The European Securities and Markets Authority (ESMA), the EU’s financial markets regulator and supervisor, has released its annual risk assessment focused on leveraged alternative investment funds (AIFs), alongside its first analysis of risks linked to UCITS funds using the absolute Value-at-Risk (VaR) approach.
ESMA’s findings highlight that while most EU investment funds employ limited leverage, there remains a notable group of AIFs with significant leverage exposure. Furthermore, a subset of UCITS funds applying the absolute VaR method have reported exceptionally high levels of gross leverage, raising concerns about their vulnerability in volatile markets.
The detailed analysis of leveraged AIFs reveals that hedge funds exhibit the highest levels of leverage, even though they constitute only a small fraction of the overall EU fund industry.
Meanwhile, real estate (RE) funds have come under strain in certain jurisdictions, affected by declining property prices and fund outflows. Nevertheless, ESMA noted that the broader RE fund sector has shown resilience at the EU level.
Notably, ESMA’s review of GBP Liability-Driven Investment (LDI) funds, which use leverage to gain exposure to the UK government bond market, indicated that capping their interest rate risk has successfully bolstered sector resilience, and even led to a reduction in leverage for some funds.
In a new area of focus, ESMA’s analysis of UCITS funds employing the absolute VaR approach shows these funds represent approximately 8% of the UCITS market. These funds pursue a wide variety of investment strategies and frequently use derivatives to increase exposures.
Within this group, a smaller segment mirrors risk characteristics more commonly seen in hedge funds, involving complex derivative positions, elevated gross leverage, and significant sensitivity to market conditions. This particular subset, though only accounting for 2% of the UCITS market, controls a larger volume of assets than all EU hedge funds combined.
The heterogeneity of strategies and the fragmented nature of the manager base among VaR UCITS funds suggest a highly dynamic segment. However, ESMA emphasised that this also highlights the pressing need for enhanced supervisory scrutiny to ensure these risks are fully understood and effectively managed.
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