Fundamentals of Leverage
The basic principle of leverage is to borrow funds to increase investment scale and aim for returns beyond own capital. For instance, a hedge fund with $100 million in capital using 2x leverage controls a $200 million portfolio. If the portfolio returns 10%, leverage results in 20% returns, excluding borrowing costs and other fees.
Common forms of leverage include repurchase agreements (Repos), where hedge funds borrow against pledged securities. In the U.S., repo rates typically range from 2% to 4% annually, depending on market liquidity and collateral quality. Futures and other derivatives can also enable funds to control large assets with minimal margin. According to CME, S&P 500 futures’ initial margin is about 5% of the contract value, meaning funds control 100% exposure with 5% capital.
Application of Hedge Fund Leverage Strategies
Hedge funds use leverage in various strategies, including:
(1) Amplifying returns
Hedge funds often leverage to amplify returns on stocks, bonds, or other assets. During the 2020 market turmoil caused by COVID-19, many funds used leverage to buy the dip. According to Bloomberg, Bridgewater Associates, the world’s largest hedge fund, increased its U.S. Treasury exposure with leverage in Q2 2020, seeking higher returns in a low-rate environment.
(2) Arbitrage
Leverage is crucial in arbitrage, such as interest rate arbitrage, where funds borrow low-rate currencies (e.g., yen) and invest in high-rate currencies (e.g., AUD) to earn a spread. According to BIS, global forex markets averaged $6.6 trillion in daily trading volume in 2021, with a significant portion involving leveraged arbitrage. In 2021, as the Fed signaled rate hikes, many hedge funds increased leverage to expand their forex arbitrage positions, aiming to profit before rate changes.
(3) Long/short strategies
In long/short strategies, funds hold both long and short positions, leveraging both to increase scale. For instance, a fund may predict tech stocks will rise while energy stocks will fall, borrowing to increase both tech longs and energy shorts, amplifying expected gains. HFR reports that hedge funds averaged 1.6x leverage in 2023, meaning $1 of capital supports $1.6 of assets.
(4) Enhancing liquidity management
Hedge funds also leverage to manage liquidity. During the 2022 Russia-Ukraine conflict, market volatility surged, and many funds leveraged short-term financing to maintain portfolio liquidity. JPMorgan analysis shows that funds raised over $50 billion in short-term leverage during the conflict to handle potential redemption pressures and market risks.
The risks of leverage
Leverage magnifies returns but also losses in downturns. During the 2008 financial crisis, high leverage led to significant hedge fund losses. According to the IMF, global hedge funds averaged over 30% drawdowns during the crisis, with some highly leveraged funds forced to liquidate.
Leverage risks include interest rate and liquidity risks. In 2022, the Fed’s rate hikes significantly raised hedge funds’ borrowing costs. According to Goldman Sachs, the Fed funds rate rose from near zero to 4.5% in 2022, nearly doubling borrowing costs. High-leverage funds faced heavy interest burdens, leading to sharply reduced net asset returns.
Regulation and leverage limits
Due to high leverage risks, major global markets regulate hedge funds’ leverage use. In the U.S., the Dodd-Frank Act requires hedge funds to regularly report leverage ratios, strategies, and systemic risks to the SEC. According to the SEC, U.S.-registered hedge funds averaged 1.4x leverage in 2022.
Europe also tightly regulates hedge fund leverage. According to ESMA, EU hedge funds averaged 1.5x leverage in 2021, with regular reporting to regulators on leverage use and risks.
