Hedge funds use several forms of leverage to chase large returns. They purchase securities on margin, meaning they leverage a broker's money to make larger investments. They invest using credit lines and hope their returns outpace the interest. Leverage allows hedge funds to amplify their returns, but can also magnify losses and lead to increased risk of failure if bets go against them. Hedge funds also trade in derivatives, which they view as having asymmetric risk; the maximum loss is much smaller than the potential gain.

Key Takeaways

  • Some hedge funds employ leverage in order to increase the size of their market bets.
  • Leverage involves purchasing securities on marginborrowing money to strengthen their buying power in the market.
  • Margin can also be used to make short bets or make trades in derivatives such as futures and swaps contracts that can be highly leveraged.
  • Using leverage can amplify returns but can also amplify losses. Hedge funds may be exposed to credit risk or may face margin calls if their investment bets go the wrong way.

What Are Hedge Funds?

Hedge funds are pools of money, usually from ultra-high-net-worth individuals or institutional investors, which the fund manager uses to chase high returns with unorthodox investing tactics. These strategies include seeking out severely undervalued or overvalued securities, and taking a long or short position based on findings, and using options strategies (such as the long straddle and long strangle) to capitalize on market volatility without having to correctly guess the direction of movement.

Buying on Margin

A popular hedge fund method to generate large returns is purchasing securities on margin. A margin account is borrowed money from a broker that is used to invest in securities. Trading on margin amplifies gains, but it also amplifies losses.

Consider an investor who purchases stock for $1,000, using $500 of their own money and $500 on margin. The stock rises to $2,000. Instead of doubling their money, which is the case if the initial $1,000 is all theirs, they quadruples it using margin.

However, suppose it drops to $200. In this scenario, the investor sells the stock for a loss of $300 and then must pay back their broker the $500 for a total loss of $800 plus interest and commissions. Because of trading on margin, the investor lost more money than their original investment.

Credit Lines

Investing in securities using credit lines follows a similar philosophy to trading on margin, only instead of borrowing from a broker, the hedge fund borrows from a third-party lender. Either way, it is using someone else's money to leverage an investment with the hope of amplifying gains. As long as the underlying security increases in value, this is a winning strategy. However, it can lead to huge losses on a bad investment, especially when interest from the credit line is factored into the deal.

Derivative Trading

A financial derivative is a contract derived from the price of an underlying security. Futures, options, and swaps are all examples of derivatives. Hedge funds invest in derivatives because they offer asymmetric risk.

Suppose a stock trades for $100, but the hedge fund manager expects it to rise rapidly. By purchasing 1,000 shares outright, they risk losing $100,000 if their guess is wrong and the stock collapses. Instead, for a tiny fraction of the share price, the manager purchases a call option on 1,000 shares. This gives them the option to purchase the stock at today's price at any time before a specified future date.

If their guess is correct and the stock spikes, they exercise the option and make a quick profit. If they're wrong and the stock remains flat or worse, collapses, they simply let the option expire and the loss is limited to the small premium paid for it.

Advisor Insight

Dan Stewart, CFA®
Revere Asset Management, Dallas, TX

Hedge funds use leverage in a variety of ways, but the most common is to borrow on margin to increase the magnitude or "bet" on their investment. Futures contracts operate on margin and are popular with hedge funds. But leverage works both ways, it magnifies the gains, but also the losses.

It’s interesting to note that the original hedge funds were actually risk reduction strategies (hence the name "hedge") to reduce volatility and downside potential. For instance, they were 70% long/30% short and aimed to hold the best 70% stocks and short the worst 30% stocks so the total portfolio is hedged against market volatility and swings. This is because 75%-80% of all stocks go up when the market goes up, and vice versa when the market goes down, but with a bias to the upside over time.