Key Takeaways
- • Hedge funds use leverage, primarily margin borrowing from brokers, credit lines from third-party lenders, and derivatives, to increase investment size and potential profit.
- • Leverage magnifies losses as well as gains, exposing hedge funds to credit risk, interest costs, and potential margin calls.
- • Derivatives such as futures, options, and swaps are used by hedge funds because they offer asymmetric risk, where maximum loss on an options position is limited to the premium paid.
- • Investopedia's illustrative example shows a $1,000 stock purchase with $500 on margin doubling to $2,000 on a gain but producing an $800 total loss, including interest and commissions, if the stock falls to $200.
Summary
Hedge funds, which pool capital from ultra-high-net-worth individuals and institutional investors, use several forms of leverage to pursue large returns, according to Investopedia. The most common method is purchasing securities on margin, in which a fund borrows from a broker to take larger positions than its own capital would allow. Investopedia's illustration shows an investor who buys $1,000 of stock using $500 of their own money and $500 on margin. If the stock rises to $2,000, the position quadruples the investor's original equity, rather than merely doubling it. If the stock falls to $200, the investor sells at a $300 loss, must still repay the $500 borrowed, and absorbs a total loss of $800 plus interest and commissions, exceeding the original investment.
Hedge funds also use credit lines from third-party lenders, following the same logic as margin trading. The strategy succeeds only if the underlying security appreciates faster than the interest cost of the borrowing, and it can produce substantial losses on poor investments.
Derivatives represent a further form of leverage. Futures, options, and swaps derive their value from underlying securities, and hedge funds favor them for their asymmetric risk profile. Investopedia gives an example in which a stock trading at $100 is expected to rise. Buying 1,000 shares outright would expose the fund to a $100,000 loss if the stock collapsed, whereas a call option on the same 1,000 shares costs a small fraction of the share price and caps the downside at the premium paid.
Investopedia notes that leverage works in both directions. Dan Stewart, CFA, of Revere Asset Management in Dallas, Texas, observes that the most common approach is borrowing on margin to increase the size of a bet, and that futures contracts, which operate on margin, are popular with hedge funds. Stewart also points out that the original hedge funds were designed as risk-reduction strategies. One example he cites is a 70% long and 30% short structure, intended to hold the strongest 70% of stocks and short the weakest 30%, to limit exposure to market swings.
Hedge funds also use credit lines from third-party lenders, following the same logic as margin trading. The strategy succeeds only if the underlying security appreciates faster than the interest cost of the borrowing, and it can produce substantial losses on poor investments.
Derivatives represent a further form of leverage. Futures, options, and swaps derive their value from underlying securities, and hedge funds favor them for their asymmetric risk profile. Investopedia gives an example in which a stock trading at $100 is expected to rise. Buying 1,000 shares outright would expose the fund to a $100,000 loss if the stock collapsed, whereas a call option on the same 1,000 shares costs a small fraction of the share price and caps the downside at the premium paid.
Investopedia notes that leverage works in both directions. Dan Stewart, CFA, of Revere Asset Management in Dallas, Texas, observes that the most common approach is borrowing on margin to increase the size of a bet, and that futures contracts, which operate on margin, are popular with hedge funds. Stewart also points out that the original hedge funds were designed as risk-reduction strategies. One example he cites is a 70% long and 30% short structure, intended to hold the strongest 70% of stocks and short the weakest 30%, to limit exposure to market swings.
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