January 28, 2014 / 4:52 PM / 4 years ago

UPDATE 1-Narula flagship mortgage fund ekes out tiny gain as Fed cuts stimulus

By Svea Herbst-Bayliss

Jan 28 (Reuters) - Deepak Narula's flagship Metacapital Mortgage Opportunities Fund, which outperformed every other hedge fund in 2012 with a 41 percent gain, faltered last year to end 2013 roughly flat after the Federal Reserve signaled it would change course on economic stimulus, the mortgage trader told his clients.

"After a dismal second quarter the fund was up nearly 10 percent in the second half of 2013 to finish the year in the black at +0.53 percent," Narula, one of the hedge fund industry's best known bond traders, told clients in a letter dated Jan. 24 and seen by Reuters. The fund managed $1.23 billion in assets.

Signals that the Federal Reserve would slow its debt buying hurt the mortgage market in the first half of 2013 and Narula said the fund exited the bulk of its money-losing basis positions for the second quarter when the fund tumbled 10.4 percent. But by having left the positions, the fund also did not benefit when those strategies recovered in the second half.

Narula did stick by prepayment trades which he said "paid off for the year" when they recovered from a terrible second quarter.

Credit trades gave the fund the biggest shot in the arm for the year, adding 4 percent in portfolio returns, the letter said.

Narula, a former Lehman Brothers mortgage trader, had been widely celebrated in the hedge fund industry for having steered the Mortgage Opportunities Fund to a 41 percent gain in 2012, placing it fifth on Barron's list of top 100 hedge funds.

Setting expectations for the future however, Narula told Reuters in November that "those returns are history," unless there is some large shock to the system.

As returns dwindled, assets in the flagship fund shrunk to $1.23 billion on January 1, 2014 from $1.26 billion.

Early last year as the prospect for rising rates became clearer, Narula also laid the groundwork for a new fund that would prosper in these types of conditions. The Rising Rates Fund, which quickly generated a buzz among investors after being launched in May, ended the year with a 20.11 percent gain. Its assets nearly doubled to $322 million on Jan. 1, 2014 from $169 million on Oct. 1, 2013.

The average hedge fund ended 2013 up 9 percent, according to industry data while the Standard & Poor's 500 index climbed 32.4 percent.

For 2014 Narula expects the Federal Reserve to keep cutting back on its stimulative bond buying but said he does not expect the central bank to raise rates for a many months.

"In all likelihood, the Fed will not start hiking short rates until very late 2015, as it waits to see the effect of the end of QE on the economy," the letter said.

Growth in the housing market will continue but at a slower pace as higher home prices and higher interest rates make it more expensive to buy.

Agency mortgage backed securities should perform well while Fed buying is ahead of net new supply, Narula wrote, adding that interest only securities "should benefit from the combination of higher mortgage rates with short rates staying anchored."

He also said that the firm has found a chance to make money in select principal only securities.

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