Certain retail investment funds are heavily leveraged and potentially riskier than hedge funds, according to new research from European regulators.
The European Securities and Markets Authority (ESMA) published a pair of papers examining the use of leverage by alternative investment funds and mainstream funds (known as UCITS), which found that while most investment funds use some form of leverage, there are some funds with particularly large exposures.
Among other things, the research found that a subset of alt funds are “substantially leveraged” — in general, hedge funds have the highest levels of leverage, it noted.
These highly leveraged funds have, on average, increased their exposure from previous years, the research found — adding that this “calls for attention” from regulators.
At the same time, the regulators also flagged potential concerns among mainstream investment funds.
Its analysis of retail investment funds — which are tightly regulated to ensure that these funds are suitable for retail investors, and sets limits on their use of derivatives — found that about 8% of funds are using the absolute value-at-risk (VaR) approach to managing their risk, which allows the funds to use a diverse range of investment strategies and to make greater use of derivatives.
The regulators found that many of the funds using the VaR approach are bond and balanced funds with limited leverage. However, certain funds look more like hedge funds, based on their risk profiles and other characteristics, “such as complex derivative exposures with high levels of gross leverage and heightened sensitivity to market conditions.”
Specifically, the analysis found that some of these funds have gross leverage of over 400% of their net asset value.
“These funds tend to be exposed to risks related to liquidity imbalances and complexity, and some have higher risks than hedge funds,” the research found.
While this represents a small share of the overall retail investment fund universe, these funds have more assets under management than hedge funds — with €152 billion in AUM for risky retail funds versus €124 billion in hedge funds.
“The diversity of strategies and relatively fragmented manager base in the VaR… segment reflects a dynamic market but also underscores the importance of close supervisory attention to ensure risks are properly understood and managed,” ESMA said.
In particular, it said that, along with national regulators, it will “closely monitor and further analyze the risks that these funds could pose to financial stability through liquidity risks, counterparty and concentration channels.”
Other areas of concern identified in the research include the growth of leverage at already highly leveraged alt funds, the rapid growth of private equity funds (which has nearly doubled since 2020), and the potential exposure of funds-of-funds to liquidity mismatches.