Absolute Return and Alpha: Hedge Fund Firms are piling into the MBS market and putting up lofty returns, but high risks remain:
“Cerberus Capital Management, Pine River Capital Management and Canyon Partners are among dozens of firms to earn market-beating returns this year by investing in mortgage backed securities. The MBS strategy they employ has become, almost by default, the most attractive in the hedge fund industry.
Hedge funds that employ an MBS strategy are up an average of 6.43% through June, according the AR database, beating all other strategies tracked by the database and compares to a composite return of 2.65%.
The question is how long those lofty returns can last . . .”
Absolute Return and Alpha:
“There is about $8.9 trillion in total outstanding mortgage debt structured in securities as of the end of the first quarter,according to datacompiled by Securities Industry and Financial Markets Association. That includes about $1.4 trillion in non-government agency residential and commercial mortgage backed securities (down from nearly $2.4 trillion in 2007) and about $7.0 trillion in agency MBS and collateralized mortgage obligations from Fannie Mae, Freddie Mac and Ginnie Mae (up from about $5.8 trillion in 2007).
The subprime mortgage securities at the center of the 2008 market dislocation have rallied since their dramatic sell-off but not fully recovered to peak 2007 prices.
Hedge funds have been snapping up all types of RMBS AND CMBS: prime and subprime, agency and non-agency. The prevailing view is that the U.S. is in the early stages of a housing market resurgence . . .”
Big returns, hidden volatility?
“There’s a lot of hidden risk in mortgage focused hedge funds,” said Raphael Douady, co-founder and research director of Riskdata, a data and software firm that tracks hedge fund returns and evaluates risk for clients. Douady said MBS managers have relatively smoother returns either because they consistently apply a conservative methodology or are too optimistic in valuing their relatively illiquid positions. That creates seemingly low volatility relative to other hedge fund strategies, which can trick investors into a false sense of security. “There’s a tendency to produce small, positive returns because of valuation flexibility, whether by active smoothing or simply conservative marking. But when the spread widens dramatically because of a big event in the market, it can cause a crash.”
“There is no easy or perfect hedge for MBS funds,” says Zilberchteine of DGAM. “But we like managers who actively hedge to minimize impact from substantial underperformance in the housing market or broader economy. You can be the best security picker in the world and still have the markets crush you.”
Markit’s ABX.HE.AAA.06-1 is a tradable credit default swap index that references a basket of 20 subprime RMBS bonds originally rated AAA that were issued to market in 2005.As the index prices in the chart fell, the cost of purchasing CDS as insurance against further losses increased. Source: Absolute Return and Alpha by Lawrence Delevingne July 31, 2012
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market and putting up lofty returns, but high risks remain: “Cerberus Capital Management, Pine River Capital Management and Canyon Partners are among dozens of firms to earn market-beating returns this year by investing in mortgage backed securities.
Hedge fund strategies involve investing in debt and equity securities, commodities, currencies, derivatives, and real estate. Hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.
Many hedge funds utilize leverage as part of their strategy to enhance potential returns. This is typically done using derivatives, which often carry low-margin requirements (a portion of notional value in cash or equity required as collateral to borrow from the broker).
All real estate hedge funds invest heavily in real estate, obviously, but the way in which they invest varies by managerial investment strategy. For the most part, real estate hedge funds invest in the publicly-traded stock of existing real estate companies, mainly real estate investment trusts (REITs).
Citadel, which ranked second in 2023, made $8.1 billion in profits after bringing in a record-breaking $16 billion in 2022. Its $74 billion in gains since inception rank it as the most successful hedge fund in history.
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
The most prevalent of the hedge fund strategies, equity strategies hedge funds take long positions in stocks perceived as undervalued and short positions in stocks considered overvalued. Equities' correlation with macroeconomic factors mean they are seen as a riskier class for investment than cash and bonds.
Hedge funds make money by charging a management fee and a percentage of profits. The typical fee structure is 2 and 20, meaning a 2% fee on assets under management and 20% of profits, sometimes above a high water mark. For example, let's say a hedge fund manages $1 billion in assets. It will earn $20 million in fees.
Hedge funds originated as a vehicle to help diversify investment portfolios, manage risk and produce reliable returns over time. While hedge funds' investor base has evolved though the years – from individuals to institutions such as pensions, universities and foundations – their core goals have remained the same.
According to the data, hedge funds collectively outperformed the broader stock market during down months in the last four recessionary periods (acknowledging that the most recent, two-month-long, COVID-fueled recession contained only one month of equity decline — albeit steep).
Billionaire Christopher Hohn's TCI led the annual ranking by 2023 returns, which were $12.9 billion after fees, while Citadel, Millennium Management and D. E. Shaw, all multi-strategy firms, were the top three hedge funds by lifetime gains.
For example, the U.S. Securities Act of 1933 bars non-accredited investors from certain private securities transactions, including hedge funds. Only qualified clients with $2.2 million in Managed assets can participate due to minimum hedge fund investments.
While hedge funds are only lightly regulated and carry high inherent risks, funds of hedge funds are thought to offer security because professional managers are picking the hedge funds that make up the pools.
According to the Urban Institute, as of June 2022, large hedge funds owned around 574,000 single-family homes nationwide. Twenty-seven percent of single-family homes sold during the first three months of 2023 were purchased by large financial groups.
Prime brokerages, at times referred to as prime brokers, are generally larger financial institutions that have dealings with other large institutions and hedge funds.
Hedge funds often engage in riskier investment strategies in pursuit of yield, which has become increasingly difficult over the years. The most common strategies include short-selling, reliance on leverage (i.e. borrowed funds), financial derivative instruments, and arbitrage strategies.
A B.S.in finance can prepare you for a range of hedge fund positions: asset manager, portfolio or equity analyst, and equity trader. A finance-oriented bachelor's degree can also be a great primer for a Master of Business Administration (MBA).
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