Leverage and Performance Metrics in Asset Pricing
31 Pages Posted: 28 Jan 2018 Last revised: 20 Apr 2019
Date Written: October 15, 2018
Commonly used performance metrics calculated from tradable long-short strategies constructed using leverage lead to specious conclusions of statistical significance. In particular, even if assets are randomly assigned to the levered strategies' long and short portfolios, too often they generate high Sharpe Ratios and statistically significant CAPM, Carhart, and Fama-French Five Factor alphas. I call this finding the mechanical effect of leverage on performance metrics and suggest various diagnostic tests to control for this effect when testing levered strategies.
Keywords: betting against beta, betting against alpha, factor models, leverage, Sharpe Ratio, alpha
JEL Classification: G10, G12
Suggested Citation: Suggested Citation