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.