Hedge Fund Leverage∗
Andrew Ang†
Columbia University and NBER
Sergiy Gorovyy‡
Columbia University
Gregory B. van Inwegen§
Citi Private Bank
This Version: 25 January, 2011
JEL Classification: G11, G18, G23, G32
Keywords: Capital structure, long-short positions,
alternative investments, exposure, hedging, systemic risk
∗ We thank Viral Acharya, Tobias Adrian, Zhiguo He, Arvind Krishnamurthy, Suresh Sundaresan,
Tano Santos, an anonymous referee, and seminar participants at Columbia University and Risk USA
2010 for helpful comments.
† Email: ; WWW: http://www.columbia.edu/∼aa610.
‡ Email:
§ Email:
, Hedge Fund Leverage
Abstract
We investigate the leverage of hedge funds in the time series and cross section. Hedge fund
leverage is counter-cyclical to the leverage of listed financial intermediaries and decreases prior
to the start of the financial crisis in mid-2007. Hedge fund leverage is lowest in early 2009 when
the market leverage of investment banks is highest. Changes in hedge fund leverage tend to be
more predictable by economy-wide factors than by fund-specific characteristics. In particular,
decreases in funding costs and increases in market values both forecast increases in hedge fund
leverage. Decreases in fund return volatilities predict future increases in leverage.
,1 Introduction
The events of the financial crisis over 2007-2009 have made clear the importance of leverage of
financial intermediaries to both asset prices and the overall economy. The observed “delever-
aging” of many listed financial institutions during this period has been the focus of many regu-
lators and the subject of much research.1 The role of hedge funds has played a prominent role
in these debates for several reasons. First, although in the recent financial turbulence no single
hedge fund has caused a crisis, the issue of systemic risks inherent in hedge funds has been
lurking since the failure of the hedge fund LTCM in 1998.2 Second, within the asset manage-
ment industry, the hedge fund sector makes the most use of leverage. In fact, the relatively high
and sophisticated use of leverage is a defining characteristic of the hedge fund industry. Third,
hedge funds are large counterparties to the institutions directly overseen by regulatory authori-
ties, especially commercial banks, investment banks, and other financial institutions which have
received large infusions of capital from governments.
However, while we observe the leverage of listed financial intermediaries through periodic
accounting statements and reports to regulatory authorities, little is known about hedge fund
leverage despite the proposed regulations of hedge funds in the U.S. and Europe. This is be-
cause hedge funds are by their nature secretive, opaque, and have little regulatory oversight.
Leverage plays a central role in hedge fund management. Many hedge funds rely on leverage
to enhance returns on assets which on an unlevered basis would not be sufficiently high to at-
tract funding. Leverage amplifies or dampens market risk and allows funds to obtain notional
exposure at levels greater than their capital base. Leverage is often employed by hedge funds
to target a level of return volatility desired by investors. Hedge funds use leverage to take ad-
vantage of mispricing opportunities by simultaneously buying assets which are perceived to
be underpriced and shorting assets which are perceived to be overpriced. Hedge funds also
dynamically manipulate leverage to respond to changing investment opportunity sets.
We are the first paper, to our knowledge, to formally investigate hedge fund leverage using
1
See, for example, Adrian and Shin (2009), Brunnermeier (2009), Brunnermeier and Pedersen (2009), and He,
Khang, and Krishnamurthy (2010), among many others.
2
Systemic risks of hedge funds are discussed by the President’s Working Group on Financial Markets (1999),
Chan et al. (2007), Kambhu, Schuermann, and Stiroh (2007), Financial Stability Forum (2007), and Banque de
France (2007).
1
, actual leverage ratios with a unique dataset from a fund-of-hedge funds. We track hedge fund
leverage in time series from December 2004 to October 2009, a period which includes the
worst periods of the financial crisis from 2008 to early 2009. We characterize the cross section
of leverage: we examine the dispersion of leverage across funds and investigate the macro and
fund-specific determinants of future leverage changes. We compare the leverage and exposure
of hedge funds with the leverage and total assets of listed financial companies. As well as
characterizing leverage at the aggregate level, we investigate the leverage of hedge fund sectors.
The prior work on hedge fund leverage are only estimates (see, e.g., Banque de France,
2007; Lo, 2008) or rely only on static leverage ratios reported by hedge funds to the main
databases. For example, leverage at a point in time is used by Schneeweis et al. (2004) to inves-
tigate the relation between hedge fund leverage and returns. Indirect estimates of hedge fund
leverage are computed by McGuire and Tsatsaronis (2008) using factor regressions with time-
varying betas. Even without considering the sampling error in computing time-varying factor
loadings, this approach requires that the complete set of factors be correctly specified, otherwise
the implied leverage estimates suffer from omitted variable bias. Regressions may also not ade-
quately capture abrupt changes in leverage. Other work by Brunnermeier and Pedersen (2009),
Gorton and Metrick (2009), Adrian and Shin (2010), and others, cite margin requirements, or
haircuts, as supporting evidence of time-varying leverage taken by proprietary trading desks at
investment banks and hedge funds. These margin requirements give maximum implied lever-
age, not the actual leverage that traders are using. In contrast, we analyze actual leverage ratios
of hedge funds.
Our work is related to several large literatures, some of which have risen to new prominence
with the financial crisis. First, our work is related to optimal leverage management by hedge
funds. Duffie, Wang and Wang (2008) and Dai and Sundaresan (2010) derive theoretical models
of optimal leverage in the presence of management fees, insolvency losses, and funding costs
and restrictions at the fund level. At the finance sector level, Acharya and Viswanathan (2008)
study optimal leverage in the presence of moral hazard and liquidity effects showing that due
to deleveraging, bad shocks that happen in good times are more severe. A number of au-
thors have built equilibrium models where leverage affects the entire economy. In Fostel and
Geanakoplos (1998), economy-wide equilibrium leverage rises in times of low volatility and
2
Andrew Ang†
Columbia University and NBER
Sergiy Gorovyy‡
Columbia University
Gregory B. van Inwegen§
Citi Private Bank
This Version: 25 January, 2011
JEL Classification: G11, G18, G23, G32
Keywords: Capital structure, long-short positions,
alternative investments, exposure, hedging, systemic risk
∗ We thank Viral Acharya, Tobias Adrian, Zhiguo He, Arvind Krishnamurthy, Suresh Sundaresan,
Tano Santos, an anonymous referee, and seminar participants at Columbia University and Risk USA
2010 for helpful comments.
† Email: ; WWW: http://www.columbia.edu/∼aa610.
‡ Email:
§ Email:
, Hedge Fund Leverage
Abstract
We investigate the leverage of hedge funds in the time series and cross section. Hedge fund
leverage is counter-cyclical to the leverage of listed financial intermediaries and decreases prior
to the start of the financial crisis in mid-2007. Hedge fund leverage is lowest in early 2009 when
the market leverage of investment banks is highest. Changes in hedge fund leverage tend to be
more predictable by economy-wide factors than by fund-specific characteristics. In particular,
decreases in funding costs and increases in market values both forecast increases in hedge fund
leverage. Decreases in fund return volatilities predict future increases in leverage.
,1 Introduction
The events of the financial crisis over 2007-2009 have made clear the importance of leverage of
financial intermediaries to both asset prices and the overall economy. The observed “delever-
aging” of many listed financial institutions during this period has been the focus of many regu-
lators and the subject of much research.1 The role of hedge funds has played a prominent role
in these debates for several reasons. First, although in the recent financial turbulence no single
hedge fund has caused a crisis, the issue of systemic risks inherent in hedge funds has been
lurking since the failure of the hedge fund LTCM in 1998.2 Second, within the asset manage-
ment industry, the hedge fund sector makes the most use of leverage. In fact, the relatively high
and sophisticated use of leverage is a defining characteristic of the hedge fund industry. Third,
hedge funds are large counterparties to the institutions directly overseen by regulatory authori-
ties, especially commercial banks, investment banks, and other financial institutions which have
received large infusions of capital from governments.
However, while we observe the leverage of listed financial intermediaries through periodic
accounting statements and reports to regulatory authorities, little is known about hedge fund
leverage despite the proposed regulations of hedge funds in the U.S. and Europe. This is be-
cause hedge funds are by their nature secretive, opaque, and have little regulatory oversight.
Leverage plays a central role in hedge fund management. Many hedge funds rely on leverage
to enhance returns on assets which on an unlevered basis would not be sufficiently high to at-
tract funding. Leverage amplifies or dampens market risk and allows funds to obtain notional
exposure at levels greater than their capital base. Leverage is often employed by hedge funds
to target a level of return volatility desired by investors. Hedge funds use leverage to take ad-
vantage of mispricing opportunities by simultaneously buying assets which are perceived to
be underpriced and shorting assets which are perceived to be overpriced. Hedge funds also
dynamically manipulate leverage to respond to changing investment opportunity sets.
We are the first paper, to our knowledge, to formally investigate hedge fund leverage using
1
See, for example, Adrian and Shin (2009), Brunnermeier (2009), Brunnermeier and Pedersen (2009), and He,
Khang, and Krishnamurthy (2010), among many others.
2
Systemic risks of hedge funds are discussed by the President’s Working Group on Financial Markets (1999),
Chan et al. (2007), Kambhu, Schuermann, and Stiroh (2007), Financial Stability Forum (2007), and Banque de
France (2007).
1
, actual leverage ratios with a unique dataset from a fund-of-hedge funds. We track hedge fund
leverage in time series from December 2004 to October 2009, a period which includes the
worst periods of the financial crisis from 2008 to early 2009. We characterize the cross section
of leverage: we examine the dispersion of leverage across funds and investigate the macro and
fund-specific determinants of future leverage changes. We compare the leverage and exposure
of hedge funds with the leverage and total assets of listed financial companies. As well as
characterizing leverage at the aggregate level, we investigate the leverage of hedge fund sectors.
The prior work on hedge fund leverage are only estimates (see, e.g., Banque de France,
2007; Lo, 2008) or rely only on static leverage ratios reported by hedge funds to the main
databases. For example, leverage at a point in time is used by Schneeweis et al. (2004) to inves-
tigate the relation between hedge fund leverage and returns. Indirect estimates of hedge fund
leverage are computed by McGuire and Tsatsaronis (2008) using factor regressions with time-
varying betas. Even without considering the sampling error in computing time-varying factor
loadings, this approach requires that the complete set of factors be correctly specified, otherwise
the implied leverage estimates suffer from omitted variable bias. Regressions may also not ade-
quately capture abrupt changes in leverage. Other work by Brunnermeier and Pedersen (2009),
Gorton and Metrick (2009), Adrian and Shin (2010), and others, cite margin requirements, or
haircuts, as supporting evidence of time-varying leverage taken by proprietary trading desks at
investment banks and hedge funds. These margin requirements give maximum implied lever-
age, not the actual leverage that traders are using. In contrast, we analyze actual leverage ratios
of hedge funds.
Our work is related to several large literatures, some of which have risen to new prominence
with the financial crisis. First, our work is related to optimal leverage management by hedge
funds. Duffie, Wang and Wang (2008) and Dai and Sundaresan (2010) derive theoretical models
of optimal leverage in the presence of management fees, insolvency losses, and funding costs
and restrictions at the fund level. At the finance sector level, Acharya and Viswanathan (2008)
study optimal leverage in the presence of moral hazard and liquidity effects showing that due
to deleveraging, bad shocks that happen in good times are more severe. A number of au-
thors have built equilibrium models where leverage affects the entire economy. In Fostel and
Geanakoplos (1998), economy-wide equilibrium leverage rises in times of low volatility and
2
