As Hedge Funds Thrive on Mortgages, the House Party Is Far from Over

Last year Karlin Asset Management tried something new. The Los Angeles–based family office, which oversees a $1.6 billion private fortune, decided to stake a hedge fund firm. Karlin invested $100 million, far more than its typical hedge fund allocation, in new local outfit Illumination Asset Management.

Founded by CIO  Todd Sherer and president Christopher Gaughan, Illumination invests in U.S. distressed nonagency residential-­mortgage-backed securities, which consist of mortgages uninsured by government lenders, and related instruments in the structured credit space. Sherer and Gaughan came from Dalton Investments, a $2 billion firm based in Santa Monica, California, where they ran a similar strategy. Before that Sherer and several Illumination colleagues worked at mortgage originator Countrywide Financial Corp.

Given that the average hedge fund returned just 2.67 percent for 2012, according to the HFRI Fund Weighted Composite Index, Karlin and other investors have good reason to seek out mortgage-related funds. Residential mortgages have been one of the few bright spots for hedge fund returns and capital-raising since 2008. “They have a great track record,” says Karlin president and CEO David Cohen of the Illumination team, who launched their new business last June with $200 million. “Todd wasn’t one of those guys working on a proprietary trading desk,” Cohen adds. “He was in the [mortgage] creation process.” As a result, he says, Illumination has a vast network and knowledge of the market.

The years after the U.S. housing market collapse of 2007–’08 have also seen several RMBS- and mortgage-focused hedge funds launched by people who had worked on bank trading desks. Among the most successful are New York–based Axonic Capital and LibreMax Capital.

Founded in 2010 by Clayton DeGiacinto, a former proprietary trader at Goldman Sachs Group, Axonic started with $110 million and now manages some $1.5 billion. LibreMax CIO Gregory Lippmann was a senior mortgage-backed-securities trader at Deutsche Bank, where he became famous for encouraging hedge fund clients to short the U.S. subprime mortgage market. In 2010 he and three former Deutsche colleagues co-founded LibreMax, which today has more than $2.7 billion in assets. LibreMax returned 20 percent in 2012, while Axonic was up more than 25 percent.

Also profiting from U.S. mortgages is New York’s Metacapital Management, which gained 41.25 percent last year. With $12.8 billion in assets, Minnetonka, Minnesota–based credit specialist Pine River Capital Management saw its Pine River Liquid Mortgage Fund finish 2012 up 29 percent.

It’s no surprise that RMBS-based hedge funds are thriving. Despite the odd dip, the U.S. housing market has been on the upswing since it bottomed out in late 2008. The S&P/Case-Shiller National Home Price Index was up 7.3 percent for 2012 and has gained more than 25 percent since mid-2008. More striking than this rebound is the duration of the investment opportunity. In the first two years of the recovery, there was money to be made just buying the bounce-back, while 2011 was a transition year because mortgages traded down again partly because of fears about Europe’s debt crisis. Since then more-specialized areas have paid off. In 2012, for example, a sweet spot for hedge funds was collateralized subprime mortgages.

Christopher Acito, CEO of $720 million, New York–based fund-of-hedge-funds firm Gapstow Capital Partners, believes the best time to raise capital for a new mortgage fund was in the two years or so after 2008. “It is difficult to start a new fund today,” Acito says. “You already have a very nice complement of talented people out there.”

Gapstow is focused on credit-related hedge funds and has some 30 percent of its flagship fund, which returned 11.5 percent in 2012, in mortgage-related investments. Bullish on the U.S. economy, Acito is confident that there’s plenty of mortgage opportunity left for hedge funds, but he sees the nature of that opportunity changing along with profit expectations. Although 2013 may not be as strong as last year, he thinks double-digit returns are possible.

Looking ahead, Karlin’s Cohen expects the best returns to come from niches such as older subprime mortgages, which he believes are still undervalued relative to the likelihood of repayment. That’s why he invested with Illumination, a firm that’s at home in the market and wants to stay small enough to shine a light into those dark corners. As hedge funds thrive on mortgages, the house party is far from over.