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New research from European regulators flags leverage and liquidity risks in certain segments of the alternative investment funds sector.

The European Securities and Markets Authority (ESMA) published its first-ever statistical report on the region’s alternative funds sector, finding that alt funds now make up about a third of the total fund industry, with €4.9 trillion in total assets under management (AUM). Approximately 19% of alt funds are owned by retail investors, with 81% held by institutional investors, it reports.

Overall, the alt funds market has a “relatively low risk profile,” the report says. Yet, it notes that the hedge fund segment is “highly leveraged,” primarily due to its use of derivatives, rather than direct borrowing.

While hedge funds represent only 5% of net asset value in the sector, “leverage is very high at 780% (7.8 times the NAV), particularly for some strategies highly reliant on derivatives.” As a result, measured by gross exposures, hedge funds represent 64% of alt fund assets.

The regulators also say that real estate funds represent a “significant” liquidity risk as they invest in illiquid assets while allowing investors to redeem their shares over a short time frame.

According to the report, investors can redeem up to 20% of real estate fund holdings in a given week, but funds can liquidate only 8% of their assets per week.

The ESMA says that this liquidity mismatch in real estate funds “is a concern,” particularly given the higher proportion of retail investors invested in the funds (26%).

Steven Maijoor, chair of the ESMA, says that today’s report provides the first comprehensive overview of the alt funds sector, which will support regulators’ efforts to enhance investor protection and promote stable financial markets.

“Our data analysis has highlighted some issues requiring further attention, including the issue of fund classification, while the liquidity mismatches identified in the real estate funds sector, with its important share of retail investors, indicates potential risks for investors,” he said.