the way. But we're back with a deep dive of a pod here talking about the infamous carry trade with our old friends and former pod guests, Rodrigo Gordillo and Adam Butler of Resolve. So what is the carry trade exactly? The currency trade that can blow up a hedge fund or the non-correlated trade that can act as a big diverse fire for multi-strat funds? We're here to find out. Send it. This episode is brought to you by RCM's Outsource Trading Desk. You know where futures carry trades like we talked about in this episode are executed?

That's right, right there at RCM's 24-6 Outsource Trade Desk Operations. Check it out at rcmalts.com slash 24. And now, back to the show. all right welcome guys we're here with rodrigo gordillo which after 10 years or so i can finally pronounce correctly uh you can go back and listen to some old podcasts where i completely butcher it uh and adam butler of resolve how are you guys we are good man yeah adam's as much easier to pronounce yeah I'm sorry I missed you here in Chicago um but we've been running around like crazy ourselves lots of baseball and softball and golf tournaments which is all good um so you guys did this recent white paper on the carry trade which you want to get into but um let's start with when i hear carry trade we just did a blog post we'll put a link to it in the show notes of like

in 2008 there was a guy who blew up from the carry trade and he had a yacht named carry positive carry so i think a lot of people when they think of the carry trade, think of this trade that can blow up. So maybe start with how traditional carry works, and then we can get into the nitty gritty of what your white paper is. Who wants to dive on the grenade first? So I'll chime in. that traditionally people have, when they hear the word carry, they think of an investment where you've got steady, relatively high returns or excess returns relative to cash or T-bills with either zero or very low levels of volatility, sort of picking up nickels in front of a steamroller. I think people are familiar with that metaphor. And every now and then there's a risk escalation and the trade goes wildly against you

and you end up losing a pile of the returns that you earned along the way. So volatility selling would be a version of that. We were chatting before the show for a very long time. There was the Mrs. Watanabe trade where you had all the Japanese housewives borrowing in yen, investing up the curve into euros with higher rates or into dollars with higher rates or emerging markets with even higher rates. And that tended to pay off quite nicely until there was some sort of risk event, which caused a

flight back into the yen or flight into the dollar or something and the trade would blow up. So what's different about the approach that we've described in the paper is that we're taking sort of a wide variety of these types of risks. Like if you think about it, equity risk is carry. You are investing in an equity index. Most of the time, it generates nice positive returns. And every now and then there's a risk event and you lose 30 to 50 percent of your wealth in a matter of a few months. Right. And we're investing in all of these different markets, equities, bonds, currencies, commodities, each of which has each market has its own idiosyncratic risk of something happening within that market. Think of a specific incident within a certain equity market because of political turmoil or some other geographic risk, or within the energy complex or specifically in Brent crude or within a specific grain, et cetera, they all have their own kind of carry risk where they could have a large spike. But when you blend all of these

markets across these different sectors together, the spikes tend to diversify one another. So it's not as if the strategy doesn't have any volatility. You know, it does go up and down and it does have drawdowns. But because of the diversity within the portfolio and the fact that you've got long and short positions conditioned on whether the market is in a positive carry state or expected carry state or a negative expected carry state, given the shape of the futures term structure or some spot analog, those spikes tend to balance out and over time you get this nice smooth growth line.

You jumped to the end in the beginning, but Rod, if you could come back up two levels i think i can add some interesting color to that idea of carrie as well because i just had a conversation yesterday with an advisor that he pointed to a book by uh what was it called the The Rise of Kerry, The Dangerous Consequences of Volatility. Yeah, Kevin Carmichael. Kevin Calderon, yeah. So he was saying, look, there's a clear... Cold iron, yeah. Cold iron, yeah.

There's a clear depiction of what Kerry is and the dangers of Kerry. And he was curious to know what our thoughts were on that. And so I think it's important to disaggregate what they mean in that book by Kerry, what a lot of people are thinking Kerry is, and what a diversified, long, short, managed futures Kerry strategy is. The idea of Kerry is what you get paid

if the price doesn't change. So the idea of Kerry in equities is your dividend is what you're going to get paid at the end of the year, assuming the price doesn't change, is your return. But of course, your actual return is a combination of did the price of the asset appreciate plus that dividend, right? And so that'll vary over time. But your selection mechanism for a diversified carry strategy is based on is the yield higher or lower relative to other things? Or is the year higher or lower relative to itself? Or is a year higher lower relative to itself or is it positive or negative there's a wide variety of ways that we describe in the paper which i gotta say adam and andrew butler both did an immense amount of work on this for months and

and they they did a great job on it so if uh aside from the podcast if nobody's got a chance to download it i would um but they go into detail of the different types of carry but going back to the the perception of what carry is and the dangers of carry is the basic nuance here on this paper is the fact that on this um book is that they describe carry as borrowing very cheaply to then invest in higher yielding assets and when that when that carry changes you're going to get blown up. So that's accurate, right? Yeah, and I think, right, I want to come back, Adam,

you kind of equated it to just what I would just call risk, right? Of like, hey, there's risk in this. We can hold that risk and get paid. So that's true, but also a little more nuanced than, right? I think the book and the perception out there is carry, the difference between carry and the carry trade so the carry trade was borrowing cheaply investing richly right and i'm curious you're saying like actual japanese housewives would do that great because you had to have a japanese long-term trade when you know call it 10, 15 years after the peak in Japanese equities and the

Bank of Japan had kept rates basically at zero all along the curve and you could borrow along the curve for next to nothing in yen and then invested up the curve in, you know, Aussie dollars or euros or what have you. And lots of non-Japanese were doing that as well. Oh, yeah. Yeah, for sure. But they had a harder time getting access to the in-country than the actual Japanese did. Yeah.

And also that carry trade, that Japanese yen trade, a lot of people think when you say carry they often just think about currency carry and currency carry can be seen as a very singular trade because even though you're trading many different securities most of the time they're thinking us and somebody somebody else's currency cross right versus the us sometimes us being the reserve currency when it all of a sudden changes and there's a a run safety, every one of those crosses will get burned at the same time, right? So this is really, this can happen in any type of carry trade, but are the same drivers affecting all carry trades across bonds, across equities, across commodities and currencies? And the answer is no, that's the key behind all of this in terms

of being a successful strategy is you want to make sure that you're diversifying all the risk across different types of carry trades in different types of markets how do you view the difference between trading right if i just own uh swiss francs against the dollar what's the difference between that and borrowing the dollar to own the Swiss franc? Essentially nothing, right? There's like a little nuance there between actually just trading the currencies and doing the quote unquote carry trade. Yeah, I mean, you're looking for changes in the carry, right? So there are periods when like there's carry is kind of a fancy word for things that actually people are very well aware of, right? Rodrigo mentioned that equity

carry is the dividend yield, right? Right. Which no RA in the history of mankind has ever called the dividend carry. Carry, exactly. That's what it is. In bonds, carry is either through a steep yield curve, right? Where you typically have a higher required return to lend your money for 10 years than you do for two years or three months. And so a positive sloping yield curve produces bond carry, duration carry. You can also have carry on the balance sheet. They're two years at 2%, five years at 5%, 10 years at 10% in an extreme example, but I'll borrow two years and buy 10 years. Yeah, exactly. And there's also credit carry,

right? Which is really what Kevin Coldiron and the other authors focused on in the rise of carry, right, which is which is really what Kevin Coldiron and and his the other authors focused on in the rise of carry is the rise of credit markets and securitization markets and and rehypothecation and leverage on leverage on leverage. You've got this kind of credit carry, right. So triple B bonds are going to typically have a higher yield than triple A bonds, so or treasury bonds, so you can swap treasury yields for credit yields and earn a positive carry on that, right? In commodities, there's a carry that arises from storage costs or for the desire of producers to hedge their forward production just to stabilize their earnings flow or to make it cheaper for them to raise financing to go and develop a new mine that sort of thing right so all of these different asset classes

have carry they're intuitive and recognizable if we don't call it carry, if we call it something that's specific to that asset class. But really, they're just all of these different sources of return in compensation for risk. It's somewhat easier to me to flip it and think of it as the cost to hold the thing. It's like the interest rate, it's the rent, so to speak. So either you're going to pay that rent to get into this asset class or receive that rent to be essentially loaning out the asset class. Yeah, that's right. That's a really good point, actually, because the idea here is you need to borrow something to invest in something else. You're always sort of borrow. In the simple case, you're always sort of borrowing cash to invest in something that

you think has a higher yield than cash over the investment horizon, or to go short to own cash and sort of borrow the other security to own cash because you think that cash is going to have a higher return than the other thing that you're shorting over that investment horizon. Yeah. I think that's an example of that would be cash versus the 30-year when the yield is inverted, right? When the yield curve is inverted, it's better to go long cash and short the 30-year to capture that carry. Exactly. And the other, what's the example of, I can't remember who it was, Grosvner or one of those commodity firms that didn't unload the oil tankers right because the carry was positive so they said oh

we're just going to keep them in the gulf of mexico filled with oil until the price of oil comes back and because they're looking at the curve and three months out it was 40 i'm using extreme examples in near term. It was $20. Like just keep it in the, and it costs $1 a month to keep it in the, in the tanker. Why not keep it in the tanker and roll it? And I think what also breaks people's brains is these hedge funds have billions of dollars.

Why do they need to borrow anything? Right? Like that's what is a little nuance there of like, right. You just put it out on there, borrowing X to invest in Y. Why does a well-heeled investor, why does a hedge fund, why does a pension, why do they need to borrow anything?

Why can't they just invest in it? Yeah, I mean, so borrowing is sort of used a bit technically here, right? All of this is expressed through, typically through futures markets, certainly the way that we describe it in of this is expressed through typically through futures markets, certainly the way that we describe it in the paper is expressed through futures markets. So when you're investing in the futures market, you're effectively borrowing to get a leveraged exposure to the underlying market that you're buying a position in, right? So you may only have to put, you know, $5 down to get $100 worth of exposure

in the S&P, right? You're borrowing the other $95 to get that exposure. And so, you know, but that borrowing is not for free. You're paying a funding rate in order to borrow that money that is implicit in the cost of the future. And so you want to invest in futures where the expected difference between the implied carry on that future exceeds the funding rate, which is typically cash plus a little bit. But the great thing about futures is that the borrowing rate is set by the participants with the lowest borrowing rate globally. So it's typically set by, you know, interbank markets, for example, who are implementing sophisticated hedges on massive balance sheets

with access to typically liquidity directly from the central banks. So the spread to the treasury rate is very small typically. Yeah. The cheapest possible financing. Right. Easy way to run that for someone at home. Y charts are similar. Look at the SPY versus the S&P futures, right? One year return, and it's going to trail by about the T-bill rate.

Yeah. T-bill plus or minus 30 basis points. Yeah. So rough heuristic is okay. And the little nuance there is they're not doing that because they don't have the money. They can use the money more wisely elsewhere right so why not borrow at t-bill rates if i can earn seven percent i'm earning that from a five percent t-bill rate to seven percent i can earn that two percent by quote unquote borrowing it's not that i need to it's that it makes more mathematical sense yep um so i love so we did we cover all three so there there's the carrying equities is dividend yield, the carrying bonds is the yield plus the roll down. What do you mean by the roll down? It's just the difference between what you'd get on a 10 year bond versus a nine year bond over

a one year period as an example. The commodities, that gets complex with all the commodity futures pricing, but essentially all the costs of holding that commodity have to get worked into the futures price. So the storage, the transportation, the insurance. Part of the cost is the insurance. Commodities, I think, actually are the most straightforward. Well, they're just as straightforward as the other asset classes. And one of the things that people don't immediately intuit about commodity carry is that it exists because it creates a win-win situation between the commodity producers and the speculators. So the commodity producers want to sell their production forward, like I

mentioned, because it locks in a fixed price or some meaningful portion of their future production. And if they want to go to the market and get debt or equity financing for new capex, then they're able to get that at a lower rate. Why do they get a lower rate? Because the earnings from what is produced from their mines or from their farms, et cetera, are mostly locked in. So you've got much more stable expected cash flows for the corporation, the producer. Those stable cash flows lower the cost of financing. That's a win for the corporation. And the corporation is more than willing to pay the insurance. You know, the fact that they may take a small loss in expectation on selling their production forward because they're getting such a payback on their lower financing rate. And on the other side, the speculators who are investing in these carry trades are harvesting those insurance premiums from the producers. And to put that in plain language, right, I'm a, we'll say I'm a human farmer, not a corporate farmer, but I'm a farmer. I'm going to the bank for a loan. He's like, well,

who knows what the crop's going to do next year? I don't feel comfortable giving you this loan. It's going to be 15% or something. Versus now he's like, no, I've already pre-sold everything that gets grown, no matter where the price of corn grows. It's at $4 an acre, which equates to $4 million for my farm. So you should lend me that $2 million at something much less than 15%, 7% or something. So you're saying that spread between what I could do with the hedge versus what I can't do with the hedge is built into that futures price. You got it. All right. So that's all these different pieces of carry most people as we said think of it in

currency terms um i don't know why that is maybe those were just the most famous blow-ups um but let's touch back on like you even think of selling volatility as carry right which i know that's even rarer than people thinking of dividends as carry, in my opinion. Like that seems like a totally separate thing of like, no, we're selling vol. We're collecting this rent. We're collecting those pennies in front of the steam train, as you said. But yeah, I don't think of that as carry necessarily. But you're saying, yeah, you're getting that roll down. You're getting that yield.

Yeah, in the futures world world it's fairly simple right we talked about carrie being i go to the bank i borrow i buy this other asset i go long or short something else there's a series of steps when you look at a futures market for a single asset you will find that the price of today's price for oil will be different than next month and the month after that. And futures contracts give us different pricing for all the reasons that we've already described across time. And so that's all we need to look at to give us an indication of what is the quote unquote carry of something. If you talk about short volatility, what you're looking at is the term structure of the VIX contract and that one generally is upward slope it's in in um contangle right and so what

when people think about these ETFs that are short volatility all those ETFs are doing is they're buying the further month out higher priced um they're shorting the future contract as it rolls down and they're they're going to continuing to capture that right so that is a carry that is a short volatility carry and sorry is it yeah it's shorting volatility let's give an example right that helps to crystallize it. Imagine that spot ball is 15. We're a month out on a VIX futures contract. The one month VIX future is trading at 20, right? So over the next month, we're expecting, if the price of the VIX doesn't change, we're expecting that thing that you shorted for $20 to fall to $15 to match at expiry or at maturity, the spot VIX. And so you're sort of betting on gathering this

$5 of carry over that, whatever, 21 trading day period. right you're the implied bet there's nothing happens in those 21 days exactly implied bet is that that spot stays the same the the implied bet is that that one month out contract we expect the price to depreciate right so it is a we are observing we don't care about, managed futures is known to be very popular in the trend following space. The selection mechanism for trend followers is to see a series of changes in prices over time.

And if it has had a positive momentum, you want to go long. If it has negative trends and momentum, you go short. The selection mechanism for carry is to observe the difference in price between one contract and another contract in the future. Or, and we'll talk about this, relative carries, right? So that differential, that carry amount, is it higher with European equities versus US equities versus Canadian equities? And maybe we can rank them based on that.

And we're selecting to hold these assets long or short based on carry, but we are expecting a price movement to go in our favor as we get closer and closer to spot. So you could have success on both sides of earning the carry and the price movement. From the perspective of futures contracts, the only thing we're really at the end of the day seeing is a change in price, right? We're seeing that December maturity contract is going to gravitate lower towards spot if we assume that spot is what we want to get to. There may be a change in funding rate as well, but that would be reflected in the price of the price, right? So we're talking about carry as, you know, theoretically as, listen, I buy a piece of property, the property costs X amount, I'm getting rent, and I'm going to extract those rent yields.

So I have a mortgage payment. Minus the cost of like upkeeping the property in the mortgage right and you get the differential so that's kind of like an idea of how to think about carry the implementation from a futures trading perspective is we're literally instead of caring about how price has moved in the past like we do for trend following what we care about is just is defining and ranking and choosing solely based on that that carry differential right that just measuring spot versus future contract what's that amount is it three bucks okay that we tally all those up across many different futures contracts and then we can have a series of selection mechanisms for what we want to go along. Well, yeah, here's a good example, right? Imagine for illustrative purposes that front month WTI crude is trading

at $50 and back month crude is trading at $50 too, right? So currently there's no carry. Now the price moves over the next month, the price moves from 50 to $60, the front month. And the back month is also $60, right? Well, you would say, well, that has exhibited positive one month momentum over that period, but the carry hasn't changed. Zero. I want to take two steps back out and talk about, we kind of jumped right into the carry,

but you guys view this in a holistic sense, right? This is part of the bigger portfolio, a compliment to trend, a compliment to all the other pieces of your overall portfolio. Talk for a minute about that, then we'll dive back in. Originally, the thought about carry was, it sort of emerged from a deep understanding of the concept of global risk parity. So global risk parity says, in a risk efficient market, you want to hold as many different sources of risk premia as possible and hold them so that their risks are generally equalized. So for example, if I've got equities and short-term bonds in a portfolio, Well, if I don't change the weight, if I hold them 50-50,

then most of the risk in a portfolio is coming from equities because equities have much more risk to bonds. Used to. So I want to hold more bonds than equities until equities and bonds are giving me the same amount of risk because at the same level of risk,

I expect them both to give me the same return. All right? So anyway, you want to interrupt, I think. John Greenewald No, no. I was throwing out a snide comment that bonds used to be less risky than stocks. Jeff Booth Yeah, right, right. Now, the idea is to own all of these different markets, a bunch of different global equity markets, a bunch of major global bond market indices, and then a wide variety of commodities to hedge against spikes in energy inflation

or metals inflation or food inflation or what have you. You want to hold this massive diversified portfolio of risk premia. And by doing that, you're earning all of the risk with all of the returns while minimizing the risk via diversification. But the wrinkle in that concept is that the risk premia for bonds is not always positive. The risk premia for commodities is not always positive. The risk premia for equities is not always positive. And so, and for currencies, it's not always positive which direction you're going to earn the premia in.

Do I want to be short dollars, long euros, or short euros, long dollars, right? So what CARE does is it says, well, I'm going to have a global risk parity portfolio, but it's going to be in the direction of the current carry. So if bonds currently have a negatively sloping yield curve, well, I'm going to be short the longer term bonds rather than being long the longer term bonds because I currently expect longer term bonds to have a lower return per unit of risk than shorter term bonds, right? If crude oil is in contango,

where the distant futures are at a higher price than the near term futures, if I'm gonna invest in the distant futures, I'm gonna expect them to roll down to have a negative return. So I actually want to be short those crude oil futures. I don't want to be long those crude oil futures, right? So we're taking all the great benefits of global risk parity. And we're saying, but when those risk premia are negative, I want to be short. I still want to maximize diversification across all these different markets and geographies

and asset classes. But I want to always be in the current direction that Cary is facing. So I'll just add to that because the biggest objection over the years, and you know, Jeff, we've spoken in your podcast many times about our love for risk parity. Risk parity is the best portfolio for preparation rather than prediction, right? It's this idea that it's really tough to predict the future price movements of things. And so I'm not even going to try. That's what risk parity says. Risk parity says, I'm not going to try to predict anything. I just, given economic reasoning i think that over my full lifetime if i set it and forget it bonds will have a positive risk premium by taking you know duration risk that

equities will have an equity risk premium over time and that commodities will have a roll down yield and i'm going to add i'm going to put those together in equal risk. And Bob's your uncle, you're done, you're set. All you have to do is rebalance once a year. There is no active management. And what people have always had a tough time wrapping their mind around is but especially three years ago was, wait, you're you're overweighting midterm bonds right now when you're out of your mind and risk parity says which they were right i don't know i i'm not i don't even look yeah i don't care what the possible return is i just i just if that does happen commodities should offset that period of loss and that's why it's there right it's it's got three pistons and we're happy now that was designed that concept was

designed by harry brown and then you know ray dalio made it popular as a way to when I die and I don't trust anybody, how do I create the simplest portfolio, set it and forget it, and be confident that I'll have reasonable returns for my family? The difference here is that we said to ourselves, okay, we got the prosperity, but we do have the ability to actively manage. We do have an ability to tilt based on something. And it is clear that if the five-year bond is providing me a lower yield than cash, that we should probably remove the shorting constraint and short that thing, but maintain the ability to equalize risk

across the securities that were both long and short. That is the major leap for us. That was when we first started thinking about Cary, we thought about it from a risk parity, maximally diversified lens, and then removing certain constraints to allow us to be active managers in that space. And it turns out that it is an incredibly robust approach to improving or migrating from risk parity, naive risk parity to a carry approach. And what I've seen from my seat is a lot of trend followers over the years would go long crude in that example adam gave in like okay the market went up but they

lost money because they kept paying the roll down um so eventually they're like why someone stood up in a meeting right like hey why do we keep paying this carry maybe we shouldn't go long right probably the first step was hey maybe we should go long the back months or or do something different instead of just rolling into this expensive roll yield maybe we should touch along the back months or do something different instead of just rolling into this expensive roll yield. Maybe we should touch on what roll yield is. But do you think people are coming up from that way too? Because lots of managed futures programs have had carry for years and years, a decade plus, I would say. They figured out, okay, this is kind of complimentary. Let's add it to the portfolio. We're already trading these markets.

We're already looking at what the curve looks like in all these markets. So I don't know if there was a question in there, but you're both nodding your head. The question I think you're asking is, you know, why did trend followers not originally use carry? Then why did trend followers decide maybe identifying how bad carry is if we're going to go long this thing how bad carry is if we're going to go

along this thing or negative carry is we're going to go along this thing maybe that's useful and then why many people were like hold on a second i don't pay you to do that right yeah i don't like carry because it doesn't give me the thing that i want and we can talk about what the thing that people think they want from trend that carry doesn't necessarily offer. So I think your question is, you know, how does carry fit into the trend following equation? And why is it a controversial, controversial premium that may or may not be a part? For sure, there's a delineation of the guys who have to defend their carry allocation and their trend versus those who are no, I'm pure trend, don't worry about it. We look at that just in how we put on our positions or whatnot. Well, there's a few different ways to cut it, right? Like DFA,

the famous, you know, multi a hundred billion dollar asset manager cult has decided that they don't believe. Sounds like you were just hanging out with Corey for a few. Yeah. They, you know, they made it clear a long time ago. They don't believe in momentum. Sounds like you were just hanging out with Corey for a few months. Yeah. They made it clear a long time ago they don't believe in momentum, but they won't take a value trade if a stock, they won't rotate into a value stock when they rebalance if that value stock has negative momentum, right? So it's sort of like a trading filter as opposed to another strategy that they've added. But they've still sort of quasi-acknowledged the merit of the signal, right?

My wife sneaks vegetables like spinach into mac and cheese for the kids because she knows it's good for them. And I think over the last decade or so, a lot of managed futures managers have kind of snuck carry in by various means because they've recognized that this is an extremely strong premium that they would rather not be short. They'd rather be aligned with than run against on occasion. Yeah. And that's a good segue. I think in the beginning, maybe some guys are like, hey, when trend following's in a flat to slightly down period, maybe it's down 5% a year for three years on average. We lose a lot of investors during that time. Maybe we should sell the VIX or do the yen carry trade and earn that 8% a year. So now we were flat in those years instead. I think that's the worst look of like, hey, we're just going to add this piece that

gives us a positive 7%. And if things blow up, our trend should make money when everything goes down. I think that's a little- That's, I think, the traditional take, right? That adding carry means you're selling ball or you're engaging in emerging market currency carry or something that has very clear correlation with cyclical risk factors that they tend to blow up when equities are also having a drawdown. So those are anti-complementary to portfolios. And so you guys are saying, hey, we have a better method is... Well, it's just if you use all of the different markets that are available, or as many as you can access with sufficient liquidity...

Which, what are we talking? 80? Well, it depends on the size of the institution, honestly. But I mean, the paper that we wrote used 20, 25, I think. But if you include all these different markets and all these different asset classes and all these different geographies, then the carry strategy doesn't have any kind of blow-up risk that doesn't have that character that everybody seems to perceive that carry exhibits because they understand it as being short ball or emerging market carry or something like that. Like it's, it's just if you if you're, if you're using leverage carry in one concentrated area of the market, like, yeah, that's gonna have times when it's gonna have a really rough go. And it may be

correlated with when the other parts of your portfolio are also having a really tough go. So it actually, it really hurts. Yeah, to hurt when it hurts in your other part of your portfolio are also having a really tough go. So it actually, it really hurts to hurt when it hurts in your other part of your portfolio. But when you take it all together, it does not have that same. So I'll add to this, Adam, because that is true. Everything that you said is true. And I think that's a perception that it's, if you're, you know, going, if you're shorting the VIX to add some cushioning while trend isn't working, what will have to happen is that trade will get hurt. Trend will do well in a big abrupt shock. There'll be a hurdle for it to pass through where trend has to outperform the losses.

And that's kind of like the whole idea. It'll be a timing mismatch but yeah but people buy i think that the the reason that that some allocators were upset by this intrusion of carry is the they want that maximum protection when they need it now another way to think about this in the way that adam described a well-diversified carry is that actually carry seems from our research, and we did a webinar on this recently that showed that it seems to be completely agnostic to market regime. Whether it's high inflation, low inflation, high growth, low growth, it tends to chug along just fine. In fact, in any given market scenario, let's say

COVID blow up, the likelihood of a well-diversified carry strategy to make money in any given market scenario let's say covid blow up the likelihood of a well diversified carry strategy to make money in any given day or lose money in a given day is around 50 like it's it's it's not correlated to a particular event trend clearly will be negatively correlated if there is an abrupt series of market moves that define trends widely, right? You can count on trend, roughly speaking, during market moves where it's risk on, risk off for a few months. You're going to make some money in trend. You can't say that about a diverse by carry strategy, right?

And if that's true, and let's say you're a trend follower that decided to just do 50% trend, 50% carry, and October of 08 happens, your trend portfolio was up 50% and your carry was flat. You've just taken away 50% of the protection, right? So even in the case where it's a well-defined and well-diversified carry strategy that you're attacking onto your risk, your trend following manager, you're still not going to be there for the reason that the allocator wanted you to be there. I think that's a fair statement for people that were allocating to trend managers, right?

They weren't allocating to an all-weather multi-strat. They were allocating for a very specific reason for protection. Selecting futures contracts long short based on carry is more agnostic. It is more like risk parity, trying to chug along as well as possible most of the time. And I think that's the major difference here. Well, I would also add that carry and trend have historically, since 1990, had the same probability of acting as an equity diversifier in the worst 20% of equity quarters. In other words, when the SAP, the 20% of quarters where the SAP had the most negative returns, then both carry and trend were equally likely to act as a nice ballast to go up during those quarters. And they don't tend to go up in the same quarters.

They don't tend to act like ballast at the same time. So you've got, I think it's honestly more helpful to think of Trend as having a zero correlation to equities. Cary on average, right? Sometimes it's going to have really high correlation to equities, sometimes really negative correlation to equities carry on average, right? Sometimes it's going to have really high correlation equity, sometimes really negative correlation equity carries same. Sometimes it's going to have high correlation to equities. Sometimes it's going to have negative correlation to equities and you know,

they're going to be positively or negatively correlated to equities at different times. And therefore there, there will inevitably be, be drawdowns where carry acts as a ballast and trend acts as a drag or is neutral and the, and vice versa. They act really nicely together. And that's not just trend,

but right. I'll say global macro, but risk premium, like risk parity, whatever hedge fund style, you're saying it's basically the same thing. Selecting based on seasonality, selecting based on mean reversion. You know, these are different ways to select.

It's no different than all these risk premium equity selection. Let's go back to what people think about most, right? They think about how do I pick a better stock? The most popular approach has been value investing the warren buffett style that's a style that does pretty well over time but the selecting based on growth is another style that seems to have done really well and guess what it performs well at times when value doesn't um selecting based on low volatility or quality. All of these things are just different ways

to skin the equity selection cat. And yes, there is religion involved. And when there's religion involved, there's only one solution. When you're agnostic, when you're an atheist and you just look empirically at, are these things real? Are these selection mechanisms likely to

continue to exist in the future do i have any ability to decide which one's going to be the best one tough maybe i should own a bunch right and this is just cutting you know shining a light on i've written a bunch of papers called a different way to manage futures in the past because i want people to think about equity and futures market selection from the perspective of many ways to select, not just trend following. Cary is another one, but we're going to continue to write about different methodologies of skinning that and that and manage futures cap. And you touched on something there like this, you guys might take offense to this, but it's not like alpha, so to speak, of identifying this carry, like in some people like, oh, what happens when that goes away?

Right. Or something of that nature of like, well, it's just the price people are paying the rent they're either paying or earning. So maybe the rent goes up or down, but it can't just stop working, right? There's always going to be an interest rate, there's always going to be demand for cash, one side or the other. So talk for a second about that, of how you view it structurally as why it is and why it will continue to be. I mean, there will be carry so long as capital markets function as they were designed to function. As long as risk is rewarded in capital markets, in other words, the risk of tying up your money in equities and deferring consumption to buy equities,

not knowing what price you're going to be able to sell those equities out in the future, that ambiguity, that's a risk that you are taking on to defer savings or consumption today. As long as people demand higher compensation for locking their money up longer in the bond market, as long as the markets that are funding commodity producers like or prefer lower variability in cash flows to higher variability of cash flows, then the carry premium will exist, right? It will fluctuate as central banks do their thing and as the economy and inflation do their things. But the reasons for carry to exist are timeless if you believe that markets operate in a certain way for a specific reason and that investors are not

risk seeking. They don't prefer to lock their money up for negative returns versus consuming something that they want to consume today, for example. Unless they're very specific commodity investors or something, but we won't go down that rabbit hole. So that made me immediately think, okay, I have an artificial zero interest rate period. That would seem like a period where it could, quote unquote, break or be weird at least, right? I just think it's got- Maybe in the bond side, but is that the case for commodities? But again, going back to different areas, different contracts, different markets will

have attractive carry. And at times, it won't be worth investing in that or taking any risk because there's like the example Adam gave earlier, spot contract is 60, futures contract is 60, there's no value there until the market has to demand a switch so that speculators are willing to take a risk to hedge out the producer's risk, right? So this is dynamic markets all of the time. And yes, there are going to be economic scenarios in which a single contract, a single sector

will be less attractive than others. And this is where we get back to, no, you shouldn't blindly just be buying anything that has a positive carry. You should be thoughtful about selecting your asset classes based on numerous signals that we can call carry that are reasonable to say, hey, that's a carry signal that we might want to use to select amongst many others. Much like trend following isn't just, are you above the 200-day moving average or below? Yeah, you'll make money over time by selecting a trend following managed future strategy on the 200-day, but you may be better off by using that signal plus the 100 day moving average,

plus a two month crossover with a five months, but some breakout systems. There's multiple ways to define what trend is. And similarly, there's multiple ways to define, in our view anyway, what carry is and help us to diversify signals as well, right? So I think this idea that trying to put a blanket statement, well, when we're at ZERP, then there's nothing there, not necessarily true. Right. Well, you could use the crude oil during COVID as an example, right? Nobody cared what the interest rate was. There was too much oil. We don't want the oil. I don't care if it's free let's talk finish up with the so what right so where are you guys implementing this

why should we care the paper's cool but then i just want to invest bread and carry does it exist as a standalone does it exist in your mind only as part of a overall portfolio talk through the so what a little bit yeah so we've been employing this carry strategy how long adam um i think all the way back 2017 i think 2017 within our multi-strats right and it's like anything you you find ideas find strategies putting together and just tack them on but once you start zeroing in on the unique characteristics of each one of the strategies that you that you implement you start learning its idiosyncrasies when it's valuable when's not, you realize, okay, these can be really interesting and intuitive premiums that could be available as standalones for the market.

And I think Cary was one that Adam's been super excited about for years. So was Andrew, who's a co-author of the paper. I got onto the bandwagon a little later as a very robust standalone. And so we started running carry for, look, we've been running SMA carry for a while. We run a portion of it for the cockroach portfolio. That's been live for two and a half years and a pretty solid track record. So, you know, on our website,

you can get access to the standalone carry SMA. We have, since we launched this paper, we've also, I think we're going to be the only ones as far as I can tell that we are the trading advisor for the return stacked stocks and futures yield ETF. And that one runs a carry strategy at a volatility of 10% stacked on top of the S&P 500. And so that's one of the easiest ways to get exposure to carry in a stack perspective. And I think, again, I don't think it's a standalone. We haven't seen any availability in the U.S. market or globally for that matter.

And I'll interject real quick. We're going to, we'll throw, these guys have done a pod on how their multi-strat works. They've done a pod with us on return stacking. So we'll throw all those in the show notes for people to go back and learn all that, right? it as a multi-strat and the evolution program. We also have rational resolve adaptive asset allocation fund, which is, again, all the things thrown at once. attract a story, low correlation to things that people are already used to on the trend side, low correlation equities, low correlation of bonds. So I'm super excited about this, this RSSY ETF as a standalone option for allocators. CRRY was taken. That would have been the good one. Well, I'm going to stick to that. Yeah. And then just quickly in the multi-strat, remind me, are you running each silo separate

and then they'll net off or are you netting before you get in them? It's an interesting point because the long-term correlation between equities, sorry, between trend and carry is in the neighborhood of 0.3. So you can imagine at any given moment, if you're running a carry portfolio with 25 futures markets, a trend portfolio with 25 futures markets, the carry might be saying, I want to sell down a market. Same time, the trend saying, I want to raise exposure to a market or vice versa. If you trade them both in the same account, well, you would

just net those two trading signals off against one another and maybe have no trade to do. If you were trading them in two different accounts, well, now I got to go long this market in one account or add to a position in one account, go short or lower the position, reduce my exposure in another account. So I'm incurring trades in these two accounts. Whereas if I traded them together, then there's no trading. And our just internal research suggests that there's maybe a 15 to 25% improvement in net returns to the investor from running them in a running carry trend and as many other different types of uncorrelated strategies as possible in one account. So you can net out when their signals kind of offset one another because you're just not having to

cross the bid ask spread and you're not having to pay commissions on those excess trades. So there's definitely a benefit to combining these in a single account. At the same time, the end investor has a preference for having control over the relative allocations that they want between carry and trend, but also between the stocks and bonds and other core exposures that, you know, we run these strategies over, right? So there's always a bit of a trade off between, you know, we don't know what else investors have in their portfolios, we can't see into the minds of RIAs and understand their full philosophy, they need to be able to express their views and their custom solutions for clients.

And we're giving them the tools to do that. And we've created independent strategies that are maximally efficient to run as distinct strategies and as overlays on those core exposures. Love it. One last piece, I forgot, you guys identified in the paper a little

that it tended to overweight bonds, or what was that piece? Yeah, I mean, if you just look back historically, bonds have had a positive yield curve about 85% of the time. Yeah. So it's probably not a stretch to intuit that a carry strategy would have on average, a slightly positive exposure to bonds, right? Because over the

historical time period, bonds have had a positive carry. If that period had been mostly negative yield curve, then bonds would have had, in our carry paper, would have shown that bonds had a persistent negative exposure in the carry strategy. So it's mostly just what's the prevailing slope of the yield curve, And that'll determine what the historical average exposure to bonds has been. But that speaks to history. Yeah. And it doesn't speak to the present or the future. So this is an important point. A lot of times when people, they ask, hey, I want to know the historical weightings here. And they look at the historical weightings of a carry strategy. And they'll be be like well you you've been long bonds and overweight bonds for x amount of years this is a very

dangerous approach because of course you made money what if 22 what if 2022 happens and there's an inversion well the reason that it's been that it's been high and long and it's because there's been a positive term premium a positive carry over time but But with the way that we have described carry in the paper and implement carry, the moment that that carry becomes negative, you can short and benefit from shorting bonds as carry strategies have over the last few years. And so there's no value in looking at history to have any expectations of what may be overweight underweight long or or short based on looking at a recent or or historical periods right so it's just looking at the carry and yes it is rare that there is negative carry and bond but when it does happen

you have something that can get out of the way and do it this goes back to our risk parity discussion that risk parity would say, it's so rare, we're just going to go keep on being long duration bonds, no matter what, versus Gary saying, you're an idiot, we should short them for now until you prove me otherwise, that it's worth holding you long again. And this is off topic, but have you guys seen, right, there was that debate three years ago of like,

when the bond bull market unwinds right the trend followers managed futures isn't going to make enough money being short as they may being long because they'll be in theory i guess the curve was maybe supposed to still be positive even though bonds were going down so i guess the answer is that well the curve went negative and bonds went down and you were able to go long energies and other commodities. So that's a silly thing. The thought was if you just trend followed bonds and yields went from 15 down to zero and then went exactly zero back to 15, that because of everything we're talking about, you would make half of what you made from the down move when bonds went back up because- The great surprise of my career is that people continue to love running trend

strategies on stocks or trend strategies on bonds or carry strategies on currencies or carry strategies on bonds. Why they don't automatically understand that you want to run carry strategies and trend spreads on everything you can get your hands on. I continue to see this over and over again by otherwise experienced, knowledgeable people and continue to scratch my head. Is there a practical limit limit will you guys stay in the futures universe like if you're like hey we've got this investment bank and we can fund this shipping route for five versus borrowing it too right like you could carry this pun intended carry this to its conclusion and you become like an investment bank and you're always

borrowing cheaply and investing richly there's obviously this concept is universal um you know think about it i was thinking about it from we use real estate as a great example right um what you're doing is you're selecting a lot of if you're promoting a real estate portfolio you're selecting for properties that and you're diversifying across geographies you're selecting properties real estate portfolio, you're selecting for properties that, and you're diversifying across geographies, you're selecting properties that have higher carry than others. But imagine the ability to go long,

the ones that have the safest locations and the highest yields, and having the ability to short those that still have a positive carry, right? But maybe a small carry is indicative of a decline in prices for those real estate properties that's what we see in the future space we see we don't necessarily need to see a negative carry in order to short we've identified that if you if you select for those assets that have really strong carry and short those assets that have less carry, it's predictive of price movement.

Right. So, you know, it can it can apply to everything. And I imagine that it's it would apply to real estate. It'll apply to shipping. Hey, I see that every day. The long Nashville, short Chicago trade. Right. People are moving out in drift.

Long Austin. Yeah. Yeah. Long Austin. But they both probably still long carry. But the pricing People are moving out in drift. Long Austin. Yeah, Long Austin. They both probably still have long carry, but the pricing mechanics are going down, right? So you could benefit by shorting one and going long the other.

And the fear is the carry in Chicago will just get higher and higher and higher, more taxes, more pension liabilities. A negative carry, yeah. Yeah, well, yeah, more and more negative. Yeah. Cool, we'll leave it there any last thoughts no i just think this is a i'm super excited about having this in market i know that other uh organizations have tried to bring it to market and failed um hopefully with a ton of education

which we're trying to do as much of people will wrap their minds around and be as excited about this factor as they are about all the other factors that they know and love um great compliment at the end of the day it's another factor add it to your portfolio yeah and but it is just also like intuitively it's just i don't think people have given it or asset um um like asset management companies are given enough time for education and so we we're going to do a lot of push. I would love being on these podcasts. We have a webinar that we launched a couple, what was it, two weeks ago.

If you go to our website at investresolve.com and you go to research, you'll be able to download the paper, download the data, download the webinar. I think we've actually posted just the webinar on our YouTube channel as well, if anybody wants to take a look at that. And then the more you give yourself a chance to learn about this, and I promise you, you'll be as excited as we are. And yeah, that's really parting words there. And then you can take a look at all the other projects that we're working on. You know, we got the YouTube channel, Resolve resolve riffs we have a new channel called the get stacked investment podcast that people we've only been two episodes with his shirt off yeah we tried get jacked podcast that's that's more of a mike philbrick

type of title um and uh and yeah you know the joint venture we have with Newfound on the returnstack.com website that you guys can visit and learn more about how you can grab these different types of premiums and stack them on top of traditional betas. All that stuff are things that we're super excited about. Yeah, you guys are crushing it. We'll put all those links. Adam, any last thoughts? No, I mean, I think this is an idea whose time has come. I'm so excited to be one of the first to market with what I think is the base strategy, is the global base, you know, first principles portfolio. And, you know, we're starting out stacking it on

top of everybody's favorite asset class. And so, you know, I'm hoping a spoonful of sugar will make the medicine go down. But yeah, this is the medicine people need right now. Love it. All right, guys. Thanks so much. We'll talk to you next time. Thanks, man. Okay, that's it. Thanks to Adam and Rodrigo. Thanks to Resolve for all the great content and research they put out. Thanks to RCM for its support. Thanks to Jeff Berger for producing. We'll see you next week with a former options prop trader turned fund to funds operator. Peace. You've been listening to The Derivative. Links from this episode will be in the episode description of this channel. Follow us on Twitter at RCM Alts and visit our website to read our blog or subscribe to our newsletter at RCMAlts.com.

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