The Billion Dollar Interview:
Steve Kuhn, Fund Manager of Nisswa Fixed Income Fund
Mr Kuhn is the lead Portfolio Manager for the Nisswa Fixed Income Fund. Prior to joining Pine River, Steve was a Portfolio Manager at Goldman Sachs Asset Management based in New York and Beijing, where he was part of a team that managed mortgage-backed securities. Steve received a Bachelor of Arts in Economics with honours from Harvard University.
Founded in 2002, Pine River Capital Management manages over US$4 billion in assets, over a number of funds. The firm is comprised of 121 staff, which includes 42 investment professionals. Pine River has offices in Minnetonka, London, Hong Kong, New York and San Francisco.
The Nisswa Fixed Income Fund's objective is to profit from pricing inefficiencies by dynamically allocating to various sectors of the residential mortgage market, within a relative value framework. The fund invests in agency and non-agency mortgages, including derivatives. The focus is to capitalise on pricing discrepancies in these sectors, including active portfolio monitoring and trading. The Nisswa Fixed Income Fund was fourth (ranked by return) in Eurekahedge's Top Performing Billion Dollar Hedge Funds by 2010 Returns table, as featured in the January 2011 edition of The Eurekahedge Report.
Eurekahedge: You have been managing the Nisswa Fixed Income Fund since its inception in 2008. What were you doing before that and what were your motivations to join Pine River?
Steve Kuhn: Prior to Pine River, I was working at Goldman Sachs Asset Management as part of their mortgage investment team. I started there in 2002 and I had a very good, very interesting experience, working with really talented colleagues. As we approached 2008, we were obviously entering an extremely interesting and fertile time (laughs) for a relative value manager in the mortgage market. We were starting to see the cracks and strains of the impending crisis and that was already starting to move relative value in the mortgage space. In my view, there were some great mispricings in the market at the time. For a relative value player, to try and extract value from mispricings, or inefficiencies in the market, it was a very fertile field, if you will. That was a particularly interesting and tempting time to be a little more entrepreneurial – to find a place where I could partner with existing funds and build a mortgage effort. Fortunately, I had known the principals and partners at Pine River for a long period of time. I had gotten to know Brian Taylor (CEO of Pine River) and the other partners and I had always had great respect for their intelligence and for their integrity. They had formed a very successful effort at Pine River and they were kind enough to be interested in bringing me onboard. I thought that given the timing and the possibility of partnering with a team that I had known and that I trusted, it was as good a time as any to make that move.
EH: Can you give us an overview of the Nisswa Fixed Income Fund's strategy? What sort of qualitative/quantitative research goes in your investment decisions?
SK: We're trading in the US residential mortgage market. It's a tremendously large market with $11 trillion of loans and securities that trade in the market. It's smaller than the US equity market, which is about $15 trillion but probably second only to that in terms of the number of opportunities and size. In and of itself, it is very tempting to be involved in a large market because typically, the broader the space, the greater the opportunity to find inefficiencies. I've been trading in the mortgage space since 1993, so it's an area I have experience in. I also think that, intellectually, it is an incredibly fascinating market in which to trade. It is always changing, never static. You can gain a lot through experience, but you can also have new things come up constantly. We have certainly seen a lot of that happen in the last three years. There's been a lot of change in the mortgage market in the way it functions in that period of time. Those are all of the reasons why we are interested in the mortgage market.
As far as investment decisions and quantitative and qualitative research, we certainly put a lot of effort in building quantitative. We have an eight-person research team, based in Beijing, to help us do that, which is staffed with some incredibly talented individuals. They build proprietary models and design analytical tools to help us be more efficient in isolating bonds which we think might be undervalued in some sense. These tools are also helpful in managing our risk. In a market such as the one we have experienced in the last few years, the rules are changing. Things are changing so quickly – purely looking at historical data to build models would not be sufficient – we also have to think, as the rules change, how will this affect things? And we've entered uncharted territory at times over the last few years so that requires a qualitative view as well, and experience is very helpful in creating those views.
EH: What are the kinds of risks involved when investing in the mortgage-backed securities industry? What risk management tools do you have in place in order to minimise the risk to your portfolio?
SK: Essentially, investing in mortgages comes down to two basic risks that you can take as a mortgage investor: prepayment risk and credit risk. If you're investing in agency-backed securities – issued by Ginnie Mae, Fannie Mae, Freddie Mac – presumably, you are not taking credit risk but you have essentially given the option to the borrower to refinance their mortgage. As mortgage rates go lower, mortgage borrowers have the option to pay off their mortgages early. Understanding borrower behaviour, and how likely they are to refinance, is a key component in assessing prepayment risk and agency security valuations. Looking at data from ten years ago probably would not be that valuable; you need to look at data over the last couple of years. Historical data certainly gives one insight, but one must also be aware of any political or legal changes to understand how borrower behaviour might change going forward. That is really the core of how you try to invest in those types of securities.
Another thing you can do in the mortgage market is that you can buy securities which are not backed by any government agency – what we call "non-agency bonds". Here, the central risk you are taking is mortgage credit risk. You are trying to estimate or predict what percentage of the bond holders in a certain pool are likely to default on their mortgage, and then upon default, what is the likely rate of recovery? Upon foreclosure, what would be the percentage expected recovery rate? Trying to estimate those two variables is central to being a good investor in a non-agency market. You have to look at a lot of data on borrowers who have mortgages in different parts of the country or borrowers with different credit scores or borrowers who have different originators to different mortgage servicers. All of these factors are important and go into an effort to predict what the future will hold. It is an extremely challenging task to do that well. There is no shortage of data available. Every loan has over 100 fields of data attached to it. The real challenge is taking that data, looking at how different borrowers have performed and using that to estimate your best prediction of the future behaviour of the remaining borrowers in that pool.
And that is a task that is very challenging. Looking at data from recent history (looking at data from ten years ago probably would not be that valuable; you need to look at data over the last couple of years) certainly gives one insight but one must also be aware of any political or legal changes to understand how behaviour might change going forward – it involves both qualitative and quantitative skills. We think that we're actually one of the few funds that looks at both of those types of opportunities. We take risks in both of those areas. And hopefully, we are able to achieve a high return per unit of risk. Our goal is to achieve the highest return per unit of risk and it has been a very fertile time in both the agency and non-agency markets.
EH: Your fund delivered excellent returns through the financial crisis when most market players, such as proprietary trading operations of banks and other hedge funds, suffered excessive losses. What did you do differently that enabled you to deliver this performance?
SK: Many other mortgage hedge funds focus either on prepayment risk or credit risk. The core thing we do differently is – as mentioned in the last answer – we look at both and we believe that is rare. The ability to have competency in both of those areas has allowed us to move capital as we see the relative opportunity getting better or worse between the two, and I think that's a big advantage for our team.
EH: Your fund returned more than 30% in 2010. Such impressive returns coupled with low volatility are quite rare, how do you achieve such statistics? Do you employ leverage to boost performance? How do you manage to use so many instruments and still keep the volatility so low?
SK: Our goal is always to maximise returns per unit of risk. Explicitly, in achieving that goal, we are thinking about how much risk are we taking and how can we manage that risk prudently. One of the ways we do that is by having a diversified set of trades. There are times when there could be changes in borrower behaviour or changes in government policy that might affect, positively or negatively, part of what we're doing in the fund, but it would probably have either limited impact or even the opposite impact to another part of our portfolio which we believe reduces our risk.
We actively think about strategy correlation and diversification to reduce our risk and I think that's one thing that has allowed us to keep our volatility low. Our volatility has been low in a time when there has been no shortage of strange and interesting things happening in the mortgage market (laughs). There has been no shortage of policy changes or interest rate changes. Nonetheless, throughout we have sailed a pretty steady course through what has been some pretty choppy seas, and I think that's a testament to our way of thinking about measuring and managing risk.
EH: To what extent will your fund be affected from government policies and new regulations that are being put into place in the wake of the financial crisis? Are there any restrictions that could potentially impact your hedging ability?
SK: A normal person, one who isn't a mortgage geek like me (laughs), is probably not aware that policy changes in the mortgage market over the last few years have been frequent. There has been no shortage of how different actors in the mortgage market have changed their behaviour. Managing that and thinking about the implications of these changes is something that is core to our process. Government policy is something we devote a lot of mental energy to. We keep a very close eye on policy change. And we think very carefully on both the effect of changes that have happened and also about how possible changes could affect our portfolio in the future. In some sense, talking to you today is kind of timely because the Obama administration owes a report to the Congress on their recommendations on the future of the government-sponsored entities - Fannie, Freddie, Ginnie – and their role in the US mortgage market going forward. That report will likely come out on February 11th [editor's note: this interview took place on February 9th] and there has already been, between ourselves and a lot of research firms on The Street, a lot of discussion of possible initiatives and possible changes that could come out of this document. I think that we have given a lot of thought to all of the possibilities, making sure that our portfolio can adjust to any of those contingencies. It's an absolutely crucial part of our process – much more so today than at any point in my mortgage career.
EH: Do you think that the regulators/central banks, Bernanke, Hank Paulson et al have done enough to prevent a bubble of this magnitude again?
SK: Here's what I would say to that. Everybody talks about what a short memory markets have. I think that's true but maybe the memory is a little bit longer than people think (laughs). The trouble the mortgage market has had, especially in regards to mortgage credit and underwriting, which have been less than robust - let's put it that way - I don't think that we are seeing those same problems today. I don't know whether that is due to the policy changes or whether that is due to certain participants leaving the market. I think, certainly, we are seeing policy makers attempting to be very thoughtful. We certainly know that the administration has done their best to think about this carefully. They are doing their best to think about what is best and, just like anyone else, it does not mean that they are going to come up with a policy that is perfect. I believe that they are trying to do something that is in the best interest of the market and the country.
EH: How has asset-raising environment been over the last 12 months? Have you accumulated most of your assets through performance or capital inflows? Do you see a lot of investor interest in your fund in particular and fixed income strategies in general?
SK: Mortgage funds have become more popular over the last couple of years. We've performed and, generally, other mortgage funds have performed well. If you look at data of the funds that have performed well over the last couple of years, often, the mortgage hedge funds are at or near the top of that list. I think there are some structural reasons why it's true and will continue to be true.
EH: Ideally, what time horizon must an investor have, in order to consider investing in a fund like yours?
SK: I think the opportunity will exist for a while. The amount of capital that was knocked out of the market has not even come close to being replaced. Therefore, I think the opportunity is not only strong today but could continue to be strong for years to come. I would hope that if the investors believe in that argument, they would hopefully have a long-term horizon.
EH: Could you walk us through your fund's structure and the management personnel? How do you maximise the efficiency of the business by sharing/centralising resources, administration, etc? How do you drive synergy with other Pine River funds?
SK: Not many people who lead normal lives are really concerned with prepayment rates in the state of New York. We are. And we have systems that help us predict that. Our mortgage systems probably do not have a tremendous amount of synergy with the other strategies we trade at Pine River because they are specialised, but there are other areas that do have synergy though. For example, take the mortgage insurance industry. It is crucial for us to understand the balance sheets of mortgage insurers because we sometimes invest in securities with credit enhancement provided by mortgage insurance companies. Having a sense of their strengths and weaknesses will give us an insight into how much value those bonds have. That is an area where we will often talk to other parts of Pine River that might have done deeper work into the special strengths of those companies and a synergy would exist there for our fund. And conversely, we might have opinions on what kind of losses those kinds of companies might suffer so that synergy can go both ways. I think some of the things we do can be very specialised and may not have a lot of synergy but a lot of things do.
Also, I would be remiss if I didn't mention Paul Richards who is our Chief Risk Officer. Paul is someone I've known for a great number of years. His intellectual credentials are absolutely first rate, and he has a great deal of knowledge and experience particularly in the mortgage market. I value Paul as a risk manager and he helps us deliver better risk-adjusted returns. And there is a lot interaction between myself and the other partners and Brian Taylor. There is a very open dialog on what trades we are doing and why we are doing them. Again, the synergy goes both ways – we benefit from them and vice versa.
EH: Could you give us your medium- and long-term outlook on the US mortgage-backed securities market? How does this outlook present opportunities for your specific strategy? What is your outlook on the overall economy in general?
SK: I tend to try not to be too predictive of things, especially about the direction of the economy, etc, because I think that's probably not my – or our team's comparative advantage. We tend to be relative value traders. Ideally, we want to construct a portfolio that will perform well in a wide variety of economic scenarios and a wide variety of housing prices, etc. That is what we would ideally like to achieve. If we can achieve that then having a view on the overall direction of the economy is really not that important to us. That is what we really strive to do – to think about relative value. I think we have other strengths and we are going to play to those strengths. As far as the outlook, specifically for the mortgage market – what I really think about is the capital flows in and out as I talked about before. There was a tremendous outflow of capital that is starting to get replaced, but if you look at the how the US housing finance system suffered in the 1990s during the savings and loans crisis, it was a crisis that lasted for almost a decade and investors who could raise capital and manage risk could outperform for a very long period of time. I think that the current crisis and the current upheaval is more than equal to that experience. One would hope that talented professionals could do well for a really extended period of time. My view is that the capital in this space will continue to achieve a high return per unit of risk.