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 margin—borrowing 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 quadruple 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 the 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.
FAQs
Some hedge funds employ leverage in order to increase the size of their market bets. Leverage involves purchasing securities on margin—borrowing money to strengthen their buying power in the market.
How do funds use leverage? ›
Leverage typically magnifies the total return of a fund's portfolio, whether that return is positive or negative, and creates an opportunity for increased common share net income as well as the possibility of higher volatility for the fund's net asset value, market price, and distributions and returns.
How do investors use leverage? ›
Key Takeaways. Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project. Investors use leverage to multiply their buying power in the market. Companies use leverage to finance to invest in their future to increase shareholder value rather than issue stock to raise capital.
What is the best way to explain leverage? ›
Leverage is the use of borrowed money (called capital) to invest in a currency, stock, or security. The concept of leverage is very common in forex trading. By borrowing money from a broker, investors can trade larger positions in a currency.
Why do hedge funds need leverage? ›
Leverage is often employed by hedge funds to target a level of return volatility desired by investors. Hedge funds use leverage to take ad- vantage of mispricing opportunities by simultaneously buying assets which are perceived to be underpriced and shorting assets which are perceived to be overpriced.
Are hedge funds allowed to use leverage? ›
In contrast to most investment funds, such as mutual funds, there are no legal limits on the use of leverage by hedge funds. Instead, any limits on hedge funds' use of leverage rely on the market discipline imposed by counterparties and regulations on markets and other financial institutions.
What is leverage in simple words? ›
to use something that you already have in order to achieve something new or better: We can gain a market advantage by leveraging our network of partners. SMART Vocabulary: related words and phrases.
How does leverage work for dummies? ›
For example, if you decide to use leverage when trading stocks or shares, you can buy an increased amount of shares. So, with a leverage of 10:1, your money is amplified 10 times, if it is 30:1, then your exposure is amplified by 30 times, and so on.
How can I double $100? ›
The classic approach of doubling your money involves investing in a diversified portfolio of stocks and bonds and is probably the one that applies to most investors. Investing to double your money can be done safely over several years but there's more of a risk of losing most or all of your money if you're impatient.
Why do rich people use leverage? ›
It helps you increase the movement of your dollars through your assets. It also allows your dollars to do multiple jobs, and when that happens you can increase your cash flow. Leverage also gives you access to deals you might not otherwise have.
Borrow against assets or stock portfolio.
Another strategy available to billionaires is asset-based lending. They can leverage their assets or stock portfolio to secure a loan, providing them with the necessary capital without selling off any of their holdings.
What is a good example of leverage? ›
Here's an example of how that would work. Let's say you have $100 of your own money, and you can borrow $1500 from the bank at an interest rate of 6%. You invest the entire $1600 in an investment, that you are confident will grow 15% in a year. You plan to return the borrowed money plus interest at the end of a year.
Why is leverage so powerful? ›
Build wealth: The power of leverage is that it boosts your returns on your financial investments, so that you can build wealth in a sustainable way. Grow your business: Leverage in business allows you to save time and money, find new efficiencies, get new information and grow your business to new levels.
What is a typical hedge fund leverage ratio? ›
It was lowest among hedge funds investing in distressed securities, a notoriously risky strategy. 8 While most hedge funds report using leverage, the vast majority employ a ratio of less than 2 to 1 (that is, less than a dollar of credit for each dollar of capital).
Do all hedge funds use leverage and derivatives? ›
The idea of investing without some form of insurance would provide returns solely based on the gambling of the outcomes. As described by Garbaravicius and Dierick (2005:8) hedge funds use any 'combination of leverage, derivatives, long and short positions in securities or any other assets in a wide range of markets'.
Do hedge funds use leveraged ETFS? ›
For example, if a hedge fund wishes to diversify its portfolio by increasing its exposure to semiconductors, but is limited by how much capital it has available, it could invest in a leveraged ETF.
Which hedge fund strategy normally uses high leverage? ›
As many beta risks (e.g., market, sector) are hedged away, EMN strategies generally apply relatively high levels of leverage in striving for meaningful return targets. Equity market-neutral strategies exhibit relatively modest return profiles.
