Investment Opportunities

The Mortgage-Backed Securities (MBS) Market

The MBS market, with over $4.5 trillion of securities outstanding, is the largest fixed income market sector in the world. Because of the market’s size and its attractive combination of creditworthiness and excess yield, virtually every major fixed income investor allocates a significant portion of their portfolio to MBS. Typically, benchmark U.S. dollar fixed income portfolio indices contain a 25-45% weighting in MBS.

The MBS market is composed of three sectors, each distinguished by property type. The largest sector consists of loans backed by residential mortgages. The other sectors consist of multifamily MBS and commercial MBS (“CMBS”). Residential MBS are further categorized by; (1) issuer/guarantor (agency versus non-agency); (2) credit rating; and (3) structure (pass-through versus CMO). Roughly 75% of residential MBS are U.S. government agency issued/guaranteed and therefore triple-A rated. Most of these are issued and guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac. The other 25% of residential MBS are issued by a variety of private financial institutions and guaranteed either by the private institutions or through subordination. Within this non-agency market sector, most of the securities are triple-A rated with the remainder of varying lesser credits. Finally, the residential MBS market is categorized by structure: pass-throughs have principal and interest cashflows that mirror those of the underlying loans, while CMOs use pass-throughs as collateral to create more complex securities, the cashflows of which are dependent on a number of variables.

The Ellington funds have participated in all sectors of the MBS market. Early in Ellington’s history, the dominant opportunity was in MBS derivatives. Since then, Ellington has broadened its MBS investment holdings to include virtually every major MBS sector. Ellington has extensive experience in these sectors and actively seeks investment opportunities in each. The availability of relatively high risk-adjusted returns determines the market sectors in which Ellington invests.

Ellington possesses the essential elements necessary to invest successfully in mortgage-backed securities: hedging expertise, trading expertise, and systems and analytical capabilities.

Hedging Expertise

Proper portfolio hedging is essential for the consistent generation of attractive risk-adjusted rates of return in the MBS market. Ellington possesses both the quantitative capabilities and the in-depth understanding of MBS necessary to implement effective hedging strategies. In addition, Ellington’s Managing Directors have proved throughout their careers that they have the ability to hedge large and complex MBS portfolios through difficult and turbulent market environments.

The fundamental risk to any portfolio of fixed income securities is a shift in interest rates. Ellington’s objective is to control the duration (which is a measure of the sensitivity to interest rate movements) of its portfolios of MBS and ABS securities. The intention is not to bet on the direction of interest rates. Ellington utilizes a variety of hedging instruments to neutralize duration, including interest rate swaps, financial futures, U.S. Treasuries, and various over-thecounter derivative products. Ellington’s hedging techniques have been put to the test over its history, during which ten-year Treasuries have traded at yields as high as 7.88% and as low as 3.11%. Despite this volatility, the Ellington funds have maintained their long-term profitability on a mark-to-market basis.

Trading Expertise

Trading expertise is critical to long-term success in the inefficient and dynamic MBS market and related fixed income markets. Ellington’s traders have extensive contacts throughout the market and many years of experience dealing with all major market participants. Ellington’s extensive contacts (including all relevant financial institutions) provide valuable insight into market trends, inventory levels, location of available products, etc. Ellington understands the analytical and trading strengths and weaknesses, as well as the strategies, of its counterparties and competitors. Together, these elements ensure broad access to market information and trading flows, while facilitating both reliable and advantageous executions of transactions. Our traders and research staff are among the most experienced and respected practitioners in their related specialties.

Proprietary Systems And Analytics

Successful investing in MBS requires the ability to identify and quantify all significant risks associated with securities and trading strategies. Ellington appreciates the critical role that analytical systems play in managing large, complex fixed income portfolios. The Managing Directors of Ellington have developed and used the most sophisticated mortgage and interest rate models. Three of Ellington’s Managing Directors are devoted entirely to research and analytical system development: John Geanakoplos, a prominent mathematical economist, Michael Zaretsky, a distinguished mathematician, and Niko Nicopoulos, an eminent physicist. Messrs. Zaretsky and Geanakoplos directed MBS analytics and research at Kidder Peabody and bring that knowledge and expertise to Ellington. Larry Penn headed CMO systems and analytics at Lehman prior to trading CMO derivatives. Members of Ellington’s research team have been responsible for some of the most important innovations in mortgage analytics. Their creative skills enable Ellington to capitalize on current and future opportunities in the MBS and fixed income markets.

Other Relative Value Strategies

While historically Ellington's principal strategies have been mortgage-backed securities (MBS) and asset-backed securities (ABS) relative value investing, Ellington also pursues other strategies consistent with its “market-neutral” philosophy of noncorrelation with other major investment classes.

Interest Rate and Volatility Arbitrage: This strategy seeks to exploit inefficiencies and mispricings in the swap markets and sovereign debt markets of the most developed nations, especially the “G7”1 countries. Both intra-currency and inter-currency positions are taken on the yield curves of various currencies, on spreads between interest rate swaps and government rates, on interest rate volatilities, on the spreads between implied and actual interest rate volatilities, etc.

Emerging Markets Arbitrage: The primary objective of this strategy is to exploit inefficiencies and mispricings in emerging market sovereign debt, currency, and option markets, while managing spread and default exposure to any single country. From time to time investments may be made in other instruments such as non-sovereign debt, equity and equity-related instruments, and other pooled investment vehicles themselves invested in emerging markets.

Capital Structure Arbitrage: Capital structure arbitrage involves taking offsetting positions in different financial instruments of a company’s capital structure, especially debt products, equity products, and derivatives on debt and equity products. The basic idea is that there are theoretical relationships and correlations between these products that, when broken due to various technical factors, create trading opportunities.

Equity Relative Value Arbitrage: Within this broad category of strategies, Ellington currently manages equity volatility strategies and equity pairs strategies. The volatility strategies seek to exploit inefficiencies and mispricings between and among the implied and realized volatilities of underlying stocks, baskets of stocks, and stock indices in a variety of worldwide equity markets. In the equity pairs strategies, opposing long and short positions are established in two or more stocks for which a fundamental relationship should exist. These strategies typically make heavy use of stocks, stock options, stock index futures, convertible bonds, credit default swaps, and other derivatives.

Convertible Bond Arbitrage: Convertible bond arbitrage attempts to identify convertible bonds whose embedded equity options are underpriced, and to monetize the underpricing by hedging either the credit risk associated with these corporate bonds, the potential movements in the underlying equity prices, or both. The universe of hedging instruments includes the underlying stocks, asset swaps, credit default swaps, corporate bonds, and stock index futures and options. Convertible bond arbitrage is technically a form of capital structure arbitrage as well as a form of equity relative value arbitrage. Statistical Arbitrage: This strategy seeks to discover and exploit statistical inefficiencies, mispricings, and anomalies in liquid instruments in a variety of markets worldwide. It often relies on diversification through the number of trades or positions, the timing and sizing of particular trades, or other methods, to provide statistically profitable results over time. The universe of trading instruments includes stocks, stock indices, commodities, currencies, and bonds, as well as options, futures, and other derivatives on the foregoing.