An example of a leveraged fund is a market neutral fund. Essentially market neutral funds (a type of leveraged Hedge Fund) go long on a stock which they believe is a very good stock and at the same time go short on a stock in the same group that they believe to be a weak stock. They do this by a combination of borrowing against equity and obtaining funds from the short. With enough good picks, a leverage of say 30% supposedly will compound returns, and very well managed funds might achieve higher returns by using this method.
These types of funds usually have very detailed and sophisticated methods of choosing strong vs weak stocks. Computer modeling is extensively used and statistics are very important. Often, this consists of an intricate screening technique whereby a broad range of securities will be screened and measured against hundreds of criteria involving everything from historical earnings, to return on equity, to measurements against market trends, and so on. Each criterion is given a weight of importance and then a calculation is made in some fashion as to the total weighting of each stock. Stocks will usually be traded in pairs with the lowest total weighting security sold, and the highest total weighting security bought. Thus it is considered that the stock bought long will increase in value and the other will decrease in value. This is theoretically a double win and the returns supposedly are good.
The method can work, but with the caveat that all stocks generally rise on a rising market and all stocks generally fall on a falling market. However in a volatile market, the strong stocks fall in similar fashion to the weak stocks. The result is that in a stable market, such a strategy can produce greater returns. However, when there is a sudden general market fall, it is more universal than not. So both the long position and the short position go in the same direction. In these circumstances, the strategy produces greater losses and is more volatile.
The Market is Always Volatile – Just not always reported in the daily press
Throughout history, and indeed on a very regular basis, markets have had sudden falls. You read about the big ones in the newspaper, but all markets move on almost a regular basis on sudden movements. These falls devastate leveraged funds. The fund that looked so good for the last 6 months, all of a sudden, looses 10% or 20% of its value on a volatile day. Then the leverage doesn’t look so good. Then the leverage is very bad because it increases the loss.
We believe that great investors have historically been able to see value, buy that value, understand that value, and in due course, that value proves itself. No-one has ever created a system that always works. No matter the amount of due diligence, some value stocks will fall, and when they fall, it is important to understand when the pick was wrong and sell.
We believe that we must be always casting a critical eye on what we have bought. When we are wrong, we try and recognize that. We sell, we move on, and we look for other value. There is a saying repeated over and over by investors over the years – ‘The First Loss is the Best Loss.’
Next – How To Recognize Value
What a great resource!