Hedge funds have a variety of strategies at their disposal that most ordinary investors never use. One strategy that many hedge funds use is to employ leverage by buying certain stocks and selling other stocks short. To the extent that a hedge fund uses the proceeds from a short sale of a stock to finance the purchase of other stocks, the fund can boost its leverage and earn more profits when it makes smart choices. Yet with leverage comes risk, so it's smart to calculate just how leveraged a hedge fund is when looking at its record of investment returns. That way, you can tell how risky a hedge fund was with investors' money in order to make its profits.
Gross leverage for long-short hedge funds
For hedge funds that employ strategies that include both long and short positions, it's easy to calculate gross leverage. To do so, add the total value of long positions and the total value of short positions together in order to get the gross value of assets that the hedge fund has under its control. Then, dividend that figure by the total capital in the hedge fund. The resulting ratio gives the gross leverage.
For instance, say that a hedge fund collects capital from investors of $100 million. It takes $70 million of that money and buys stocks with it, and it takes on short positions with a value of $50 million. In this case, the gross leverage will be $70 million plus $50 million, or $120 million, divided by $100 million. That works out to 1.2.
Gross leverage for hedge funds using other strategies
Other hedge funds use different strategies for generating returns. If a fund borrows substantially in order to invest more than its initial capital, then gross leverage can be substantial.
For instance, say a fund raises $100 million in equity capital and then obtains a $400 million loan. It takes the total of $500 million and buys investment securities with it. In this case, you can calculate the gross leverage as $500 million divided by $100 million, or 5.
In general, the higher the gross leverage, the riskier the fund is. But bear in mind that leverage is only one part of the equation. You also have to consider the inherent risk of a particular strategy. For example, a fund pursuing one strategy with gross leverage of 2 might be riskier than a fund pursuing a different strategy even if it has gross leverage of 5. Leverage is only directly comparable across funds pursuing the same strategy.
Hedge fund investing has great potential for profit, but it also carries substantial risk. The gross leverage figure gives you an idea of just how big those risks can be.
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