The lucrative investment trend hedge funds don’t want you to know about

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FORTUNE — Hedge fund executives who descended on Miami last month for a conference on unpaid property taxes were treated to waterfront cruises of estates owned by Madonna, Shaquille O’Neal, and Elizabeth Taylor. But unlike those celebrity residences, the houses the profit-chasing investors were hunting at the gathering have a prosaic facade: tax liens.

Far from the mansions of Greenwich, Conn., houses owned by homeowners struggling with delinquent property-tax bills are sparking a gold rush by the elite money pools. Leading the recent lien-buying surge is Fortress Investment Group, the $53 billion alternative investments company now working with former executives who drove J.P. Morgan’s prior rush into the business from 2008 through mid-2011.

David Zussman, a Newport Beach, Calif.-based investor in foreclosed homes, calls the buying frenzy by hedge funds “reminiscent of junk bonds.”

The investing has only accelerated amid a federal antitrust probe of past bid-rigging at some auctions and a pullback last year by large banks from the market. Still, some hedge funds are finding help from Wall Street, as big banks that sold risky mortgages in recent years, including Wells Fargo (WFC) and Capital One (COF), extend low-interest credit to buy liens.

Here’s how it works: Several times each year, municipalities in 28 states, plus Washington, D.C., Puerto Rico and the U.S. Virgin Islands, auction off scores of property tax liens, also called certificates, to investors. The rules and rates vary, but homeowners typically have from six months to two years to pay back the notes, plus interest, or lose their homes to the investors. Less than 1% of sales go that foreclosure route, said Brad Westover, executive director of the National Tax Lien Association, which sponsored the Miami conference. Investors immediately pay the municipalities the taxes owed, then over time collect that amount plus interest from the homeowner.

MORE: New home sales: Poised to double?

With buyers identified only by numbers or unrelated names, the fragmented, unregulated industry is opaque. Even the market’s size is debated — $15 billion a year, according to Howard Liggett, the chief executive of Distressed Real Estate Consulting Services, or $5 billion a year, according to the National Tax Lien Association, a trade group. While returns are a closely kept secret, investors typically make between 2.5% and 10% a year, or in the low teens for larger buys.

“The hedge funds are chasing yield in this business” says Albert Friedman, a principal at Alterna Capital, an alternative investment firm in Boca Raton that buys tax liens.

Insiders estimate hedge funds now control 40% of the tax-lien market, from under 5% five years ago, with regional banks, obscure partnerships sporting names like God’s ATM LLC, and mom-and-pop investors making up the rest.

Interviews and auction records point to recent buying by Apollo Global Management, MD Sass, Denver-based Arrowpoint Asset Management, Tang Capital of San Diego and Cazenovia Creek Asset Management in Charlotte, N.C., as big buyers. BlackRock (BLK) expects net revenues of $242 million from its tax-lien investments over five years through 2016, according to a securities filing. The firms declined to comment, citing the ongoing probe, or did not respond to calls.

But Fortress (FIG) is what Thomas McOsker, a co-founder of BloxTrade, an online secondary market for liens, calls “the 300-pound gorilla in the market.” While the company jumped into the business around four years ago, it has ramped up its buying in over the past two years in New Jersey, Pennsylvania, Florida, and elsewhere, pouring at least hundreds of millions of dollars into the business.

MORE: Behind the foreclosure surge in New York, New Jersey

“We like the investment from a risk-return standpoint,” said Michael Fallacara, a Fortress managing director, “but the investment process can be tangled and laborious.”

Recent auction records show Fortress working through Tower Capital Management, a “tax lien monetization” firm in Morristown, N.J. that operates behind-the-scenes to place bids at lien auctions in Florida, New York, Arizona, Tennessee, California, and elsewhere on Fortress’s behalf. Fortress bids via special entities with names like Tudor Tax Lien, Anc Acquisition General, and Tower DBW, records show.

Tower Capital’s chief executive, John Garzone, ran Xpand, the J.P. Morgan tax-lien unit that received grand-jury subpoenas in 2010 as part of the federal bid-rigging probe. By the time J.P. Morgan (JPM) said it had exited the lien business in 2011, Garzone and other former Xpand executives, including Neil Harreveld, had joined Tower and stepped into the breach. Reached for comment, an unidentified Tower employee said, “We’re not interested in talking,” and hung up the telephone.

Proponents argue that the sales put money into the hands of cash-strapped cities to fund schools and roads. But to counter bad optics, the recent Miami conference, held at the Eden Roc Renaissance Resort and Spa, raised $10,040 from a record-setting 206 attendees for the National Coalition for the Homeless.

Said one investor who declined to be identified: “We don’t want other hedge funds to know” about this industry.

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