Pedro Barroso

Beyond the Carry Trade: Optimal Currency Portfolios

We test the relevance of technical and fundamental variables in forming currency portfolios. Carry, momentum and reversal all contribute to portfolio performance, whereas the real exchange rate and the current account do not. The resulting optimal portfolio outperforms the carry trade and other naive benchmarks in an extensive 16 year out-of-sample test. Its returns are not explained by risk and are valuable to diversified investors holding stocks and bonds. Exposure to currencies increases the Sharpe ratio of diversified portfolios by 0.5 on average, while reducing crash risk. We argue that currency returns are an anomaly which is gradually being corrected as hedge fund capital increases. The appendix may be found here: http://ssrn.com/abstract=2771667.

The Bottom-Up Beta of Momentum

A direct measure of the cyclicality of momentum at a given point in time, its bottom-up beta with respect to the market, forecasts both the returns and the risk of the strategy. Challenging a potential risk-based explanation, a highly cyclical momentum portfolio forecasts both higher risk and lower returns for the strategy. The results show robustness out-of-sample (OOS) and controlling for other variables. One predictive regression of monthly momentum returns on its bottom-up beta produces an OOS R-square of 2.41%. This contrasts with the usual negative OOS R-squares of similar predictive regressions for the market excess return.

Do Limits to Arbitrage Explain the Benefits of Volatility-Managed Portfolios?

We investigate whether transaction costs, arbitrage risk, and short-sale constraints explain the abnormal returns of volatility-managed equity portfolios. Even using five cost-mitigation strategies, after accounting for transaction costs, volatility management of common asset-pricing factors besides the market return generally produces zero abnormal returns and significantly reduces Sharpe ratios. In contrast, abnormal returns of the volatility-managed market portfolio are profitable after transaction costs and concentrated in the most easily arbitraged stocks, those with low arbitrage risk and short-sale constraints. Moreover, the managed-market strategy only provides superior performance when sentiment is high, consistent with prior theory that sentiment traders under-react to volatility.

Time-Varying Predictability of Consumption Growth, Macro-Uncertainty, and Risk Premiums

We find that the relation between state variables, such as the t-bill rate and term spread, and consumption growth is time-varying. In the cross-section of US stocks, risk premia for exposure to state variables vary over time accordingly. When a state variable predicts consumption strongly relative to its own history, its annualized risk premium increases by 6\% (0.4 in Sharpe ratio). This effect implies that risk premia can switch sign and is increasing in the conditional variance of the state variable. These common drivers of time-varying risk premia are consistent with the Intertemporal CAPM. Benchmark factors contain the same conditional expected return effects as state variable risk premia.We show that the relation between state variables, such as the t-bill rate and term spread, and consumption growth varies significantly over time. Consistent with an Intertemporal CAPM, we find that state variable risk premiums (in the cross section of individual stocks) vary over time accordingly: Risk premiums increase by 5% (annualized) when a state variable predicts consumption growth strongly relative to its own history. This effect is magnified by time-variation in the variance of the state variables, which we argue to be associated to general macroeconomic uncertainty. Our conditional evidence contributes to recent literature that focuses on the unconditional pricing of state variable risk and finds mixed results. JEL Classification Codes: G12

Lest we forget: Using Out-Of-Sample Errors in Portfolio Optimization

Portfolio optimization usually struggles in realistic out of sample contexts. I de-construct this stylized fact comparing historical estimates of the inputs of portfolio optimization with their subsequent out of sample counterparts. I confirm that historical estimates are often very imprecise guides of subsequent values but also find this lack of persistence varies significantly across inputs and sets of assets. Strikingly, the resulting estimation errors are not entirely random. They have predictable patterns and can be partially reduced using their own previous history. A plain Markowitz optimization using corrected inputs performs quite well, out of sample, namely outperforming the 1/N rule. Also the corrected covariance matrix captures the risk of optimal portfolios much better than the historical one.

Hedging with an Edge: Parametric Currency Overlay

Campbell, Serfaty-De Medeiros, and Viceira (2010) propose an optimized method to hedge currency risk in portfolios of international equities. In a demanding out-of-sample test, incorporating transaction and rebalancing costs, and margin requirements we find their method reduces risk in real time, but also underperforms economically a naive alternative or even a purely domestic portfolio. We propose modeling the currency hedging strategy as a function of characteristics proxying for expected returns and risk. We find that using currency momentum, value, carry, and autocorrelation significantly reduces the cost of hedging. Proxies for risk, such as volatility, skewness, beta on volatility, and equity sensitivity are irrelevant in our optimizations. Our optimal strategy is close to a fully hedged portfolio, but with a sizable 38% gain in Sharpe ratio.

Managing the Risk of the 'Betting-Against-Beta' Anomaly: Does It Pay to Bet Against Beta?

We study the risk dynamics of the betting-against-beta anomaly. The strategy shows strong and predictable time variation in risk and no risk-return trade-off. A risk-managed strategy exploiting this achieves an annualized Sharpe ratio of 1.28 with a very high information ratio of 0.94 with respect to the original strategy. Similar strategies for the market, size, value, profitability, and investment factors achieve a much smaller information ratio of 0.15 on average. The large economic benefits of risk-scaling are similar to those of momentum and set these two anomalies apart from other equity factors. Decomposing risk into a market and a specific component we find the specific component drives our results.We study the risk dynamics of the betting-against-beta anomaly. The strategy shows strong and predictable time variation in risk and no risk-return trade-off. A risk-managed strategy exploiting this achieves an annualized Sharpe ratio of 1.28 with a very high information ratio of 0.94 with respect to the original strategy. Similar strategies for the market, size, value, profitability, and investment factors achieve a much smaller information ratio of 0.15 on average. The large economic benefits of risk-scaling are similar to those of momentum and set these two anomalies apart from other equity factors. Decomposing risk into a market and a specific component we find the specific component drives our results.