Leveraged Funds and the Shadow Cost of Leverage Constraints

Abstract

Using the most comprehensive dataset of leveraged funds known to the literature, we measure the market-wide shadow cost of leverage constraints and examine its pricing implications. The shadow cost averages 0.56% per annum from 2006 to 2016, spikes upon quarter-ends when banks face tighter capital requirements, positively predicts future betting-against-beta (BAB) returns, and negatively correlates with contemporaneous BAB returns. Stocks that underperform when the shadow cost increases earn 0.64% more per month. Overall, our shadow cost measure fits the predictions of leverage-constraint based theories better than the widely-used TED spread.

Keywords: Leverage Constraints, Shadow Cost, Financial Intermediaries, Leveraged Funds

JEL Classification: G11, G12, G17, G23