This paper examines how leverage affects asset prices via delegated portfolio management. We develop a stylized model in which a hedge fund raises capital from investors in order to benefit from its leverage advantage in the spirit of Berk and Green (2004). Deteriorating funding conditions tighten hedge fund leverage and induce the fund to invest more in high-beta stocks so that hedge fund holding betas reflect the tightness (and thus the shadow price) of leverage in equilibrium. Consistent with the model, we observe that: 1) hedge funds with top-quintile asset-implied leverage reap 38% more economic rents (fees) than bottom-quintile funds, 2) hedge funds simultaneously adjust leverage and holding beta during adverse funding conditions (proxied by recent poor performance), and 3) a leverage-tightness factor constructed from hedge fund holding betas can significantly predict the cross-section of asset returns. Its prediction power goes beyond traditional factors (including mutual fund holding betas) and concentrates in periods with hedge fund leverage reductions. Our results suggest that the leverage choice of hedge funds plays a fundamental role in delegated portfolio management and asset pricing.
