Overview
Given increases in volatility and uncertainty in the global economic outlook, the rising tide that lifted all ships has given way to tumultuous waves that will pose problems for those who have been simply going with the tide. During the strong bull market from 2009 to 2014, beta exposure was often misclassified as alpha generating strategies. An active, market-neutral approach that combines both strategic and tactical positioning is well suited for generating alpha through exploiting market inefficiencies, while remaining insulated from the ebbs and flows of the market.
Alpha, the most used metric for quantifying risk-adjusted returns, is measured as the difference between the unleveraged portfolio return and passive market exposure. Alpha is a relative metric with roots stemming from modern portfolio theory for traditional investments. However, market-neutral strategies can be thought of as a source of pure alpha since return is provided without benchmark exposure. Alpha can be enhanced through targeted, tactical exposure when market dislocations have created asymmetric return profiles with positive skew. Capitalizing on these dislocations provides tactical alpha through return enhancement and diversification.
The following discussion focuses on the drivers of alpha within the context of a multi-strategy mortgage portfolio.
Prepayment Arbitrage
Prepayment arbitrage, as a fixed-income arbitrage strategy, offers skillful managers a variety of ways to capture alpha in mortgage backed securities (MBS) while hedging out exposure to interest rates (beta). Proprietary models aid mortgage investors in identifying opportunities when a security is cheap, relative to its intrinsic value, by establishing a more accurate view on prepayments and the resultant cash flows than what is priced into the market. Given the varying degrees of sophistication across the heterogeneous mix of MBS investors with differing objectives and constraints, those with superior models are presented with lasting opportunities to capture prepayment arbitrage. Purchasing cash flows that are overly discounted in the market, and intrinsically undervalued, generates a stream of incremental yield (hedge-adjusted carry) that serves as a persistent stream of alpha.
Relative Value Trading
Relative value trading strategies in Agency MBS pass-throughs can provide a pure alpha stream. These securities, which are the second-most liquid fixed income instruments after US Treasuries, can be used for statistical arbitrage and mean reversion strategies that identify and profit from statistically significant deviations from normal market relationships. With the many constituents of the universe of Agency MBS, there are unremitting moments of detachment that can be capitalized upon in tactical, duration-neutral trades. These include the Agency mortgage basis (versus Treasuries or swaps), or pair trades in Agency MBS coupon swaps, term swaps and inter-agency swaps. The return profile in these moments of dislocation is asymmetric and stop loss mechanisms further enhance the distribution to create a program with high-conviction, short-term trades that last from days to weeks.
Opportunistic Credit
Investing opportunistically in Non-Agency mortgage credit allows for a source of alpha, through the disproportionate upside offered at moments of technical dislocations, that result in the mis-pricing of securities. Opportunistic purchases of securities are available to managers who are equipped and poised to act as a liquidity provider to investors seeking to sell at inopportune times (e.g. late in the trading day or low-volume days near a holiday or event). The gap between the purchase price and fair value is a liquidity premium that adds to alpha generation. There are also technical factors such as large liquidations or bursts of origination that can cause certain sectors to become displaced by forces that ultimately abate. Reduced correlations and incremental alpha are the end result.
Summary
Multi-strategy mortgage portfolios are well-equipped to generate alpha in times of increased volatility. By implementing a duration-neutral combination of prepayment arbitrage, relative value trading and opportunistic credit, Tradex aims to provide superior risk-adjusted returns over a full range of market environments.
We encourage readers interested in learning more about capturing alpha through a mortgage strategies to contact the investment team at Tradex for further discussion.
Tradex Global Advisory Services, LLC
investorrelations@thetradexgroup.com
203-863-1500
@Tradex_Global
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