Hedge Fund Leverage, Asset Liquidity, and Financial Fragility

Using newly available data on hedge fund leverage that specifies the type of leverage employed (e.g. gross or net), we examine the potential for a credit spiral and financial fragility in hedge funds. We find that funds belonging to fund families that are highly levered, have multiple prime brokers or whose holdings are illiquid have outflows that are over two times more sensitive to prior poor performance than the average hedge fund. Furthermore, negative returns predict future poor returns, and this return persistence is strongest in illiquid and highly leveraged funds. Despite the apparent risks of high leverage that we document, aggregate hedge fund leverage at the end of 2014 exceeded its pre-crisis level even though financial-sector leverage declined over the same period.