Here’s Why the Smartest Hedge Fund Managers Invested in Mortgages

While Narula’s bet might seem like a no-brainer, given the gift of hindsight, it was informed by years of studying the bond markets as a mortgage bond analyst and trader at Lehman Brothers. And in this case, timing was key — invest too early or too late, and he might have seen quite different results. That’s a lesson his fund learned in 2005, when Narula first recognized danger in the market for subprime mortgages and started shorting them. As valuations kept rising, his investors headed for the door. After returning $500 million, he closed the fund.

In 2008, Narula launched Mortgage Opportunities, taking advantage of increased Federal Reserve involvement in the market. According to Bloomberg, by predicting the Fed’s moves, Narula knew in the third quarter of 2008 to buy agency bonds backed by 30-year mortgages while selling U.S. Treasury securities. When agency mortgages prices rose, he shorted 30-year mortgage bonds and bought 15-year bonds. At the end of 2011, he switched back to 30-year bonds in anticipation of further government buying.

Narula also tries to anticipate how homeowners are likely to act. “Betting that homeowners will not be refinancing has been a winning wager,” Narula told Bloomberg. That’s because he knew declining home values and stricter lending practices in the wake of the financial crisis would prevent them from doing so, despite record low interest rates…