Mourn the death of the carry trade and look forward

Naturally, we like to invest with winners, and winners usually have a track record of making money. After all, would you invest with a manager who shows you a long track record of mediocre results?

No, me neither. Still, there is a reason that all investment offers contain the warning that past results are not indicative of future results.

When looking at past returns, the first thing I ask is, what were the conditions under which those returns occurred? Was the general market going up or down? Was the economy good or bad? What were interest rates at the time? What about inflation?

I then compare those factors to today’s and try to assess whether or not the manager’s past successes are likely to repeat.

If we look back over the past 10 or 15 years, we see consistently great investment results from a broad array of asset classes. Even accounting for the stock bubble that peaked in early 2000, it was hard to not make money for a long time. Hedge funds were high on the list of investment styles that could seemingly do no wrong.

However, in the past few years, most hedge fund returns have moderated to a high degree. Across the spectrum of styles, these managers are finding it ever more difficult to eek out respectable returns.

In keeping with my first-order questions when examining past returns, I try to figure out what might have changed for these folks. Did they suddenly lose their smarts, or is something more daunting at work?

It turns out there is something more daunting. It’s called the yield curve. The yield curve is a plot that shows the interest rates on notes and bonds of various maturities. Normally, short-term investments have a low rate and longer ones have higher rates.

This is a fundamental ingredient to a thriving and growing economy. I wrote about the economy’s need for an upward-sloping yield curve earlier this year. If you missed it, contact me and I’ll send you a copy.

Hedge funds had become addicted to a simple way to make money: Borrow in the short-term market at low rates and reinvest that money in the longer-term market at higher rates. As long as the short-rates stay low, this is easy money.

Given the magic of leverage and loose lending standards, a hedge fund or bond manager could produce outstanding returns on capital. Even managers investing in long-term assets besides bonds profited from this strategy via a technique called “portable alpha.”

The hedge fund’s statements might have shown exposure to stocks, but it was really investing in the yield curve. Through some nifty financial engineering, it appeared that the profits were being made in other assets.

This borrow-short and invest-long strategy is an ancient and venerable practice known as the carry trade. The carry trade is a strategy to take advantage of low rates in one market, and to use those cheap borrowed funds to invest in another market. The risk, of course, is that your short-term cost of funds will rise while you are waiting for your long-term asset to pay off. The portfolio can rapidly turn against you.

This has, in fact, happened. Short-term rates are now higher than long-term rates, wiping out any ability to profit from the carry trade. Hedge fund returns as a whole reflect this so-called inverted yield curve.

While you might not be a hedge fund investor, the inverted yield curve has implications for you. If you borrowed on an adjustable-rate mortgage and bought an investment property, you are engaging in the carry trade. You have borrowed short-term money and have invested in a long-term asset.

Real estate is the quintessential long-term asset. The cost of your loan has risen dramatically, while the return on your asset is stagnant or declining. The inverted yield curve’s negative effect is beginning to be felt throughout the economy, as last week’s new GDP figures indicate.

Past returns cannot be counted on to simply repeat themselves. Even the best managers will produce results that are more a product of the era than of the manager’s own smarts.

In the current era, any strategy that relies on using borrowed funds is most likely doomed to poor returns. The carry trade is dead for the time being.