dombrovskis

Valdis Dombrovskis, Vice-President of the EC European Union, 2019 Source: EC – Audiovisual Service

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Steffen Kern, Chief Economist, ESMA


Have you ever wondered what financial market regulators were doing with all the market data they started to collect in the wake of the financial crisis? Here’s a great example of something that has been done: statistics on the EU’s alternative investment fund market available for the first time.

Transparency on alternative funds as a post-crisis priority

Collecting data on alternative investment funds and making operational use of them has been one of the most important policy initiatives in response to the global financial crisis. In 2009, G20 leaders agreed that hedge funds or their managers should be registered and required to disclose appropriate information on an ongoing basis to supervisors or regulators.

In the EU this commitment was translated into reporting requirements under the Alternative Investment Fund Managers Directive (AIFMD). This means that since July 2014 alternative investment fund managers have reported detailed information on the alternative investment funds they manage to national market regulators.

Five years later, we are now able to produce statistics from this highly sophisticated reporting system and what emerges is a picture of a very diverse market with six crucial characteristics:

1. Wide investor choice

Investors in the EU can choose among more than 26,000 funds, including around 5,000 fund-of-funds, more than 3,000 private equity funds, more than 1,000 hedge funds and 2,600 real estate funds. Just by the numbers, this makes the EU one of the most diverse alternative investment markets in the world. Average fund size, however, stands at just $220 million, highlighting that for the alternative universe, as for investment funds in general, EU funds may not be realizing the full scale and efficiency potential of the single market.

2. More than just hedge funds

While hedge funds were the focus of the response to the crisis, the EU alternative funds universe was subsequently designed by lawmakers to be broader. It includes private equity and real estate funds, but also a large residual of

vehicles pursuing diverse strategies (mainly in bonds and equity with insurance and pension funds as the main investors). In terms of assets, hedge funds, in fact, make up only 5% of the $5.6 trillion EU alternative fund market and 80% of EU hedge funds by assets are managed in the UK. Private equity accounts for 4%, real estate for 11% and funds-of-funds for 16%.

3. Retail investors are exposed

Primarily targeted at professional investors, alternative funds can also be accessed by retail investors. The latter make up around one-fifth of the investor universe. Retail exposure to the riskier fund types, however, is more limited, with only 3% and 8% of hedge fund and private equity fund shares held by non-professionals, respectively.

4. Strong use of the EU passport

More than three-quarters of the alternative funds are registered for the EU passport, that is, they can be marketed across EU member states. Unsurprisingly, hedge funds are the exception of which more than 70% are designed for domestic investors only. The extent to which final investors in practice can and do make use of passported alternative funds is an interesting issue for future analysis.

5. Leverage is a crucial risk, but comparatively limited across the alternative investment fund landscape

Leverage remains one of the essential concerns of regulators when it comes to financial entities, including investment funds. This is why we provide ample evidence of metrics around this risk. Across all alternatives, leverage remains reassuringly limited, with a multiple of below 1.5 on average. Again, hedge funds stand out, as would be expected, with an average multiple of 45, which, however, goes down to 8 if adjusted for their use of interest-rate derivatives. In individual strategies, such as macro and relative value, the multiple can be distinctly higher.

6. Liquidity on average at acceptable levels, but uneven

Two-thirds of Alternatives in the EU are open-ended, so need to stand ready to redeem fund shares at short notice. That exposes them to liquidity risks, which is why cash cushions, fund liquidity (the ability of funds to liquidate assets in their portfolio) and investor liquidity (the ability of investors to ask for a redemption of fund share at short notice) have the full attention of supervisors. Across the Alternative universe, the liquidity profile is relatively balanced, with the exception of real estate funds given the low liquidity of their invested assets. Naturally, liquidity metrics vary widely by fund type and strategy and outliers exist at entity level.

Towards a safer investment fund market

Does all of this mean that Alternative Funds in the EU are safe? Nothing ever is, even if our first industry view may look encouraging. This is exactly why our analysis – and the massive data collection on which it is based – is vitally important. Our statistics inform fund supervisors and help them prioritise their work, for example, by identifying pockets of risks and individual outliers.

Our analysis can help supervisors to work even more effectively and make the EU investment funds market safer. This is why we need financial market data.