The Impact of Leverage on Hedge Fund Risk and Return

Abstract

As in the case of traditional investments, hedge funds are often compared on a risk adjusted basis. Risk adjustment is of particular importance for hedge fund analysis since two funds may differ solely by leverage, such that they may differ on an absolute return basis, but be similar on a risk adjusted basis. While leverage should theoretically not affect the level of risk adjusted return within a strategy, it is possible that funds which use higher levels of leverage may in fact trade differently than funds using lower levels of leverage. In this article, the effect of leverage on hedge fund risk and return is analyzed. In brief, results are presented on the level of leverage used in various hedge fund strategies. Results are also provided on the degree to which leverage above or below the median fund leverage results in superior or inferior risk adjusted performance within a particular hedge fund strategy. Overall the results show that while different hedge fund strategies may use different amounts of leverage, within a particular hedge fund strategy, there is little evidence of a significant difference between risk adjusted performance of funds with above-median and below-median leverage.