How Hedge Funds Use Leverage to Amplify Returns

Hedge funds seek to maximize returns by using leverage, borrowing capital, or employing financial instruments to increase exposure beyond their initial investment. While this can enhance gains, it also raises the risk of significant losses if markets move against them.

Understanding the various methods hedge funds use to apply leverage provides insight into how they operate and why they can experience both outsized profits and dramatic downturns.

Margin Borrowing

Hedge funds frequently use margin borrowing to amplify market exposure by taking loans against their existing securities. This allows them to control a larger position than their available capital would otherwise permit. Brokers provide these loans using the fund’s portfolio as collateral and charge interest on the borrowed amount. The cost of margin borrowing depends on factors such as the fund’s creditworthiness, broker terms, and prevailing interest rates.

Leverage through margin borrowing magnifies returns when asset prices move favorably. For example, if a hedge fund has $100 million and borrows another $100 million, it effectively doubles its exposure. A 10% gain results in a $20 million profit instead of $10 million, assuming no interest costs. However, losses are also amplified. A 10% decline would mean a $20 million loss, potentially triggering margin calls.

Brokers impose margin requirements to manage risk, requiring funds to maintain a minimum equity level. If the collateral value falls below a set threshold, the broker may issue a margin call, demanding additional funds or liquidating positions. This forced selling can deepen losses, especially in volatile markets.

Repurchase Agreements

Hedge funds use repurchase agreements, or repos, as a short-term financing tool. In a repo transaction, the fund sells securities—typically government bonds or other high-quality assets—to a counterparty, usually a bank or financial institution, with an agreement to repurchase them later at a higher price. The difference between the sale and repurchase price functions as the interest cost of borrowing.

Repos provide hedge funds with immediate cash while allowing them to retain exposure to the underlying securities. The borrowed cash can be reinvested into additional assets, increasing leverage. Since repos are collateralized, lenders offer better financing terms than unsecured borrowing. However, the amount of leverage depends on the quality of the collateral and market conditions. In times of financial stress, counterparties may demand higher haircuts—the discount applied to the collateral’s value—reducing the amount of cash that can be borrowed.

The repo market is sensitive to interest rate changes and liquidity conditions. If short-term rates rise or lenders become more risk-averse, funding costs increase, squeezing hedge fund profitability. A decline in collateral value can also prompt lenders to demand additional margin or liquidate assets, forcing funds to unwind positions at unfavorable prices. This dynamic contributed to liquidity shortfalls during the 2008 financial crisis, playing a role in the collapses of Bear Stearns and Lehman Brothers.

Total Return Swaps

Hedge funds use total return swaps (TRS) to gain leveraged exposure to assets without directly owning them. In a TRS, the fund enters a contract with a counterparty—typically an investment bank—agreeing to pay a floating interest rate, often tied to SOFR (Secured Overnight Financing Rate), in exchange for the total return of an underlying asset or index. This return includes both price changes and any associated income, such as dividends.

TRS allows funds to take large positions with a relatively small initial outlay, bypassing capital requirements that would apply if they held the assets outright. Since the underlying securities remain on the counterparty’s balance sheet, the hedge fund avoids direct ownership costs and regulatory constraints.

These agreements require hedge funds to post collateral, which is adjusted periodically based on market fluctuations. If the referenced asset declines significantly, the fund must provide additional margin to maintain the position. This can create liquidity pressure, especially if multiple positions move against the fund at once. The collapse of Archegos Capital in 2021 illustrated these risks, as its excessive use of TRS led to margin calls it could not meet, forcing counterparties to liquidate positions and causing billions in losses.

Prime Brokerage Financing

Hedge funds rely on prime brokerage services from investment banks such as Goldman Sachs, Morgan Stanley, and JPMorgan to access customized financing arrangements. These services allow funds to borrow cash and securities, execute complex trades, and optimize capital deployment across multiple markets. Unlike standard margin lending, prime brokerage financing is structured through tailored agreements that consider the fund’s asset mix, liquidity profile, and overall risk exposure.

A key advantage of prime brokerage financing is portfolio-based lending, where credit is extended based on the risk-adjusted value of an entire portfolio rather than individual security margins. This enables hedge funds to maximize capital efficiency by pledging a diversified basket of assets, including equities, fixed income instruments, and derivatives, to secure funding.

Prime brokers often have rehypothecation rights, meaning they can use the pledged assets for their own funding needs. This can lower borrowing costs for hedge funds but introduces counterparty risk. If a prime broker faces financial distress, the availability and security of the fund’s collateral could be affected.

Short Selling as a Leverage Tool

Short selling allows hedge funds to profit from declining asset prices while increasing market exposure. Instead of borrowing cash to buy more assets, short selling involves borrowing securities and selling them in the open market with the expectation of repurchasing them later at a lower price.

To execute a short sale, hedge funds borrow shares from a prime broker, sell them, and later repurchase them to return to the lender. If the price declines as expected, the fund profits from the difference. However, if the price rises, losses can be substantial since there is no limit to how high a stock can climb.

Short sellers must also pay interest on the borrowed shares and cover any dividends issued during the holding period, adding to the cost of maintaining the position. In volatile markets, short squeezes—where rapidly rising prices force funds to buy back shares at elevated levels—can drive significant losses. The 2021 GameStop episode demonstrated this risk, as retail-driven price surges led to billions in losses for hedge funds caught in short positions.