Homemade Leverage

Abstract

If investors are rational, firms and fund managers should not worry about the degree of their leverage or investment in the riskless asset? investors can always increase or reduce leverage by borrowing or lending themselves, thus creating their own so-called homemade leverage. The CAPM, the Sharpe ratio, and the Modigliani-Miller theory of capital structure rely on this idea. But are investors capable of effectively employing homemade leverage in their decision-making? When financial practitioners and management students are asked to choose one of several funds that they can mix with a risk-free asset, almost half of them fail to integrate the cash flows from the risky asset and the risk-free asset, and thus choose very inefficient portfolios. When they can choose from mixed funds, which perform the cash flow integration for the subjects, efficient choices are made 98% of the time. Clearly fund managers should carefully consider their funds' leverage; capital structure may influence firm values by virtue of a clientele effect.