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Are There Still Opportunities in Structured Credit Hedge Fund Strategies?

Traders Magazine Online News, September 14, 2017

Donald Steinbrugge

Hedge fund managers focused on structured credit strategies can be simplistically divided into two categories: beta managers or alpha generators. Many investors believe the beta opportunity born out of the financial crisis has substantially run its course. As such, they find risk adjusted returns from structured credit beta managers are not particularly attractive. On the other hand, inefficiencies in the structured credit markets persist, providing opportunities to generate strong, alpha-driven risk adjusted returns relative to other hedge fund strategies.

Beta managers are defined as primarily long biased managers with some leverage. Typically their net exposure will range from 75% to 200%, adding value through security selection with low turnover. Many of these beta managers were founded after the 2008 financial crisis to take advantage of depressed securities prices and double digit spreads above treasuries. These managers were rewarded for adding risk as both interest rates and credit spreads declined from 2009 through 2014, and subsequently control the majority of assets in structured credit hedge funds.  It was during this time that structured credit morphed from an exotic niche strategy to a long term core component of many investors’ portfolios. Today, many investors believe the “trade” is almost over due to the housing recovery and the potential bottoming out of interest rates and credit spreads.  Demand for beta structured credit managers has significantly declined since 2014 and has resulted in a few of the larger players closing.  The carry for high grade unlevered structured credit has declined to the low single digits, and many of these managers are now exposed to the risk of widening credit spreads.

Alpha generating structured credit managers are defined as those focused on gaps in inefficient structured credit markets and seeking to take advantage of mispriced relative values.  They generally carry low net exposure, hedge their portfolio’s tail risk and have more frequent turnover.  Their returns are not dependent on leverage or a directional bet on the market. One example within the structured credit market that we particularly like is junior tranches of non-agency residential mortgage backed securities (RMBS). Since shorting the RMBS market is not possible, corporate credit index default swaps (CDS) are one example of instruments that can be used to hedge. In addition to providing an offset to the market risk, investors can take advantage of mismatches between the demand from protection buyers and sellers in different maturities or various option strike prices.

How has structured credit evolved since the financial crisis? Why do market inefficiencies exist in structured credit? 

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