The impact of leverage on risk-adjusted returns

Leverage is generally considered a key ingredient of what hedge funds do.

Indeed, it is widely recognised as a distinguishing aspect of the hedge fund industry, especially because most of the headline-grabbing news, whether good or bad, comes from highly leveraged funds.
Long Term Capital Management remains the superstar in this highly competitive field, having famously posted a loss of US$4.6 billion in 1998 on the back of leverage of more than 25 to 1, or, in absolute terms, exposure of around $125 billion based on equity of around $5 billion.

In the context of risk-adjusted returns, however, there is a well-known theoretical argument that leverage cannot make a difference, and some empirical studies suggest that, as a matter of fact, it doesn’t. In this article I look briefly into what all of this might mean.

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