How Hedge Funds Use Leverage
Hedge Fund Leverage
Hedge funds use various forms of leverage to generate high returns, and they do so by investing in credit lines, hoping that the return will be higher than the interest rate. They buy securities with leverage, which means they use brokers “money for large investments.
Hedge funds also trade in derivatives that they believe carry asymmetric risks, and these bets are placed against themselves. With leverage, hedge funds raise returns, but increase the risk of failure and increase losses, because the maximum losses are much smaller than the potential gains. They also increase the risk of failure by increasing returns from leverage, making them more vulnerable to losses.
Asset Backed Leverage
Some of the more progressive offshore funds such as Asset Secured Investments use leverage in the traditional sense, thus benefiting from deploying significant multiples of assets under management without the volatility of traditional hedge fund positions.
Leverage in real estate is using borrowed money to buy a property. When leveraging a property, you borrow funds from a lender to be able to purchase an investment property instead of having to cover the entire purchase price yourself. Being able to leverage your investment is one of the reasons real estate investing is so attractive.
How Hedge Funds Use Leverage to Increase Returns
Using leverage can increase returns but also exacerbate losses, so hedge funds use leverage to increase their market bets. Leveraged companies buy securities by borrowing money, which boosts their purchasing power in the market. The margins can also be used for other purposes, such as derivatives, which can themselves be highly leveraged. Hedge funds also use leverage in other ways, such as by increasing their “market bets” and trading in derivatives.
Hedge funds are funds typically held by high net worth sophisticated investors, with fund managers using unorthodox investment tactics to achieve high returns. These strategies include searching for securities that are grossly undervalued or overvalued, taking long and short positions based on insights, and using leverage to capitalize on market volatility without having to guess the direction of movement. If their investment bets go the wrong way, they may be exposed to margin calls and credit risks.
Hedge Fund Margin
One popular way hedge funds achieve high returns is by buying securities on margin. Margin trading boosts profits but also exacerbates losses, the Securities and Exchange Commission said. A margin account is money borrowed from a broker and used to invest in securities.
Let’s say an investor who uses $500 of his own money and another $500 in margin drops $200. That money quadruples profit margins and doubles the money, as it does when the initial $1,000 is worth $2,500, or about $100 a share.
In this scenario, the investor sells the stock at a loss of $300 and has to repay the broker. Trading in margins means investors lose more money than their original investment. Because hedge funds do not borrow money from brokers or third-party providers, investing in line-of-credit securities follows a similar philosophy to trading in margins.
If the interest on the credit line is transferred to the company, this can lead to huge losses from bad investments. This is a winning strategy and it is a way to use other people’s money to invest in the hope of increasing profits.
Financial derivatives are contracts derived from the price of an underlying security; futures, options and swaps are examples of derivatives. Hedge funds invest in derivatives because of the asymmetric risk they offer and the risk of loss.
Suppose a stock is trading at $100 and a hedge fund manager expects the stock to rise quickly. Instead, he or she buys a call option for $1,000 a share at a tiny fraction of the stock price. This gives him or her the opportunity to buy this stock at any time at today’s price on a given future day, without it coming at today’s prices. If you buy the $2,500 call options on the same stock instead of directly buying the 1,000 shares, you risk losing up to $10,800 of your $3,600 investment, or $50,200 of $500 if your estimate is wrong and the shares collapse, then the investment has lost $200,300 instead of the original $5,700, with a risk of losing $100.00.
If your estimate is correct and the stock rises, you make use of the options and make a quick profit, but your losses are limited to the small premium you paid for the option. If you are mistaken and your stock remains flat or collapses, you can have your options expire at a loss of $100.
Hedge funds use leverage in many ways, but the most common is borrowing to increase the size of their investments. Futures contracts, which are margin-dependent and popular with hedge funds, are often leveraged against stocks, bonds and commodities.
Stocks tend to rise over time, and leverage works both ways, increasing profits but also losses. Stocks rise when the market rises and falls, but when markets rise, leverage increases and the original hedge fund is leveraged to reduce volatility and downside potential. For example, it aims to hold an overall portfolio that is hedged against market volatility, or “volatility,” at 75% against the US stock market and 25% against the world market.
Zanthe Alexander Bentley is a finance veteran with over 25 years’ wealth management experience advising both family offices and institutions on their corporate finance requirements including capital raises (debt & equity), restructurings and M&A activities. He has significant experience in investment management and investment banking and spent nine years at UBS focused on convertible bond arbitrage and equity derivatives.
Prior to getting involved in Asset Management he expanded a small Spanish brokerage from a handful of staff in Barcelona to a diversified brokerage company with over 150 personnel spread across 9 countries, transacting deals from High Grade to High Yield Fixed Income and Loans; Structured Products through to exchanged traded equities.
After taking time to focus on family office activities in Asia, Zanthe-Alexander now leads an ambitious zero-leveraged fund providing exceptional growth and income to Sophisticated Investors.
Zanthe Alexander Bentley Twitter: https://twitter.com/BentleyZanthe