February 2011 cover of Bloomberg Markets magazine
Jan. 6 (Bloomberg) -- Don Brownstein, chief executive officer of Structured Portfolio Management LLC, talks about investing in mortgage securities and the Federal Reserve's quantitative easing. Brownstein's flagship Structured Servicing Holdings LP returned 50 percent in the first 10 months of 2010, putting him at the top of Bloomberg Markets' list of the 100 best-performing hedge funds managing $1 billion or more. He talks with Erik Schatzker on Bloomberg Television's "InsideTrack." (Source: Bloomberg)
Jan. 6 (Bloomberg) -- Don Brownstein is the founder of Structured Portfolio Management LLC, a company managing $2 billion in five partnerships. His flagship fund, the abstrusely named Structured Servicing Holdings LP, returned 50 percent in the first 10 months of 2010, putting him at the top of Bloomberg Markets magazine's rankings of the 100 best-performing hedge funds managing $1 billion or more. Bloomberg's Erik Schatzker reports. (Source: Bloomberg)
Jan. 6 (Bloomberg) -- Mattias Westman, co-founder of Prosperity Capital Management, discusses investment strategy for Russia. Westman speaks from London with Deirdre Bolton on Bloomberg Television's "InsideTrack." Prosperity Capital is the largest Russia-focused equity investor. (Source: Bloomberg)
Donald Brownstein, chief executive officer of Structured Portfolio Management, speaks during the Milken Institute Global Conference in Los Angeles, California on April 28, 2010. Photographer: Jonathan Alcorn/Bloomberg
For 20 years, Don Brownstein taught philosophy at the University of Kansas. He specialized in metaphysics, which examines the character of reality itself. In a photo from his teaching days, he looks like a young Karl Marx, with a bushy black beard and unruly hair.
That photo is now a relic standing behind the curved bird's-eye-maple desk in Brownstein's corner office in Stamford, Connecticut. Brownstein abandoned academia in 1989 to try to make some money, Bloomberg Markets magazine reports in its February issue.
The career change paid off. Brownstein is the founder of Structured Portfolio Management LLC, a company managing $2 billion in five partnerships. His flagship fund, the abstrusely named Structured Servicing Holdings LP, returned 50 percent in the first 10 months of 2010, putting him at the top of Bloomberg Markets' list of the 100 best-performing hedge funds managing $1 billion or more.
The $1.2 billion fund skyrocketed 135 percent in 2009.
In percentage terms, Brownstein, 66, beat out funds run by bigger, better-known competitors, including Ray Dalio's Bridgewater Associates LP. Dalio, though, has three funds in the top 15. Brownstein also topped Steven Cohen's SAC Capital International (No. 53).
Brownstein did it by exploiting his expertise in something almost as esoteric as metaphysics: the market for exotic securities built from residential mortgages.
Financial Crackup
It was the crackup in housing and mortgage markets that brought the U.S. economy to its knees in 2008 and earned billions for hedge-fund managers such as John Paulson, who saw it coming and bet that mortgage securities would crash.
Brownstein and William Mok, Structured Portfolio's director of portfolio management, won't say exactly how they made their 2010 killing. Their longtime strategy is to develop models that predict when homeowners will refinance their mortgages -- a move that reduces interest payments on mortgage bonds. They then buy securities they conclude are underpriced.
Many homeowners have been unable to take advantage of tumbling rates to refinance their mortgages because their houses are worth less than they owe on their loans. Investors that bet against a refinancing boom have profited.
Two of Brownstein's other funds are in a three-way tie for ninth place in the ranking of mid-size funds, which manage from $250 million to $1 billion. The SPM Core and SPM Opportunity funds were both up 31 percent.
Mortgages Predominate
The hedge-fund ranking uses data compiled by Bloomberg and information supplied by research firms, fund companies and investors. Three of the top 10 funds made money on mortgage bonds, according to Bloomberg data. The mortgage market is often lucrative for hedge funds because it's volatile, says Jeffrey Gundlach, chief executive at Doubleline Capital LP, a Los Angeles manager of mutual funds that trade mortgages.
"The mortgage market has every single risk," Gundlach says. People default, banks foreclose on housing loans, and the government often changes the rules. "Any market that has risks morphs into opportunity," he says.
Another fund that profited from betting on mortgages is the $1.2 billion Nisswa Fixed Income Fund Ltd., run by Pine River Capital Management LP of Minnetonka, Minnesota. It ranks No. 7, with a 27 percent return after manager Steve Kuhn bought mortgage bonds selling at what turned out to be bargain prices. The fund returned 92 percent in 2009, and is up a cumulative 196 percent since it was founded in September 2008 through Oct. 31.
Russian Surge
The top-performing hedge-fund managers also made money in emerging markets, particularly Russia, and in gold. The No. 2 large fund, with a 39 percent return, according to Bloomberg data, is the Russian Prosperity Fund, managed by Moscow-based Prosperity Capital Management. The No. 2 mid-size fund, with a 48 percent return, is also run by Prosperity, while the No. 1 mid-size fund, returning 50 percent, is a unit of Moscow-based VR Capital Group Ltd.
Gold jumped 24 percent to $1,359.40 an ounce in the 10 months covered by the ranking. The rally lifted Paulson & Co.'s Paulson Gold Fund 26 percent, making it No. 17 on the mid-size list, and helped to boost Daniel Loeb's Third Point Offshore Fund Ltd. to No. 8 among large funds, with a 25 percent return. Loeb invested in mortgages too, in addition to his usual bets on stocks and bonds, according to people familiar with his holdings.
Overall, hedge funds had a lackluster year, with less impressive returns than in 2009, when the top fund, run by David Tepper's Appaloosa Management LP, returned 132 percent. The same fund earned 21 percent in 2010.
Lackluster Average
On average, the top 100 hedge funds rose 13.9 percent through October, with Nos. 99 and 100 gaining just 6.7 percent. The Standard & Poor's 500 Index rose 6 percent in the same period. A broad index of hedge funds compiled by Hedge Fund Research Inc. in Chicago rose 6.8 percent.
Spotty performance aside, wealthy Americans are pouring money into funds. Half of all households with a net worth of $25 million or more were invested in hedge funds in 2010, up from 35 percent in 2007, according to Spectrem Group, a Chicago-based research firm that tracks the affluent.
The surge doesn't make sense, says Bill Berg, founder of Sigma Investment Management Co. in Portland, Oregon. Investors are paying high fees, Berg says, usually 2 percent of assets to cover hedge funds' costs, plus 20 percent of any profits, for gains they could get from cheaper mutual funds. (All figures in the Bloomberg Markets ranking are net of fees.)
Not Justified
"People insist on viewing hedge funds as being different from normal investments," says Berg, who picks fund managers for individuals and institutions. "They're not."
Only a few funds at the top of the ranks can justify their fees, Berg says.
"If you can get into a fund that's in the top 10 percent, do it," Berg says. "The problem is that those funds are probably closed to new investors."
Some hedge funds have a new worry: the wide-ranging investigation of insider trading by the U.S. Justice Department. On Nov. 22, the Federal Bureau of Investigation raided the offices of Diamondback Capital Management LLC in Stamford, Level Global Investors LP in New York and Loch Capital Management in Boston. Diamondback and Level Global were started by alumni of SAC Capital Advisors LP, which received a subpoena in November demanding documents.
No firm or employee has been charged with wrongdoing.
Because of hedge funds' fee structure, managers need healthy returns on a large pool of client cash to make big money. A 5 percent return on $10 billion is better than a 50 percent return on $100 million.
$2.25 Billion Profit
The most profitable fund in 2010 was Dalio's Pure Alpha II, which earned Bridgewater $2.25 billion. His Pure Alpha 12% fund was No. 3, earning another $428.6 million in fees.
Westport, Connecticut-based Bridgewater manages $60 billion in hedge funds, making it the biggest hedge fund firm by assets.
The Pure Alpha funds made money betting against the U.S. economy, according to a person familiar with Bridgewater's trading. Dalio and his managers bought U.S. Treasury bonds, which rallied as economic growth, which can produce inflation, remained anemic, the person said.
SAC Capital International was the second-most-profitable fund, earning $1.1 billion in fees through the first 10 months of 2010, according to Bloomberg data.
Brownstein's Structured Servicing Holdings has returned an average of 28 percent annually since February 1998, when the fund made its first trade, a person familiar with its performance says. Its only losing year was 2008, when it returned negative 6 percent, according to an investor, while the average hedge fund dropped 19 percent.
Philosopher King
The 50 percent gain through October earned Brownstein's investment team $87 million in fees, according to Bloomberg data.
Brownstein has prospered in a market dominated by math savants. The value of many mortgage bonds depends in large part on how long homeowners make payments at their current interest rate before either refinancing or defaulting. The top traders have proprietary formulas that predict behavior based on a homeowner's credit score, address, loan size, loan age and other factors.
The walls of SPM are scrawled with such formulas, worked out by Mok, a Salomon Brothers alumnus who has a bachelor's degree in computer science from Columbia University, and his team of math and physics Ph.D.s. Brownstein's strength is his mastery of the logic behind the formulas.
"If you're wrong, he'll prove you wrong," Mok, 47, says.
Brownstein, who these days looks more like entertainment mogul Barry Diller than the father of communism (much less hair, much nicer shirts), says he loves his role.
Parmenides to Florida
"I'm here to argue," he says in a three-hour interview that ranged from ancient Greek philosophers Parmenides and Plato to foreclosures in Florida. "I'm in charge of pontification and arguing."
The son of a furrier, Brownstein grew up poor on Gun Hill Road in the Bronx, New York. He got his bachelor's degree from Queens College before heading west for graduate school, earning his Ph.D. in philosophy from the University of Minnesota. He started teaching in 1969 at the University of Kansas in Lawrence.
Brownstein's career suggests a restless mind. In Lawrence, he made documentary films on the side and once interviewed Beat Generation writers Allen Ginsberg and William Burroughs, author of Naked Lunch. Brownstein became friendly with Burroughs, a St. Louis native who had moved to Lawrence late in life.
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