Leverage and Risk in Hedge Funds

68 Pages Posted: 27 Feb 2020

See all articles by Daniel Barth

Daniel Barth

Board of Governors of the Federal Reserve System

Laurel Hammond

Office of Financial Research, US Department of the Treasury

Phillip Monin

Board of Governors of the Federal Reserve System

Date Written: February 25, 2020

Abstract

The use of leverage is often considered a key potential systemic risk in hedge funds. Yet, data limitations have made empirical analyses of hedge fund leverage difficult. Traditional theories predict leverage and portfolio risk are positively linearly related. Alternatively, an emerging wave of theories of leverage constraints predict leverage and asset risk are negatively correlated, and therefore leverage and portfolio risk may be unrelated or even negatively related. Consistent with theories of leverage constraints, we find that hedge fund leverage and portfolio risk are weakly negatively correlated. This arises from a strong negative association between leverage and asset risk — in particular, market beta. The average market beta on funds' assets explains 20% of the cross-sectional variation in hedge fund leverage, and 47% for the subsample of equity-style funds. Also consistent with these theories, leverage and portfolio alpha are strongly positively related, but this relationship is entirely explained by market beta. Our findings suggest that the association between leverage and risk in hedge funds is nuanced, and that leverage is in part used to scale the payoffs of low-beta, high-alpha securities, resulting in an essentially flat relationship between leverage and portfolio risk.

Keywords: hedge funds, leverage, systemic risk, financial stability, low beta anomaly

JEL Classification: G11, G12, G23

Suggested Citation

Barth, Daniel and Hammond, Laurel and Monin, Phillip, Leverage and Risk in Hedge Funds (February 25, 2020). OFR WP 20-02, Available at SSRN: https://ssrn.com/abstract=3544304 or http://dx.doi.org/10.2139/ssrn.3544304

Daniel Barth (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Laurel Hammond

Office of Financial Research, US Department of the Treasury ( email )

717 14th Street, NW
Washington, DC 20220
United States

Phillip Monin

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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