Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Impact of Leverage, Short Selling, and Derivatives

One of the essential parts of a hedge fund's value proposition is its ability to enhance the basic return from security selection and directionality with leverage, short selling, and derivatives.

Hedge funds effectively combine traditional securities with leverage, short selling, and the use of derivatives to generate unique outcomes, such as higher return and lower volatility.

Leverage refers to the ability of a hedge fund to buy or sell more market value in shares or derivatives than the amount of capital it has raised from its investors. A fund that raises $100 million and buys $150 million or short-sells $200 million does so by combining its capital with money or shares borrowed from a bank or obtained via a derivative instrument, such as a listed or OTC option or futures contract.

Short selling refers to the ability of a fund to sell a stock, bond, or futures contract today that it plans on buying in the future. A short seller profits from a fall in the value of the instrument or security sold. A fund can borrow shares for short selling from a bank or dealer or can obtain short exposure and profits via a derivative instrument or futures contract.

A derivative can be a listed instrument, such as an option or a futures contract, that is exchange traded or an OTC instrument negotiated with a bank directly. The derivative can be used to provide leverage and short selling capability and can also modify income, tax, or other payoffs ...