Optimal Carry and Momentum Returns in Futures Markets : A Compensation for Capital Constrained Hedge Funds?

We provide evidence that speculative capital of hedge funds is a key determinant for the profitability of optimal carry and momentum strategies in futures markets across asset classes. We construct optimal carry and momentum portfolios from the perspective of a utility maximizing risk averse investor. The investor trades off the risk presented in the moments of his expected utility against the predictive strength of the carry and momentum signal. We parameterize the portfolio choice problem and adapt it to accommodate asset classes with varying volatility levels. We find that the returns to optimal carry and momentum strategies yield high Sharpe ratios (above 1.2) which are not a compensation for traditional risk exposure or time varying risk due to macroeconomic cycles or funding liquidity. Including optimal carry and momentum portfolios in a diversified portfolio of traditional asset factors increases the Sharpe ratios of the portfolios by on average 0.6 and reduces skewness and kurtosis. However, the returns to optimal carry and momentum portfolios are significantly related to pro cyclical hedge fund capital flows. Contemporaneously larger capital flow lead to higher optimal carry and momentum returns, implying that expected returns decrease with the total amount of assets under management by hedge funds. We argue that the predictability of expected returns in futures markets reflects the scarcity of speculative capital and is consistent with the notion of limits to arbitrage. This finding has important policy and investment implications