Synthetic Leverage and Fund Risk-Taking

Abstract

Mutual fund risk-taking via active portfolio rebalancing varies both in the cross-section and over time. In this paper, I show that the same is true for funds’ off-balance sheet risk-taking, even after controlling for on-balance sheet activities. For this purpose, I propose a novel measure of synthetic leverage, which can be estimated based on publicly available information. In the empirical application, I show that German equity funds have increased their risk-taking via synthetic leverage from mid-2015 up until early 2019. In the cross-section, I find that synthetically leveraged funds tend to underperform and display higher levels of fragility.

Keywords: derivatives, leverage, mutual funds, risk-taking, securities lending

JEL Classification: G11, G23, E44