Leverage and Alpha: The Case of Funds of Hedge Funds

Abstract

In this paper, we develop a theoretical model of fund of hedge fund net leverage and alpha where the cost of borrowing is increasing with net leverage, thereby impacting the performance. We use this model to determine the conditions under which the leverage has a negative or a positive impact on investors' alpha. Moreover, we show that the manager of a fund of hedge fund has an incentive to take a leverage that hurts the investors' alpha. Next, we develop a statistical method combining the Sharpe style analysis and a time-varying coefficient model. This method allows the weights of the regression to vary over time while being constrained to sum up to one. Subsequently, we use this method to get estimates of the leverages of a sample of funds of hedge funds. The estimates of leverages are then used in predictive regression analyses to confirm the negative impact of leverage on fund of hedge fund alphas and appraisal ratios. Finally, our results being robust to various robustness checks, we argue that this effect may be an explanation for the disappointing alpha delivered by funds of hedge funds.

Keywords: hedge funds, fund of hedge funds, time-varying coefficient models, leverage

JEL Classification: C22, G11, G23