How Hedge Funds Use Short-Selling & Leverage - Nicola Wealth

Alternative Strategies Part 2: Don’t Try This at Home


Read Part 1 of our series on Alternative Strategies here.

How hedge funds use leverage and short selling towards the goal of generating market-agnostic returns.

As we discussed in the first installment in this series, the objective of alternative strategies is to generate returns from a variety of asset classes that are unrelated to market conditions. To do this, hedge fund managers use tools not available to managers of mutual and exchange-traded funds or retail investors. Two key tools in the alternative manager’s toolbox are leverage and short sales.

What is leverage?

Leverage is the use of borrowed capital to boost the size of the asset you’re buying. Homebuyers do this all the time—they borrow multiple times their own capital (the down payment) to acquire a residence. With extremely low borrowing costs, using prudent amounts in leverage in safe assets assists in generating higher returns much like purchasing one’s own home. The degree to which the property appreciates faster than the rate of interest they’re paying on the mortgage is money in their pocket or at least equity towards their net worth. By the same token, they are taking a risk that the home’s value declines, and the bank forecloses, causing them to forfeit their own capital invested.

Professional investors use leverage in a similar way to magnify their returns. Say they are executing a strategy that exploits small differences in the price of interchangeable assets from day to day or in different currencies or marketplaces. Leverage can help turn those small differences into a considerable profit.

What is short selling?

Shorting (also known as short selling) is a way to make money from a decline in an asset’s value. The short seller borrows a security he or she believes is set for a fall (usually from a brokerage or bank) and promptly sells it in the public markets for the current market price. At some point, ideally, after the price has come down, they must “cover” their short position by buying it back in the marketplace and returning it to its owner. The difference in the price constitutes their return on the trade, minus any carrying cost paid to the owner. This is most often done with stocks, but can also be employed with derivatives, indeed any securitized asset.

One reason why regulations restrict short sales to qualifying investors and hedge funds is that they are riskier than conventional “long” positions. When you own a stock, the most you can lose is 100% of your capital invested. But when you short a stock, you face a potentially unlimited liability should it increase in value two, three or more times over.

Leverage and short selling open up a world of unconventional ways to make money

Used on their own or in combination, leverage and short selling open up a world of unconventional ways to make money in investment markets. For example, in a textbook long/short trade, the investor takes two similar assets—say, rival stocks in the same industry. She’ll short what she considers the weaker stock and long the stronger. Both stocks will rise and fall with the markets, but to the extent, the long position falls less in a bear market or rises more in a bull market, the investor makes money.

This can even be done with different kinds of investments in the same organization, in what’s called capital structure arbitrage. If the investor perceives that the convertible bonds a corporation issues are mispriced relative to its equity (due to the fact there are different buyers for each asset class), she might long one and short the other.

Again, the point of these machinations is to generate a return heedless of the investment cycle. Far from distorting markets, they serve to weed out the markets’ own inefficiencies. And the returns they generate are steadier than stocks’, falling somewhere between equities and fixed income on the risk/return scale.

In our next post, we’ll examine why alternative strategies could be especially beneficial at this stage of the economic cycle.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.