What is the meaning of" hedge funds use large degree of leverage"?

Question

What is the meaning of" hedge funds use large degree of leverage"?

Answer 1

To put it simply, it means that the funds use money that people invest directly, and add to that a large amount of money that they borrow, in order to boost potential returns.   This borrowed money increases their leverage but also increases risk.   So it only boosts returns if they are correct in their strategy -- it boosts losses if they are wrong, and increases the risk that the fund will simply go belly-up.

Answer 2

Leveraging allows one to get more bang for the buck.  You can essentially take your existing holdings, which have a value at a given point in time, and borrow money using that as a collateral.  

As an example, you could have used all your money to buy as many possible shares of Google at 600 bucks a share.  Let's say that's 10 shares or 6000 dollars.  But you want more shares than just 10.  Now, there are different margin requirements, but for the sake of this example, let's say you can borrow up to 50% of the value of the underlying shares.  So basically, you can then buy another 5 shares of Google.  Thus, when Google goes up to 800, you made 1500 instead of 1000 bucks.  Sounds pretty good?

The problem though is if Google goes down.  Let's say you feel greedy after Google hits 800 and decide to hold.  Google then goes down to 500.  Now, those underlying shares that you bought for 600 are only worth 500 each.  The first 10 shares you borrowed against would not have enough intrinsic value anymore for that borrowed money you used to buy the 5 additional shares.  You would then be forced to sell all of the shares at whatever the current market value is (you would not be able to wait for the share price to go back up again).  

Now, you can use many things to gain leverage.  I just gave you an example with stocks.  You can also use real estate...mortgage-backed securities.  Again, if the underlying value of the thing you are borrowing against crashes (i.e. the housing bubble bursts), you will be forced to sell, regardless of the price.  This then drives the market for that item further down, causing others to run into the same problem.  Sounds familiar?