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Hedge fund leverage?

Long only funds tend to make higher returns than real hedge funds in a bull market. No hedging means no hedging cost. But what about the risk that was taken to generate those returns? Risk-adjusted performance means factoring in drawdown frequency, duration and depth, volatility and standard deviation, negative skew, rare event and geopolitical risks that investors endure when they put money in an unhedged relative return fund.

Hedging means neutralizing risk factors as much as possible. Investors can choose to either 1. take these risks or 2. pay a professional hedge fund manager to hedge them and still produce returns. Over time, choice 2 is ALWAYS better and cheaper. As with many things, you get what you pay for.

Recently a prominent investment "advisor" made the following bizaare comment: "One thing we can be sure of is that many of the hedge fund managers aren't taking any risks with their own money." WRONG. All reputable managers keep most of their liquid assets in their fund. I know many funds where the manager is or even insists on being the largest investor. Some of the best don't even bother having external clients any more.

Besides, where else are they going to invest? Never invest in a financial product marketed to you unless the portfolio manager, the salesperson or intermediary and the senior management of the sponsoring firm have committed SUBSTANTIAL personal assets to the fund. Eating your own cooking applies to the restaurant owner as much as the chef and waiter. Standard practise in the hedge fund industry but elsewhere in finance...

Another retort from experts is to decry the use of leverage. If leverage is so bad, shut down all the banks and abolish mortgages and loans. Then see what that does to the economy. Most equity hedge funds use little or no leverage while fixed-income, futures and fx funds do. While $/Euro and $/Yen might move a few big figures on any given day there is NO chance that a major currency rate could halve tomorrow. There is also no chance whatsoever that the US 10yr bond yield goes to 15% anytime soon. These things could happen over an extended period but the large overnight gap risk is just not there. If you know what you are doing in risk management and are properly diversified with shorts and longs, leverage is not a problem.

Long only funds, whether passive indexed or active stock pickers, are an UNACCEPTABLE risk if you care about your money and want a reliable, consistent return. Even then, if you are a speculator and insist on having some money in long only you STILL need hedge funds to get adequate diversification. The purpose of hedge funds is to provide another source of performance, independent of market or any other asset class direction.

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