Carry Analysis - Small vs Large Universe

Adam Butler: [: 00:00:00

This feels really relevant right now because we've seen these two approaches diverge pretty considerably over the last few months and so I thought it would be helpful to sort of put this in context. We published a research piece on this and I'm going to just basically walk through that because it provides some helpful visuals and stuff.

Feel free obviously to just download it. I'll provide a link below this video for you to download it and read through it at your leisure. Before I get going just let me quickly explain what carry means for those who maybe aren't totally familiar. I bet that is even people who have read the white paper, you know, thought about investing in carry.

ample, like trend following. [: 00:01:00

In stocks, it's dividends and currencies. It's the interest rate differential. So, for example, maybe the, you can borrow in U. S. dollars at an interest rate of 2 percent to invest in Brazilian Real at an interest rate of 9 percent and earned that 7 percent carry. In commodities, it's related to the difference between spot and futures prices, and it's often related to differences between short term and long term demand, and changes in storage costs, that sort of thing.

within a futures investment [: 00:02:00

So we go long markets with high carry, expecting the futures prices to rise and short markets with negative carry, expecting the prices to fall. And this approach is historically delivered. Positive returns across different market environments and like any strategy, it does have its ups and downs, but what's great is it seems to have ups and downs that are mostly uncorrelated with the ups and downs of other diversifying strategies that investors often gravitate to, for example, like managed futures trend following.

So we think it's a highly complimentary strategy. It's just as compelling as any of the other alternative strategies that you might be considering and we think it's an extremely useful quiver in any advisor toolset. So Sort of back to the issue at hand. Here's the situation since January So keep in mind right reminding you there are two different carrier strategies.

ly liquid universe. It still [: 00:03:00

But we're trading less liquid markets as well. So we trade somewhere between 65 and 80 markets, right? We're going to study about a 65 universe less liquid strategy in this case study, but that's it.

So what's interesting right now is that the liquid universe is going through a painful drawdown Right. So over the last few months, it's hit a real rough patch down around 20%. That's definitely on the painful end of the spectrum.

ulation going back to sort of: 1990

And, you know, those are fair questions and that's exactly [00:04:00] what we wanted to address in publishing this research piece and why I felt compelled to record this today. So, let's start by looking at what's actually happening. So, this is just the research report. I'm just going to scroll down to this plot, which, by the way, is Just a really good plot to spend a little bit of time on.

liquid universe. Since early: 2024

And so what we get is sort of 10, 000 random paths that are all kind of valid random paths that we might expect the carry strategy to experience. And you can see what we, the different shaded regions represent different probability bands. So the sort of lightly shaded blue range, not the really light shading, but the sort of medium shading represents about 95 percent of the time we would expect over this sort of time horizon that the carry strategy would have a return stream that is in that range.

percent of the time. [: 00:06:00

About one period out of a hundred of the length of this scenario that we just that we're plotting here, right? So it's highly unusual, but you know once out of a hundred times these it happens about once every 100 days So, or, you know, once every 100 periods like this. So it's not totally out of the realm of possibility.

rical character since sort of: 2024

What's interesting is that this is, well, this is the performance of the liquid universe. When [00:07:00] we compare this performance, this is the dark blue line here of the liquid universe over the same time period. against the performance of the larger universe.

So keep in mind, it's exactly the same mechanics we're using to measure, carry, form portfolios, target. Everything is exactly the same, it's just a different universe. The dark blue line is a liquid 26 market universe. The yellow line is a large universe. And then the black line here is, well, what if we took the large universe, extracted all the markets in our liquid universe, and then only traded the remaining markets?

With the carry strategy, how would that have performed over the same time period? And you can see obviously that does even better, right? And in fact, you know, the performance of the Large universe carry strategy has been just fine. Up about 4. 4 percent over the same period with a sharp ratio of around 0.

rse carry strategy, but also [: 00:08:00

46. So, obviously considerable. But this tells us something really important, I think, which is that carry as a concept isn't broken. It's still working totally fine across a broader set of markets. So the question is why are we seeing this divergence and you know, is this something that we've seen before, right?

ecially productive over this [: 00:09:00

Driven by commodities like cocoa, coffee, also, excuse me, also grains, palm oil, along with some European and Asian equity markets. Meanwhile, scrolling down to the small universe, it's really struggled in equities and metals, especially though it's doing relatively okay in currencies, it's almost like two different weather systems.

ppened before, it happened in: 1994

2016, right? But in almost every case, what happened next was a reversal, so if I go back and just look at some of these historical periods, right? In the 1994 case, the blue line is the liquid universe. The yellow line is the expanded X [00:10:00] small universe. Obviously x small did much better than the liquid universe during this time period.

erse went on to outperform in: 2001

And so of course there are, right? So 2016 is one of those periods. In this case, you see the blue line, the liquid universe dramatically outperforming the yellow line. And in that case, the yellow line goes on to outperform. It's the same in 2018 going into 2019 the the X liquid universe dramatically outperforms after a period of underperformance.

The same in: 2022

Right. So you get this really nice snap back. So what are the implications? For me, it suggests that what we're seeing now, isn't some fundamental breakdown of carry and liquid markets. No. Rather, it looks more like a temporary phase that we've seen several times before.

It's normal, painful, but normal, and it's not structural, and it's likely to revert and go on to deliver pretty strong outperformance.

When is it going to revert? In my experience, when most people capitulate. When most people give up on it, that's exactly when it reverts. There may be something mechanical in markets about that. Just, you know, in terms of flows or something, I don't know. But I've seen this happen so often. Typically once investors have decided it's too painful, that's when the strategy goes on to dramatically outperform.

I've just seen it too [: 00:12:00

If you're in this for the long haul, which is really the only way any of us should be in these strategies in the first place, then I think there's really good reason to maintain conviction. Markets and strategies go through cycles, and what we're seeing now appears to be a fairly normal, if admittedly painful, part of that cycle for carry.

I hope this helps put things in perspective. Thank you so much for tuning in, and of course, let me know if you have any questions by hitting me up in the comments. Down below. Okay. Ciao.