How and Why do Hedge Funds Use Leverage?
Leverage is generally described as the use of debt to amplify returns, but at a higher risk profile. Hedge funds use leverage for a few different reasons: to 1) bolster returns at a higher risk with a potentially much higher reward, 2) amplify low-risk strategy returns, 3) reduce risk levels, or for 4) improved liquidity and lower transaction cost reasons.
Type of leverage used depends on hedge fund strategy. A manager would choose to boost returns at a high risk with leverage if they were highly confident in an investment thesis, typically a long bias equity fund. A different manager would choose to boost lower risk returns, such as arbitrage trades, which are usually hedged and have less downside but provide little return without leverage. Leverage with the purpose of risk mitigation is common across all funds. For example, a long/short equity fund would balance out its long exposure with short positions, resulting in less volatility. Liquidity benefits can be directly experienced in the commodities market, where taking positions in derivatives is much more efficient than the commodity itself.
The Mechanics Behind Leverage Tools
The most common explicit leverage method is through shorting. The fund manager can select which securities the fund will sell short and immediately receive cash for their selection. This cash can be used to buy more assets, ultimately resulting in more assets purchased than the fund originally could have bought without the extra cash. The manager must buy the shorted security back later, so there is a risk of price appreciation of the underlying security, which would drain cash in the future.
Another explicit form of leverage is available to hedge funds through their prime broker, most of which can offer credit (buying power to purchase assets) in exchange for a smaller fixed percentage of the fund’s cash/securities and a fee. Implicit leverage can be obtained through the use of derivatives,such as futures, options, forwards, and swaps. Leverage is used to expose the trader to amplified price movements in the underlying security without having to put up the capital that would be needed in the underlying’s market (i.e., buying a call option exposes the buyer to the price movement of 100 shares of an equity, but at a small fraction of the cost). The fund can then put capital saved to work in other ways to generate returns.
