Momentum works, whether structured as a times series or a cross-sectional strategy, across many asset classes. Carry strategies or risk premiums also work across a wide set of asset classes. More importantly, we know when these strategies do not work, or we at least know what are times to avoid. Also, when trend-following (time series momentum) does best, carry will likely under-perform and when carry is doing well, trend strategies are likely to under-perform. These are statistical relationships, but there are good narratives for why these two strategies are complements.
Trend-following can be described as divergent trading. It will make money when there are market dislocations away from equilibrium prices. Trends occur when there are transitions between regime, states of riskiness, or changes in fundamentals. Given these divergences are not immediate, prices may react slowly over time which allow for the identification of trends. A dislocation or divergence in any asset class will likely lead to exploitable trends by long/short CTA’s. Carry can be described as a convergent strategy or one based on market stability. You earn a carry premium because markets are stable, or you may earn more carry premium when markets have dislocated and are now moving back to equilibrium. Because each strategy or premium will do well in different environments, they are complementary when building a diversified portfolio.
The question is how to access each in the most effective manner. We can suggest one simple alternative. Buy the carry risk premium through a low cost total return swap exploiting carry through some simple rules or a lower cost manager who offers the pure beta of the premium and buy the momentum or trend-following through a skilled manager who can control the sizing of positions and downside risk.
In a portfolio, the trend-carry combination can be structured around a simple weighting scheme and rebalancing or a switching mechanism with dynamic adjustments. In a switching model, carry is held or is “on” until there is a risk transition at which time it is turned “off” and requires an exit or switch into greater exposure to the trend model. Research has shown that carry will underperform when the market switches to investor risk-off mode. The excess returns for carry may be associated with the same direction as market risk. Similarly, when markets are in risk-on mode and more stable or trendless, there is a switch away from trend and into carry strategies.
Momentum strategies are known to have crash risk, but it can be managed through position sizing as well as entry and exit signaling. Given the wide variety of markets to be traded, timing of trends, and sizing of positions, trend-following risk can be better managed than a carry trade which is often more focused with a limited set of markets.
Previously, there was a focus on identifying alternative risk premiums, but now the state of the art is the blending of risk premiums and attempting to dynamically adjust these premiums. As our understanding concerning the differences between carry and trend has increased, our ability to blend these premiums has improved. This improvement allows investors to find mixes of risk premiums that provide better long-term return to risk blends.