How do hedge funds use leverage?
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. Hedge funds also trade in derivatives, which they view as having asymmetric risk; the maximum loss is much smaller than the potential gain.
What Are Hedge Funds?
Hedge funds are pools of money, usually from ultra-high-net-worth 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 his own money and $500 on margin. The stock rises to $2,000. Instead of doubling his money, which is the case if the initial $1,000 is all his, he 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 his broker the $500 for a total loss of $800 plus interest and commissions. Because of trading on margin, the investor lost more money than his original investment.
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.
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, he risks losing $100,000 if his guess is wrong and the stock collapses. Instead, for a tiny fraction of the share price, he purchases a call option on 1,000 shares. This gives him the option to purchase the stock at today's price at any time before a specified future date. If his guess is correct and the stock spikes, he exercises the option and makes a quick profit. If he is wrong and the stock remains flat or, worse, collapses, he simply lets the option expire and his loss is limited to the small premium he paid for it.
Because they are investing other people's money and they get rewarded only on the upside, but not penalized on the down side. Leverage is perfect for this. If things go right, you will make a bunch more money. If things go wrong, they still get their 2% management fee. Of course, this is the skeptical opinion, but that's the financial reason.
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. For example, and to keep it simple, the hedge fund may raise 100 million dollars, then borrow another $400 million to increase the size of their investment. If they are right, they simply pay off with interest with a portion of the gains on the $400M and the rest of the gains adds to the overall return. Futures contracts work on margin and many hedge funds employ futures contracts.
But leverage works both ways, it magnifies the gains, but also the losses. That is why it is a double edged sword. It is great when it goes in your favor, but horrible when it goes against you.
Funny, the original Hedge Funds were actually a risk reduction strategy (hence the name "hedge") to reduce volatility and risk. They were, say 70% long and 30% short, attempting to pick the best 70% stocks long and the worst 30% short so that they had less volatility or swings as the market. This is because 75%-80% of all stocks go up when the market goes up, and 75%-80% of all stocks go down when the market goes down, but with a biased to the upside over time. And a "market neutral" fund was one the was 50% long and 50% short.
Some hedge funds still employ these strategies attempting to truly hedge to make "reasonable" returns while moderating risk, but many others have "special" strategies used to cover a broad spectrum of strategies and styles and really refers more to the structure of the fund itself. So, a 2 and 20 fund means the the ongoing management fee of the fund is 2% annually, regardless of performance, but the manager gets 20% of the gains if any.
Hope this helps.
Broadly speaking hedge funds employ leverage explicitly through their prime brokerage who gives them lines of credit, repurchase agreements or margin or they do it implicitly using derivatives such as options, futures and credit derivatives.
Leverage enhances returns but works both ways ie it enhances positie returns as well negative returns. Hedge fund managers who have a good risk management system and are talented can use leverage very profitably.