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.
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.