(Bloomberg) — Brett Jefferson told his 5-year-old son this about Wall Street recently: “Never will you find a place where so many smart people do so many stupid things.”
That’s a good deal for Jefferson, 49, who has been profiting from bankers’ blunders for more than a decade. His hedge-fund firm, Stamford, Connecticut–based Hildene Capital Management, vacuums up complex securities when others are shunning them as toxic junk. So does Michael Craig-Scheckman’s Deer Park Road Corp., Bloomberg Markets magazine will report in it February issue.
“We make money because people on Wall Street make mistakes,” says Craig-Scheckman, 62, whose firm is based in Steamboat Springs, Colorado.
Six years after the 2008 debt crisis exposed how clueless the smart people on Wall Street can be, both men are profiting from what could be called the schadenfreude trade — buying for pennies what big investment banks once flogged for dollars. Their bottom-fishing lifted them into the top five of Bloomberg Markets’ annual ranking of the best-performing hedge funds managing $1 billion or more.
Craig-Scheckman’s STS Partners Fund, up 23.9 percent in the 10 months ended on Oct. 31, took third place. Jefferson’s Hildene Opportunities Fund, up 23.6 percent, came in fourth.
The top spot went to activist investor Bill Ackman’s Pershing Square International, which returned 32.8 percent on investments including Allergan Inc. and Canadian Pacific Railway Ltd.
Ackman was an outlier. Most managers on the list were debt traders, including a dozen funds dealing in bonds backed by mortgages and other assets, or quants — investors who use mathematical models to trade a variety of securities.
It was debt trading that powered the best quant fund on the list: Quantedge Global, which ranked No. 2, with a 32.3 percent gain. The firm is a group of hypereducated actuaries, most of them in Singapore.
The 15 people on Quantedge’s investment research team hold degrees in math, economics, finance, financial engineering and physics from Harvard University, the University of Pennsylvania’s Wharton School, the University of Oxford, the University of California at Berkeley and the Massachusetts Institute of Technology. They trade everything — stocks, bonds, currencies, commodities and insurance-linked securities such as catastrophe bonds, where their actuarial skills come in handy.
Yet it was fixed income that drove gains in 2014, a Quantedge Capital spokeswoman said in an e-mailed response to questions.
Mortgage funds did well in 2014 because home prices rose and fewer debtors missed payments on their loans — including the subprime borrowers whose debt hedge funds love. At the end of the third quarter, 18.8 percent of subprime home loans were delinquent, down from 27.2 percent in March 2010, according to the Mortgage Bankers Association. Bonds backed by home loans rallied for the fifth year, making analysts wonder how long the good times will last.
“Everyone thought mortgages were over,” says Chris Acito, chief executive officer of Gapstow Capital Partners in New York, which has $1.1 billion invested in hedge funds that trade credit. Yet the party goes on.
“If people haven’t defaulted on these yet, they probably won’t,” Acito says.
Better yet for the sketchy-debt crowd: There aren’t enough old bonds to go around, Acito says. When prices get low enough, Wall Street’s gaffes turn into gold. And with more homeowners paying their mortgages, that gold is going platinum.
Hedge funds as a group had a horrendous 2014, with an average return of just 1.6 percent through October among the 2,400 funds that make up the Bloomberg Global Aggregate Hedge Fund Index.
Until October, managers complained that volatility in stocks and bonds made it tough to make money. Then, many got spooked and sold during October’s plunge, missing a quick profit as prices rebounded. Some of the largest and best-known funds, caught up in crowded trades that went against them in October, lost the most.
The preferred shares of U.S. government–controlled mortgage aggregators Fannie Mae and Freddie Mac were favorites among hedge funds, and they tumbled more than 50 percent when a court ruling went against investors. Merger-arbitrage managers lost big when drugmaker AbbVie Inc. dropped a plan to buy Shire Plc and Shire shed more than a quarter of its value in two days.
John Paulson, who had five funds in the top 100 in 2013, was among the biggest losers in 2014. His $19 billion firm, Paulson & Co., lost money in both Fannie-Freddie and AbbVie- Shire trades. His Advantage fund plunged 14 percent in October and 25 percent for the year as of Oct. 31.
The flagship fund of Claren Road Asset Management, majority owned by private-equity firm Carlyle Group LP, dropped 9.1 percent in the 10-month period on the Fannie Mae and Freddie Mac trade.
Two funds that did not make the top 25 nevertheless were the most profitable. No. 26 Viking Global Equities led that list, pulling in $573.3 million in incentive fees for the 10 months ended on Oct. 31. Israel “Izzy” Englander’s Millennium International made $389.5 million even though it tied for 75th in performance, with a 7.4 percent return.
The top midsize fund, with assets from $250 million to $1 billion, was the Mauritius-based India Capital fund, run by Jon Thorn, which was up 47.2 percent in the ten months ended Oct. 31, after falling 21.7 percent in 2013.
STS’s Craig-Scheckman floated through October’s volatility. He and Deer Park Road Chief Investment Officer Scott Burg, a former offensive guard on the University of Colorado football team, buy mortgage-backed bonds that pay a healthy yield, and they are ready to hold them long term. Even if prices decline, they clip their coupons.
And if it snows, they go skiing. Craig-Scheckman is in the midst of constructing a new office building for his 19 employees at the base of the gondola at Steamboat Springs. They all get lockers and a ski pass as perquisites. If fresh snow lures them out at midday, they bring their mobile phones to complete trades.
Like many mortgage bond managers, Craig-Scheckman has an academic background. In the 1970s, he was pursuing a doctorate in X-ray astrophysics at New York’s Columbia University, working on gas-scintillation technology for Geiger counters used in space probes, when it all started to feel like grunt work, he says. He had an uncle at Salomon Brothers. And his cousin, trader Asher Edelman, was a model for Gordon Gekko in the movie “Wall Street.”
In 1978, Craig-Scheckman left physics and joined them in finance. He traded gold, then mortgage bonds. In 1993, he went to work for Englander’s Millennium Management. Craig-Scheckman started Deer Park Road in 2003, moving his family to Steamboat Springs that same year.
Mortgage bonds that were minted from 2004 to 2007 are among Craig-Scheckman’s favorites. That’s when lenders offered negative-amortization mortgages, in which the payments didn’t cover all the interest, so the principal just kept growing.
“These were the worst possible loans people could take,” he says.
Lately, they’ve been among the best for Deer Park Road. Bonds backed by them tumbled so much that a little improvement in payment on the underlying loans boosts their value.
Hildene Capital’s Jefferson trades exotic stuff too, and he does it without a physics degree. He grew up in Rye, New York, the son of a container-ship captain. More jock than geek, he majored in English and played lacrosse for Syracuse University in 1988 when it won the national championship. He played on a club team while working on an MBA from the Kellogg School of Management at Northwestern University.
Jefferson started his career in structured debt in 1997, when his bosses at Salomon Smith Barney asked him to figure out a new category of securities called collateralized loan obligations — bundles of corporate loans structured as securities. Back then, a little experience made him an expert, he says. He joined Marathon Asset Management in 2002 and ran the Marathon Structured Finance Fund until 2006. Under his watch, the fund never had a money-losing month, according to fund documents. Even so, he and Marathon CEO Bruce Richards parted ways.
“Mr. Richards and I had a disagreement,” Jefferson says, declining to say more.
Jefferson spent the next two years sitting out the excesses of the mortgage bubble.
“I made the smartest investment decision of my life by not working in 2006 and 2007,” he says.