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.
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