Leverage Constraints Affect Portfolio Choice: Evidence from Closed-End Funds

Abstract

The market for auction rate securities collapsed in February 2008, significantly constraining some closed-end funds' access to leverage. We use this exogenous shock to study empirically how leverage constraints affect investors' portfolio choice. We find that tightened constraints result in an increased appetite for systematic risk: in the months following the shock, the affected funds bought significantly more high-beta stocks, and sold significantly more low-beta stocks, than their unaffected peers. Our results are consistent with the theoretical predictions of Black (1972) and Frazzini and Pedersen (2014) and provide causal evidence of the central mechanism underlying asset pricing under leverage constraints.

Keywords: leverage constraints, portfolio choice, closed-end funds

JEL Classification: G11, G12