As money flows in ever-greater amounts into the hedge fund industry, managers are racking their collective brains for new investment ideas. Centrix Financial has entered the fray by creating a fund invested in “specialty auto loans.”

What’s so special about these loans? No, they don’t underwrite the purchase of a Rolls, or Lamborghini, or some other really “special” car. Instead, they are made, according to the company literature, to “credit-challenged” car buyers. Meaning, pretty shaky loans.

On the surface, this would not appear to be a very appealing concept. Most people flee from investments that might not have solid underpinnings, or from making loans to non-credit-worthy individuals – such as out-of-work relatives.

Centrix, however, has made an art of profiting from such financial transactions. The parent company, founded in 1990, has developed a means of panning for gold in the enormous autoloan stream.

They package the top end of the bottom end of such loans, provide insurance against default, and then service the loans for the ultimate lenders, which happen to be credit unions. In effect, Centrix is providing a risk-management product.

Specifically, if a person with a bad credit history wants to buy a car and applies for a loan, his application may be funneled through the dealer’s referral programs to Centrix. If Centrix makes the loan, they call the borrower and establish a relationship that may encourage that person meet his obligations.

The company has built an extensive dealer network and is active in 40 states. New territories continue to come on stream. All loan servicing is done out of Denver.

Centrix has placed about $2 billion of such loans with credit unions looking for consistent and predictable returns. With such a successful model in hand, they naturally turned to creating another outlet for their program – and Centrix Funds was born.

The company brought in Clark Gates, formerly head of HighMark Capital Management, the money management arm of Union Bank of California, to run this new unit. So far, the group has spawned two funds. The first is for American investors, and the second is for overseas buyers.

The Centrix Loan Participation Fund, available to domestic investors, was launched in December 2003 and currently has about $97 million under management. Through October, the fund is up about 8.3% this year. This compares favorably with most other hedge fund strategies, which are typically up around 2%.

The fund employs no leverage and takes no short positions. There is, in effect, no “hedge” against, for example, shifts in credit markets. This is because, according to Mr. Gates, the fund has little, if any, exposure to interest rate moves.

The loans are made at high, fixed rates, in the range of 16% to 21%. It would take a terrific boost in overall credit costs to raise these charges. (The range for all specialty auto loans is 15% to 28%; the high end would indicate an unacceptable level of risk for Centrix investors.)

What can go wrong? Other than macro factors that could impact the default rate, such as unemployment or income levels, the biggest concern is the state of the used auto market. And what determines the prices of secondhand cars? A variety of factors.

For example, if auto companies launch a successful big sales push, offering 0% financing or some other compelling sweetener, an unusually large number of owners might be tempted to trade in their old cars, creating a glut on the market. More subtle trends may also make a difference.

Interestingly, one of the factors that has depressed pre-owned auto prices in recent years has been the increased availability of subprime credit. A growing portion of the populace has been in a position to buy a new car, thanks to these aggressive lenders, reducing demand for used cars.

According to Manheim Auctions, an outfit that publishes a Used Vehicle Value Index, the prices of used cars peaked in February 2001. The September 11 terrorist attacks and consequent softening of the economy caused values to drop from an index high of 117.4 to a low of 102.4 early last year; the most recent reading is 106.4. Encouragingly, throughout this soft period, Centrix’s business has held up quite well.

Not surprisingly, today the market for used compacts and other small cars is quite strong, while the value of preowned SUVs and luxury cars is sinking. The price of oil is to blame. This disparity couldn’t be better for Centrix, since “credit-challenged” buyers typically own smaller, cheaper cars.

Can Centrix run out of loans to feed into its clients’ portfolios, or its own? Not likely.

Astonishingly about 31% of the $500 billion annual car loan market is classified as subprime, up from 18% in 1993. It has been the fastest growing sector of consumer finance.

In the six years since Centrix developed its program, the company has underwritten 125,000 loans, totaling about $2 billion. These loans, and the ones in which the fund is invested, are on average for only $16,000. Gates points out that the small size of these loans underpins the consistent nature of the fund’s returns. A default on any one loan is insignificant.

How can Centrix’s other clients be sure that the very best loans aren’t being drained off to the company’s internal hedge funds? The firm uses a software program that automatically provides the allocations, prorating loans to clients, including the hedge funds, according to the institutions’ demands, on a first-come first-served basis.

Overall, the objective of the Centrix Loan Participation Fund is to provide a targeted (but not guaranteed) return of 8% or more per year; it is on track to do just that. Recognizing that the fund is limited as to upside, the firm is charging a 1.35% management fee, and a low performance fee of only 5% (as compared with a more normal 20%.)

The next step may well be to initiate a fund that employs leverage to realize higher, possibly more volatile, returns. The low volatility of the existing funds (targeted at .5% annual standard deviation) might make this a reasonable prospect.

Ms. Peek is a former managing director of Wertheim Schroder, now a part of Citigroup.