Leveraged Funds and the Shadow Cost of Leverage Constraints

Abstract

Using the most comprehensive data set 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 0.53% 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 experience lower returns when the shadow cost increases earn 0.85% more per month. Overall, our shadow cost measure fits the predictions of leverage-constraint-based theories better than the widely used TED spread.