Is leverage driving procyclical investor flows? Assessing investor behaviour in UCITS bond funds
A recent ECB study shows that leverage is an important driver in investors’ redemption decisions. Regulatory changes to the UCITS framework facilitated the use of derivatives, increasing leverage for some European mutual funds which amplified investors' responsiveness to negative returns in a procyclical manner.
The use of derivatives has increased for leveraged mutual bond funds after a change to the UCITS regulatory framework adopted in 2010. The rules adopted in 2010 established the use of the absolute Value-at-Risk (VaR) approach as regulatory limit under certain conditions. Funds opting for this approach use derivatives to increase their leverage more than other undertakings for collective investment in transferrable securities (UCITS).
Leverage amplifies the flow-performance nexus in mutual funds and thereby adds to procyclicality in the sector. Empirical evidence shows that investors in corporate bond funds and other less liquid funds respond in a procyclical manner to negative returns, suggesting heightened fragility and procyclicality during these periods. A study by Molestina Vivar et al. (2019) documents the effect of leverage on the flow-performance nexus for UCITS bond funds. The study finds that investors in leveraged funds react more strongly to past negative performance compared with investors in unleveraged funds.
2 Leverage restrictions under the UCITS Directive
UCITS funds generally employ traditional investment strategies with low leverage. They typically invest in marketable securities and have to comply with leverage restrictions under the UCITS Directive. Financial leverage, meaning leverage obtained through outright borrowings, is limited to 10% of net asset value and can be carried out only on a temporary basis. Furthermore, “global exposures” gained through the use of derivatives are restricted to 100% of net asset value, de facto limiting synthetic leverage in UCITS.
EU Member States may allow fund managers to use one of three regulatory limits taking into account the fund’s investment strategy and its use of derivatives. According to Commission Directive 2010/43/EU, adopted in July 2010, EU Member States may allow UCITS management companies to calculate global exposure by using the commitment approach, the relative VaR approach or the absolute VaR approach. The decision regarding the exposure limit should take into account the fund’s investment strategy and its use of derivatives.
The absolute VaR approach generally allows a higher use of derivatives and leverage compared with the other regulatory approaches. Whereas the other two approaches aim to curtail the gearing effect of leverage, the absolute VaR limit is a risk-based measure that does not measure leverage per se. It limits the maximum potential return loss to 20% of net asset value under normal market conditions, irrespective of the level of leverage. Consequently, depending on the type of derivatives and the volatility of the underlying assets, the absolute VaR limit allows a higher use of derivatives and leverage relative to alternative approaches.
3 Empirical findings
After the adoption of the Commission Directive in July 2010, the use of derivatives increased for leveraged funds, including alternative UCITS often referred to as “Newcits”. Chart 1 plots derivative exposures as a share of total portfolio value over time for UCITS bond funds that were leveraged and unleveraged before July 2010. While the use of derivatives remained relatively stable for unleveraged funds, it increased for leveraged funds after the regulatory change. This increase in the use of derivatives for some UCITS funds is in line with media and industry reports describing the rise of alternative UCITS. These include leveraged UCITS funds that invest in derivative instruments increasing synthetic exposures.
Use of derivatives for leveraged and unleveraged bond funds before and after the regulatory change
(y-axis: derivative exposures as share of total portfolio value; x-axis: year)
Source: Authors’ calculations based on Lipper IM (Thomson Reuters).
Notes: This chart shows the derivative exposures as a share of the total portfolio value for UCITS bond funds that were leveraged before July 2010 (blue line) and funds that were unleveraged in all periods before July 2010 (yellow line). The vertical line represents the adoption of Commission Directive 2010/43/EU. The full sample includes 5,227 unique fund share-classes from 2,032 actively managed unique UCITS funds between January 2007 and August 2018 (see Molestina Vivar et al., 2019).
Since the regulatory change, investors in leveraged funds reacted more strongly to negative returns compared with investors in unleveraged funds. Chart 2 shows the flow-performance relationship over time for funds that were leveraged and unleveraged before July 2010. Before the regulatory change, both groups moved largely in parallel. Afterwards, however, investors in leveraged funds reacted more strongly to negative returns than investors in unleveraged funds. This finding is confirmed in a difference-in-differences framework, suggesting that the change to the UCITS framework increased investors' sensitivity to negative returns for leveraged funds.
Flow-performance relationship for leveraged and unleveraged funds before and after the regulatory change
(y-axis: flow-performance sensitivity; x-axis: year)
Source: Authors’ calculations based on Lipper IM (Thomson Reuters).
Notes: This figure plots the flow-performance sensitivities using rolling-window estimates for UCITS bond funds that were leveraged before July 2010 (blue line) and UCITS bond funds that were unleveraged in all periods before July 2010 (yellow line). The first vertical line marks the adoption of Commission Directive 2010/43/EU (July 2010), while from the second vertical line onwards (January 2013) the rolling window estimates are based on post-Directive observations only. Controls include lagged flows, funds’ total net assets, age, cash holdings, total expense ratio, load costs and past year’s return volatility (see Molestina Vivar et al., 2019).
Leverage is used more by absolute VaR funds compared with other UCITS funds, while their investors react more strongly to negative returns. Table 1 compares leverage and the flow-performance relationship between absolute VaR funds and other UCITS funds following either the commitment approach or the relative VaR limit. Absolute VaR funds use leverage more than other UCITS funds, in particular through derivatives (see rows 1‑3). Furthermore, investors in absolute VaR funds react more procyclically to negative returns than investors in other UCITS funds (row 5), although this is not the case for positive returns (row 4).
Absolute VaR funds in comparison to other UCITS funds
(sample means; regression coefficients)
Sources: Authors’ calculations based on Lipper IM (Thomson Reuters). The regulatory limits are hand-collected from funds’ investor prospectuses.
Notes: This table shows (i) the means of leverage dummy variables and (ii) the flow-performance coefficients for the group of funds using the absolute VaR approach, compared with the remaining UCITS funds using alternative regulatory approaches. The first three rows show the dummy means, indicating whether a fund uses leverage according to the respective definition or not. “Leveraged” funds have either financial or synthetic leverage. The variable for “financially leveraged” is taken from the Lipper IM database. “Synthetically leveraged” captures those funds holding derivatives positions that are not used for hedging purposes and with an average CAPM Beta above one. The last two rows show coefficient estimates from a flow-performance model indicating sensitivities of flows after positive and negative returns respectively (see Molestina Vivar et al., 2019). Asterisks denote standard statistical significance (* p < 0.1, ** p < 0.05, *** p < 0.01).
Leverage is an important driver in investors’ redemption decisions, suggesting greater outflows for leveraged funds after negative fund performance. Chart 3 plots the relationship between past fund returns and investor flows in UCITS bond funds, based on a semiparametric regression model. While the flow-performance relationship is similar after positive returns, outflows are larger for leveraged funds than for unleveraged funds following negative returns. This result is confirmed in a linear flow-performance regression model, controlling among other variables for fund and time-fixed effects. Corroborating evidence is provided showing that additional security sales from fund managers in leveraged funds increase negative externalities among investors during stressed periods. This may explain investors’ increased sensitivity in leveraged funds to negative fund performance.
Flow-performance relationship for leveraged and unleveraged UCITS bond funds
(y-axis: net flows as percent of lagged total assets; x-axis: lagged relative return, in percentage points)
Source: Authors’ calculations based on Lipper IM (Thomson Reuters).
Notes: This figure plots the semiparametric relationship between net flows as a percentage of a fund’s lagged total net assets (y-axis) and lagged fund returns, relative to the fund’s benchmark returns, in percentage points (x-axis) based on Robinson (1988), for leveraged and unleveraged UCITS bond funds. The sample includes 5,227 unique fund share-classes from 2,032 actively managed unique funds between January 2007 and August 2018. Controls include lagged flows, funds’ total net assets, total expense ratio, load costs and past year’s return volatility (see Molestina Vivar, Wedow and Weistroffer, 2019). The blue (yellow) line represents the semiparametric function for leveraged (unleveraged) funds and the corresponding dotted lines represent the 90% confidence intervals.
The findings presented in this article provide evidence that leverage amplifies the flow-performance nexus after negative fund returns. A change in the UCITS framework in July 2010 facilitated the use of derivatives, increasing leverage for some bond funds. Investors in leveraged funds react more strongly to negative past performance than investors in unleveraged funds, suggesting greater outflows for leveraged funds during these periods. Leverage in UCITS funds thus adds to procyclicality and can amplify fragilities in the sector.
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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