How hedge funds use debt

An article arose recently from Hedge Fund Research (hedgefundresearch.com) with a study stating that 23% of hedge funds with capital (money put in the fund by investors) over $1 billion used leverage of between two and five times. Leverage is calculated as: the value of the firms assets, divided by the value of its equity (equity for a hedge fund is just the money put into the firm by investors). To give this number (five times) some meaning: for every one dollar of money put into the hedge fund by investors, the company has five dollars worth of assets. The fund has $1 billion put into it by investors, and it owns $5 billion in assets that it has bought. And the answer to the obvious question, “where did the fund get the money to buy the other assets?”: it borrowed money. We’ll keep the leverage ratio at five for the purpose of this article’s example.

To show how important borrowing is to a hedge fund, it helps to show how they use it. Trading on margin is a common way for hedge funds to borrow and amplify returns. The hedge fund might want $1000 worth of exposure to gold. If they use the $1000 that was put into the fund by investors, and then gold rises by 5% to $50, they make a 5% profit for investors ($50/$1000). But that’s a suckers game (sarcasm by the way). The hedge fund could just as easily ask its brokers at Goldman Sachs (or any investment bank) to buy gold, but ask to do it on “margin”. The fund gives the bank $200, and Goldman might let the fund borrow $800 (charging a small interest fee for the use of its funds) and $1000 of gold is bought for the fund. Now if gold rises by 5%, the fund still makes $50 profit, but only used $200 of its funds, hence its return is now 25% ($50/$200). And this (ignoring the fact that a small interest fee charged to the fund will the lower the profit marginally) is the magic of leverage. When the hedge fund is leveraged to this extent, the original money put in to the fund by investors is not so much invested, but it is used as collateral for the fund to borrow against to make trades. In our example the firm put up $200 collateral to borrow $800.

Magical as this may seem, there are no free lunches. Leverage is just as powerful a stimulant  on the way down. If the gold falls in value by 5%, the non levered fund (who didn’t borrow from Goldman) just loses 5%.  But the levered fund finds that its $1000 of gold is worth $950 (same as the non levered, but here’s the difference) the $50 loss as a percentage of the $200 is a 25% loss, five times the loss without leverage (no coincidence with respect to the fact that their leverage ratio was five times). Once again, as we always find in finance, to access greater reward you must take on greater risk. If the fund had decided to put all of its $1000 capital up as collateral, and borrowed $4000 to purchase $5000 of gold (giving it a leverage ratio once again of 5) a 5% decrease in the price of gold would result in a $250 loss, or 25% wiping out one quarter of the capital put in by investors.

So what does this mean when your deciding which financial wizard to put your money with?