- Ample high-quality research has identified three key factors operating in the global macro context—carry, momentum, and value—that can be employed in systematic global investment strategies as a diversifying alternative source of investment returns.
- A portfolio of 12 individual strategies using stocks, bonds, currencies, and commodities delivers a package of carry, momentum, and value that generates strong absolute returns at moderate levels of risk and leverage.
- Global macro offers the average investor an opportunity—once enjoyed by only the most sophisticated hedge funds—to benefit from alternative sources of return.
A quarter-century before Brexit came “Black Wednesday.” On Wednesday evening, September 16, 1992, the British government announced its exit from the European Exchange Rate Mechanism, prompting a dramatic devaluation of the British pound. Renowned hedge fund manager George Soros’ legendary bet against the pound in 1992 and his $1 billion profit on Black Wednesday defines for many the swashbuckling style of a global macro trader. Global macro has since become a well-established discipline, and for good reason. Handsome returns can be generated from strategies that profit from the predictable relationships between macroeconomics, politics, and monetary policy.
While forecasting market reactions to idiosyncratic macro events may seem a black art or a fool’s errand, our study of capital markets reveals recognizable patterns and the possibility of consistently profitable trading strategies. Ample high-quality research has identified three key factors operating within the global macro context: carry, momentum, and value. Today we may choose from a growing category of strategies that employ these factors to deliver alternative return premiums. These systematic global investment strategies may provide an attractive and diversifying alternative source of investment returns to the low yields and low returns offered by mainstream stocks and bonds.
From Asset Classes to Factors
The investment industry has evolved since the early 1990s, when Soros infamously battled central bankers. Global macro managers still rely on economic and political events to generate the conditions that present attractive trades across the capital markets—equities, fixed income, currencies, and commodities—but in today’s world, the strategies we use to spot attractive investment opportunities have become more systematic. The rise of machines has improved our ability to process information and identify from large datasets the patterns that can turn opportunity into profit.
Systematic strategies employ quantitative models to determine trading decisions. Models are specified upfront and (ideally) change infrequently. Indeed, if managers frequently manipulate their model parameters to generate the trades indicated by their gut, then the process remains qualitative. Beyond relying on objective evidence, systematic approaches isolate trades from the psychological biases, internal politics, and other personal and organizational stresses that too often interfere with executing sound investment strategy.
As a result, an increasing number of funds have migrated from discretionary human pattern recognition to systematic models. These quantitative strategies using modern financial technology may allow investors access to profit from global macro opportunities with much greater transparency and lower cost than the typical global macro hedge fund. At the core of systematic macro strategies lie few, if any, secret ingredients: the strategies invest across markets by relying on signals that measure well-documented return factors.1
Factors exploit patterns in capital markets to generate return premiums from long–short positions, which provide an alternative to the traditional returns offered by long-only positions in stock and bond markets. An exhaustive examination of these patterns and their resulting trading strategies is beyond the scope of this article. We will discuss, however, the most robust and well-understood factors that may produce alternative return premiums: carry, momentum, and value. These factors behave uniformly across assets and can be harvested in a consistent fashion using liquid exchange-traded instruments.
Readers interested in scholarly articles explaining the theory and evidence in support of the carry, momentum, and value factors can find what they seek on Social Science Research Network or Google Scholar.2 We explain here in layman’s terms why each provides consistent profits, and then review our results, verifying and extending earlier research on systematic global macro investing.
The Carry Trade
Carry is the staple of many global macro strategies. The carry trade refers to a long position in a relatively higher-yielding security financed by a short position in a lower-yielding security. The spread between the yields is the carry on the position. Like all profitable investment strategies, carry is not risk free. The returns from the carry trade are, however, too large and consistent relative to traditional stock and bond market return premiums to be fully explained by their risk. Supply and demand imbalances created by structural rigidities likely explain the excess returns of carry trades.
Mrs. Watanabe, the proverbial Japanese housewife, is the world’s most famous carry trader. For decades, she has been astutely exploiting official policy in Japan to boost the returns on her savings as she sells yen to buy higher-yielding securities denominated in foreign currencies. Why is this persistently profitable carry trade available to Mrs. Watanabe?
Mrs. Watanabe understands that interest and exchange rates are not set by a free market for capital assets. The Japanese Ministry of Finance, in cahoots with the Bank of Japan, has for many decades regulated local financial markets to depress the cost of capital to benefit Japan’s exporters by restricting local investment choices for Japanese savers. This intentionally depressed cost of capital has resulted in persistently low and even negative interest rates for local Japanese savers. The policy to manipulate prices to pursue policy goals creates the opportunity for Mrs. Watanabe to sell persistently low-yielding yen to purchase securities denominated in other higher-yielding currencies.3
“Trend following” is the common term for investing using price momentum. Going long securities whose prices have been rising over recent months and going short securities whose prices have been falling has provided consistent profits. This strategy is so popular that an entire investment style called “managed futures” is dedicated to nothing more than straightforward trend following.
The persistent profits from long–short trend following may create a conundrum for believers in efficient markets, but few actual participants in financial markets can fail to notice the reality of price trends. New information immediately moves the price of a security or group of related securities. While the direction of the move may be obvious, the correct magnitude of price change consistent with the news is much less certain. Press attention to both the news and the following price reactions in the market creates feedback that reinforces the initial price moves, thereby creating trends.
Trends may begin with moving the prices of securities toward a changed perception of value resulting from fundamental news, but often persist far beyond any reasonable estimate of fair value. Investors often seem to jump on a trend without much regard for the connection of prices to fundamentals. History is replete with such self-reinforcing trends divorced from valuations: the tulip craze in 1630s Holland, the South Sea Bubble of 1720, railway manias of the mid-1800s, the roaring bull market of the 1920s, Nifty Fifty stocks in the 1960s, Japan’s asset price bubble of the 1980s, and the late 1990s tech bubble, to name just a few. Momentum has proven to be robust across the financial markets, including currencies, commodities, equities, and fixed income.
The trouble with trend following is getting off the train before it changes direction, often after a violent crash. The mirror image of trend following is value investing. The basic tenets of value investing have been known at least since Graham and Dodd wrote Security Analysis in the 1930s. To understand why value investing does not prevent trends from proceeding beyond fair value, but remains a persistently profitable discipline, we need only consider the profound discomfort required to hold the contrarian positions revealed by valuation information.
The recent tale of Michael Burry, the eccentric physician and value investor portrayed by Christian Bale in the movie based on Michael Lewis’ book The Big Short, provides a particularly poignant example. Spotting the housing bubble and mispricing of mortgage-backed securities was not sufficient to correct prices in the US housing market. Michael Burry had to negotiate for the creation of credit default swaps on subprime mortgages, battle disgruntled fund investors demanding the liquidation of his positions and the return of their capital, and generally display conviction and strength of character few of us could match—all while waiting to see if his solvency could outlast the markets’ irrationality. Uncomfortable indeed.
To explore the potential for systematic global macro investing, we empirically investigate the performance of carry, momentum, and value factors across equity, bond, currency, and commodity markets. We have examined many different definitions for the three factors in these markets. Our discussion of empirical results centers on the following factor definitions: