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Gearing In Hedge Funds

Hedge Funds are very secretive about their investment processes. Managers claim proprietary knowledge that they do not wish to reveal to competitors, which also leads to hedge fund managers preventing their management companies to float on the stock exchange, as this in turn would require them to disclose their methods. Whilst this may protect their proprietary knowledge, it means that investors are not told what risks they are being exposed to.

Undisclosed practices include leveraging or gearing, which spice up returns. This is the practice of borrowing against the investor’s money to get noticeably higher returns.

An example of this would be using $1.0 billion of investors money placed in US Govt Bonds as security. The manager borrows say $5.0 billion in Japanese Yen at 1% and invests the money into more Bonds at 6%. That is a profit of 5% x 5 = 25% plus the 4% on the original capital = 29% return.

On the surface this looks like an excellent return with little risk. There is, however, a major risk in this hypothetical structure. If the Japanese Yen declines against the US$, the fund makes a currency profit but if the Yen appreciates against the US$, there would be a loss. The investment has now become a currency investment and when the currency trades in the wrong direction the lender will make a margin call and the fund manager will be forced to sell securities to meet the margin call.

Holborn Assets as a rule refuses to get involved in gearing of investments. To find out more about our Hedge Funds practices and advice on investing, please talk to a qualified Holborn Assets adviser today.

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