FX carry strategies, in which low-yielding currencies are sold to finance the purchase of higher-yielding currencies, perform well in times of elevated risk appetite.However, the problem for investors is that they are prone to sudden reversal if risk appetite is disrupted and heightened volatility forces a wave of position deleveraging, such as that provoked by the collapse of Lehman Brothers in 2008. “Our aim was to create an investment product that tries to extract the value from that core carry principle, while at the same time protecting clients’ investments at time of large carry unwinds,” Tamas Korchmaros, head of FX Indices at HSBC tells EuromoneyFXNews. HSBC first created a benchmark carry index, which simply consists of a basket that is long of the five highest-yielding currencies among the 32 in its model, and short of the five lowest-yielding currencies. The basket is equally weighted and rebalanced each quarter. Unsurprisingly, the benchmark performed well ahead of the financial crisis, but was prone to large swings thereafter, with intermittent sudden and large losses. “We took the benchmark and further developed an algorithm with two proprietary mechanisms to protect investments in times of carry unwinds,” says Korchmaros.
HSBC calls the first the value-preserving mechanism. The algorithm monitors the relative volatility of each currency and excludes those that display volatility above a certain level.
Furthermore, it assesses how many currencies exhibit relatively high volatility and defines the world to be in three states: calm, medium, and volatile. Depending on which state the world is in, the algorithm will either have a 100%, 60% or 0% exposure to carry, meaning a basket of five long and five short currencies, of three long and three short currencies, or nothing. “We can have zero allocation to carry because studies have shown that, in volatile times, carry tends to underperform," says Korchmaros. The second mechanism is a stop-loss trigger, which is enforced if the index drops below 96% from the maximum of the previous six months. When the market calms down and the carry strategy starts to pick up momentum again, the strategy reallocates back into carry. HSBC says the benchmark index, which it back-tested to December 2004, has average annual returns of 3.9%, with annualized volatility of 10.6%, giving a relatively low Sharpe ratio of 0.37. The maximum drawdown during the Lehman crisis was nearly 28%. In contrast, the HSBC Global Carry Index has an average annual return of 8.8%, volatility of 5.8% and a Sharpe ratio of over 1.5. The maximum drawdown was below 6.5%.
Performance and annualised volatility of the HSBC Global FX Carry Index
|Source: Bloomberg, HSBC|
Korchmaros says in the new world of risk-on/risk-off (RORO), where everything in the market is dominated by that one phenomenon, it is difficult to take an educated investment position. “It is very difficult to escape the phenomenon altogether, but what we tried to do is bring down that correlation, but more importantly bring down that correlation compared with the benchmark,” he says. HSBC believes the Global Carry Index will be relevant to investors that might not have had exposure to FX in the past, and says it is drawing interest from institutional and private banking clients. “Clients are looking for an alternative and everybody is looking for yield pick-up,” says Korchmaros. “It’s very difficult to find something that is immune to the RORO factor, but this product exhibits low correlation to the general market.” HSBC says that although the index offers exposure to carry, it is also an EM product, given that the universe of currencies available to be included is not just G10 currencies, but also those of developing countries. Indeed, the index tends to go long EM currencies and short developed market currencies, while the number of alternatives on the short side, which before the financial crisis tended to be limited to just CHF and JPY, has been extended to include USD, EUR and GBP thanks to ultra-loose monetary policy in the US, eurozone and the UK. “That helps us diversify on the funding side, and then we have the whole range of EM currencies in which the index can go long,” says Korchmaros. He says that is where HSBC’s carry index differs from other products on the market. “It is up to us to demonstrate to our clients that we are different. It’s not just a carry trade play. It is an interest differential play, but at the same time it’s a global emerging markets play and that is where HSBC is very strong.”
32 candidate currencies in HSBC Global FX Carry Index