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.