29 October 2019

ECB: Is leverage driving procyclical investor flows? Assessing investor behaviour in UCITS bond funds

Leverage may have played a role in amplifying outflows in some recent cases where UCITS funds faced substantive liquidity mismatches. Between July 2018 and June 2019, sixteen mutual funds held by three asset managers under the UCITS Directive experienced significant investor outflows after a deterioration in portfolio liquidity.

In these cases, poor past performance in combination with illiquid asset holdings prompted investors to withdraw their money, which resulted in almost bank-like runs. Although the extent to which derivatives and leverage played a role in the outflows is unclear, it is noteworthy that at least fourteen of the sixteen funds involved were leveraged UCITS funds and used the absolute VaR approach as a regulatory limit.

While the UCITS framework has contributed to the growth of the investment fund sector, possible regulatory shortcomings regarding the use of leverage may need to be further addressed. The UCITS framework has successfully contributed to the widespread expansion of investment funds as one of the main investment vehicles in Europe.

Considering the findings presented and the corroborating evidence provided by the recent investor turmoil, leverage can however amplify procyclicality and fragilities in the UCITS bond fund sector. From a financial stability perspective, it is important to investigate how leverage interacts with other factors that can add to negative externalities, such as fund illiquidity or certain investor types.

In this regard, regulatory exposure limits, in particular the use of the absolute VaR, may need to be reviewed. More generally, rules regarding fund leverage should also take into account other risk factors, including possible liquidity mismatches to ensure the sector’s resilience in a stress scenario.

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