How Hedge Funds Got Rich Last Year

Every year, Bloomberg Markets magazine publishes its annual list of the world's best-performing hedge funds (link opens PDF). Given the events in Europe, the top of the list in 2011 (link opens PDF) was dominated by macro funds -- funds that employ strategies designed to profit from macroeconomic events. Fast forward one year, and many macro funds were supplanted by competitors that specialize in mortgage-backed securities.

The source of success in 2012 can be traced directly to the Federal Reserve. In September, the central bank initiated its third round of quantitative easing. While its two previous rounds had largely focused on long-dated Treasury securities, this most recent program zeroed in on MBSes issued by the government-sponsored entities Fannie Mae, Freddie Mac, and Ginnie Mae. The Fed has committed itself to buying $40 billion in MBSes a month until the labor market improves "substantially."

As with anything, from pencils to automobiles, the massive increase in demand for securities backed by residential mortgages sent their prices soaring. And it's for this reason, as you can see in the table below, that four out of the top 10 best-performing hedge funds focused specifically on these assets.

Source: Bloomberg Markets, The 20 Top-Performing Large Hedge Funds.

At this point, you're probably wondering how you can get in on this action as a private investor. The answer is twofold. First, the easiest way is to buy shares in mortgage REITs like Annaly Capital Management , American Capital Agency , or AMOUR Residential . Holding MBSes is precisely what these companies do. At the same time, however, it's important to note that there's another side to the coin here, as high MBS prices translate into low yields. This is why mortgage REITs, popular because of their yield, have underperformed of late.

And second, though more importantly, the MBS ship has sailed. In terms of upside, it seems safe to assume that MBS prices are what they are at this point, as it's unlikely the Fed will increase its monthly purchasing quota for MBSes anytime soon. If anything, then, there's more downside risk associated with buying them going forward. In addition, mortgage REITs are replete with challenges right now, leading my colleague Matt Koppenheffer to identify Annaly as the one stock to avoid in 2013.

At the end of the day, I'll be the first to admit that I'm no fan of mortgage REITs like Annaly and Chimera Investment (NYSE: CIM). Yet, it's hard to ignore the siren song of their double-digit yields. To read more about whether this is an industry you should venture into, check out our new, in-depth report on Annaly Capital Management. Among other things, it outlines the risks and benefits associated with holding Annaly's stock, and points to three things specifically that every investor in this company must know. To access this report while it's still available, simply click here now.

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