Hedge funds generally invest in assets and asset classes that are not highly correlated with the U.S. stock market or bond markets. As such, they are useful for "hedging" more conventional investments. While the Investment Company Act of 1940 restricts what conventional diversified mutual funds can invest in, hedge funds generally have no such limitations as unregistered securities and are free to employ large amounts of borrowed money -- or "leverage" -- to make investments. Some hedge funds do this, particularly when they are investing in areas where price movements are small.
How Leverage Works
When an investor or a fund borrows money to invest in a given asset and invests that money along with its own money, returns are magnified. For example, if the fund invested $1 million in XYZ stock and borrowed $1 million to invest in XYZ, and XYZ rose by 10 percent, then the investor would actually realize a 20 percent return, disregarding the costs of carrying the loan. But leverage works both ways: If XYZ lost 10 percent, the fund would lose 20 percent, since the loan must still be repaid in full. If XYZ loses 50 percent, the fund's investment in the company would be wiped out.
Hedge Funds and Leverage
As mentioned, hedge funds vary widely in their leverage practices. Some assets, such as certain kinds of derivatives and covered call options, are leveraged by their very nature and don't necessarily involve a huge debt position. It's not unusual for a hedge fund to be leveraged between 100 and 500 percent, however, depending on the asset class. Leverage up to 10 times is not unheard of, though that would mean that a 10 percent decline in the leveraged part of the investment portfolio would wipe out investors' equity altogether. A recent survey from the United Kingdom Financial Authority finds that the average hedge fund was leveraged about 2.5 times.
Long Term Capital Management
One extreme instance of leverage was Long Term Capital Management, a hedge fund founded by several Nobel prize-winning economists. This fund sought to exploit small arbitrage opportunities in currency markets by "going long" in one market and "selling short" the same asset in another, where the same thing was priced differently on a different exchange. In theory, one or both positions must gain as the price anomaly disappeared. LTCM borrowed a huge amount of money, perhaps leveraging to 25 to 1, to magnify these small price movements to levels meaningful to investors. But when things didn't go as planned, in 1998, LTCM defaulted on the loans and threatened to take a number of lenders down with it in a chain reaction. The U.S. Treasury Department and Federal Reserve, along with Warren Buffett, chairman of Berkshire Hathaway, organized a bailout.
Because many hedge funds can be volatile and invest in narrow niches, the Securities and Exchange Commission does not believe they are suitable for retail investors. Hedge fund salespeople are prohibited from soliciting shares to individuals who are not "accredited investors," defined as a corporation or an individual with at least $1 million in net worth or verifiable income of at least $200,000 per year ($300,000 for married couples).
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