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Hedge Funds

Structured credit funds no longer big business

End of mortgage trade means new investments few and far between

Hawes Bostic said the end of uncertainty about real estate was a big nail in the coffin.

Private credit remains high on asset owners' lists of most sought-after investment strategies, but one pocket — structured credit hedge funds — is losing some of its luster.

The problem is that the huge post-crisis mortgage trade is mostly over and opportunities available now are generally smaller and harder to find, sources said.

"Across structured credit broadly, returns have been muted between 2015 and 2017 (compared to) previous years," said Hawes Bostic, partner and director of research, Magnitude Capital LLC, New York, a hedge funds-of-funds manager.

"The large-scale, directional trades in structured credit, particularly in mortgage-backed securities, have largely run their course. Outside of some relative-value trading, the asset class doesn't have a lot of return left in it, which makes sense because there isn't much uncertainty about real estate compared to post-crisis," Mr. Bostic said, noting that assets are stable or falling for most managers in the asset class.

Magnitude manages $3.9 billion in commingled hedge funds of funds.

"It's been almost 10 years since the crisis and the environment is normalizing. The mortgage trade worked really well, but it's not working now," agreed Putri Pascualy, partner and managing director of hedge funds-of-funds manager PAAMCO Prisma Holdings LLC, Newport Beach, Calif.

The technical pressure exerted through the reduction in residential mortgage purchases by the Federal Reserve Bank along with improvement in pricing has turned investment in residential mortgage-based securities into a "low-risk, low-return trade," she said.

The low-risk nature of the MBS trade is impacting aggregate performance of structured credit hedge funds, sources said.

Using eVestment Alliance LLC's MBS Strategies index as a proxy, annual returns of structured credit managers declined precipitously from a post-crisis high of 49.1% in 2009 to 7% in 2016 and 6.1% for the first half of 2017. Performance over the eight-year period reached a nadir of 2.1% for the eVestment MBS index in 2015.

Assets have followed returns, said Peter Laurelli, eVestment's New York-based global head of research, noting that "flow was generally very good post-financial crisis, peaked in mid-2013, stumbled, ​ resumed, but since (the) end of 2015 has generally been negative."

Aggregate assets tracked in eVestment's MBS index increased 306.6% to a peak of $99.2 billion in May 2015 from $24.4 billion in January 2009. Assets have since declined 16.7% to a post-2009 low of $85 billion in July 2017, data provided to Pensions & Investments by eVestment showed.

If the current pace continues through year-end, 2017 net outflows from MBS strategies could significantly exceed the net outflows of $5.9 billion in 2016. eVestment reported year-to-date net outflows of $4.6 billion as of Aug. 31, with $2.4 billion yanked in the last three months alone.

Assets falling

Asset declines were evident among specialist structured credit hedge fund managers in P&I's annual ranking of hedge fund managers by worldwide assets as of June 30. Firms experiencing significant asset declines included Seer Capital Management LP, with a 30.1% drop to $1.1 billion; Tricadia Capital Management LLC, which fell 22.6% to $2.4 billion; and Structured Portfolio Management LLC, which dropped 9.4% to $1.9 billion.

Representatives from each firm declined to comment.

Some hedge fund firms have substantially reduced their portfolio allocations to structured credit. PAAMCO Prisma, for example, scaled down structured credit exposure to "not quite to zero" in the $17.9 billion it manages in commingled and customized hedge fund-of-funds portfolios, Ms. Pascualy said. And Magnitude has reduced its exposure to credit strategies by more than half over the last five years, Mr. Bostic said.

Startup hedge fund manager Smith Cove Capital Management LP, Greenwich, Conn., uses an opportunistic, value-oriented strategy that can invest across the entire capital structure but is not invested in structured credit, said David A. Russekoff, CEO and chief investment officer.

"We're looking for distressed, dislocated situations where we can make money in less crowded areas, and structured credit is just not as good as it used to be," Mr. Russekoff said.

Smith Cove manages $70 million in its flagship hedge fund.

Experienced structured credit specialists are finding opportunities in complex niche areas. "The story for structured credit is not different than it was four or five years ago. A big part of the problem is that the environment hasn't changed much — interest rates are low and credit spreads are tight — so you really need to know what you're doing and probably need to add a little bit of leverage to make money," said Kenneth J. Heinz, president of index creator Hedge Fund Research Inc., Chicago.

Ms. Pascualy's team at PAAMCO Prisma has observed a switch to opportunistic trades by veteran hedge fund firms tackling complicated restructuring of legacy MBS portfolios. The strategy involves the acquisition of an MBS portfolio, re-securitizing and applying leverage to the "clean" bonds and segregating distressed securities into a separate portfolio, a move she described as "such a pure hedge fund play."

Structured credit managers also are finding new investment opportunities in the MBS portfolios created through the credit risk transfer program offered by the Federal National Mortgage Association and Federal Home Loan Mortgage Corp., said Eli Sokolov, managing director and a credit analyst at alternative investment consultant Cliffwater LLC, Marina del Rey, Calif.

Given long-running market conditions, Mr. Sokolov said "structured credit managers had to evolve" and moved away from commingled funds to offering institutional investors separate accounts or drawdown vehicles using a private equity-like structure with a two-year investment and a three-year harvest period and only charge fees on invested capital.

Interest still exists

Institutional investors have not entirely lost interest in structured credit hedge fund strategies and have maintained a modest investment pace this year, despite industry woes and the difficult investment environment.

Two large institutional investors — the $11.1 billion University of Michigan endowment and the New Jersey Division of Investment, which manages the $73.6 billion New Jersey Pension Fund — made commitments to private structured credit strategies.

The Ann Arbor-based University of Michigan allocated $35 million to Corbel Management LLC for investment in privately negotiated structured credit in lower-middle-market companies. And the Trenton-based New Jersey investment agency earmarked up to $150 million to a separate account managed by Crayhill Capital Management LP for investment in private structured credit vehicles secured by real and financial assets.

The $48.7 billion Teachers' Retirement System of the State of Illinois, Springfield, earmarked $200 million for Magnetar Constellation Fund V. The fund's manager, Magnetar Asset Management LLC, will seek investment opportunities in structured credit and direct lending.