Where in the World Do Investment Returns Come From?

I've been in New York all week. It's been great.

I've talked to journalists covering topics like "managed futures" ETFs, and I spoke at a conference at the NYSE yesterday.

The topic of the conference talk was "The Return of Carry." The return of who???

Yeah, don't worry. If that's confusing, give me a minute, and we'll clear that right up...

A common thread through these conversations has been some version of, "Wait, but where are those returns coming from?"

It's actually a very profound question, and a critical one.

Most people buy assets with the basic understanding that it's a way to "make money." The slightly higher-level version of that is a belief that "stocks go up over time." The people who talk the talk say things like "up and to the right," as they visualize a line tracing the value of their investments over time on a piece of paper.

I'm not telling you that assuming "up and to the right over time" is a good or bad assumption, but it's pure faith unless you understand what pushes lines up, down, or sideways.

One way to break it down is what we can call "use of money."

You have money. Someone else needs it (or wants it) to do something.

• If they take your money now and promise you money back later, then you'll say, "That's fine, but you're asking me to part with something I value for a while, so I'm going to need more of that thing later as compensation." And thus is born the return known as "interest." You earn interest on loans to governments, companies, people who want to buy big houses, whatever. You don't get the house; they do. Eventually, they just pay you back, with interest.
• If they take this money to engage in some activity that does things other people value and are willing to pay for, you collectively have a business on your hands, and you're business partners. We call that owning equity, and the return to you is your fair share of profits "rolling off of the business" (we'll skip over complications like valuations for this conversation).

These are helpful ways to think about things, but they don't totally "generalize" (as people with their heads in the clouds say).

So let's generalize...

Now, like most ways to organize your thinking, it's not going to be perfect, but it can be pretty helpful.

Carry, Value, and Momentum

Three simple thoughts:

• Momentum is the driving force behind returns when prices keep going in the direction they've been going for a while.
• Value is the return driver from prices switching directions (some people call that "mean reversion").
• Carry is the return you get when prices don't change one way or the other.

Those are pretty easy to get. Most prices tend to go in one direction for a while. They also tend not to go in the same direction all the time because of the gravitational pull of forces like valuations. And because you're not sure that prices will go up or down, thinking about what's in it for you if nothing happens is a reasonable question to ponder.

Back to the Conference...

You see, for the last two-ish years, we've been in this suspended state where carry has been on the table.

How do we know that?

If you buy a one-year Treasury bond with a yield of 5%, what do you need to happen between now and maturity to earn 5%? The answer is "nothing, just the passing of time." That's the simplest form of carry, and when it's available at scale, people notice (see money flowing into Treasuries and money market funds for that sweet, sweet 5% carry).

The other thing is market volatility has been low to very low relative to historical standards over that period of time. This is true of volatility measures that are supposed to estimate future volatility. Saying that prices aren't expected to change with any degree of violence can quickly be simplified to "prices not changing." And you're back to carry...

With all this carry energy around, people did a lot more than buy Treasuries.

• The adventurous hedge-fund types did "the carry trade." They borrowed in countries where you can borrow for cheap (like Japan) to lend in countries where you can lend for good interest (like Brazil). That sort of thing is all well and good until... you've guessed it... prices change. When the Yen rose in value in early August because of central banks, prices changed violently, and the carry trade had a very bad hair day.
• The enterprising asset-management types dusted off their financial engineering textbooks and created new investment products that are a lot more fun to put together (and sell to carry-minded people) when rates are at 5% than at 0% and when volatility is low. A reasonable question is what will happen to these fun engineering and marketing projects as interest rates come down and if volatility makes a comeback. That's probably a conversation for another day.

Where Does That Leave Us?

When I was asked where I see the balance of carry, value, and momentum in people's portfolios, I noted a few things:

• Most people have momentum exposure—at least in a diluted form—via equities that are dominated by winners that keep on winning.
• Some people "want to want" value, but it's a hard thing to do in the face of a wall of FOMO.
• I empathize with the natural appeal of carry (and its very real empirical basis), but assuming prices don't change is quite the assumption to make outside of market holidays.

Maybe that's what I need.

Maybe that's what we all need... A market holiday.

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Disclaimer: This content is for general educational purposes only and does not constitute financial advice. Investing involves risk, including potential loss of principal. Please consult a financial professional before making investment decisions.